UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




Form 10-K


(Mark
                One)þ
            
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF 1934For
                the fiscal year ended December 30, 2007ORo
            
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF 1934For
                the transition period
                from          to




Commission
      File Number 001-33196




Isilon
      Systems,
      Inc.


(Exact
      name of registrant as specified in its charter)


Delaware
            
            91-2101027(State
                or other jurisdiction of
            
            (IRS
                Employerincorporation
                or organization)
            
            Identification
                No.)3101 Western
                Ave
              Seattle,
                WA
              (Address
                of principal executive offices)
            
            98121
              (Zip
                code)




Registrant’s
      telephone number, including area code:


206-315-7500




Securities
      registered pursuant to Section 12(b) of the Act:


Title
                  of Each Class
            
            Name
                  of Exchange on Which RegisteredCommon
                Stock, par value $0.00001 per share
            
            The
                Nasdaq Stock Market LLC




Securities
      registered pursuant to Section 12(g) of the Act:


None




Indicate
      by check mark whether the registrant is a well-known seasoned issuer, as defined
      in Rule 405 of the Securities Act.  Yes o     No þ




Indicate
      by check mark whether the registrant is not required to file reports pursuant
      to
      Section 13 or Section 15(d) of the Act.  Yes o     No þ




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 þ   No o




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 the 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.  o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting
      company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
      Exchange Act.


Large
                  accelerated filer o
              Accelerated
                  filer þ
              Non-accelerated
                  filer o
              Smaller
                  reporting company o


Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Act).  Yes o     No þ




The
      aggregate market value of the voting and non-voting common stock held by
      non-affiliates of the registrant as of the last business day of the registrant’s
      most recently completed second fiscal quarter was $352,503,088. Shares of
      voting stock held by each officer and director and by each person who, to the
      registrant’s knowledge, owns 5% or more of the outstanding voting stock (as
      publicly reported by such persons pursuant to Section 13 and
      Section 16 of the Securities Exchange Act of 1934) have been excluded
      in that such persons may be deemed to be affiliates of the registrant. This
      determination of affiliate status is not necessarily a conclusive determination
      for other purposes.




As
      of
      March 17, 2008, 62,918,671 shares of the registrant’s Common Stock were
      outstanding.




DOCUMENTS
      INCORPORATED BY REFERENCE




Part III
      incorporates certain information by reference from the definitive proxy
      statement for the Annual Meeting of Stockholders scheduled for May 14,
      2008.







1





TABLE
      OF CONTENTS




Part IItem 1.
              Business
              5Item 1A.
              Risk
                  Factors
              18Item 1B.
              Unresolved
                  Staff Comments
              29Item 2.
              Properties
              29Item 3.
              Legal
                  Proceedings
              29Item 4.
              Submission
                  of Matters to a Vote of Security
                  Holders
              30Part IIItem 5.
              Market
                  for Registrant’s Common Equity, Related Stockholder
                  Matters and Issuer Purchases of Equity Securities
              31Item 6.
              Selected
                  Financial Data
              33Item 7.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              35Item 7A.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              50Item 8.
              Financial
                  Statements and Supplementary
                  Data
              51Item 9.
              Changes
                  in and Disagreements with Accountants on Accounting
                  and Financial Disclosure
              77Item 9A.
              Controls
                  and Procedures
              77Item 9B.
              Other
                  Information
              78Part IIIItem 10.
              Directors
                  and Executive Officers of the
                  Registrant
              79Item 11.
              Executive
                  Compensation
              79Item 12.
              Security
                  Ownership of Certain Beneficial Owners and
                  Management and Related Stockholder Matters
              79Item 13.
              Certain
                  Relationships and Related
                  Transactions
              79Item 14.
              Principal
                  Accounting Fees and Services
              79Part IVItem 15.
              Exhibits
                  and Financial Statement
                  Schedules
              79Signatures
              
              81EXHIBIT
                  23.1EXHIBIT
                  31.1EXHIBIT
                  31.2EXHIBIT
                  32.1EXHIBIT
                  32.2




2
 Table
            of Contents




EXPLANATORY
      NOTE






In
      this
      Annual Report on Form 10-K, or this Form 10-K, Isilon
      Systems, Inc., or the Company, is restating its consolidated financial
      statements and information for the following fiscal periods: (i) the fiscal
      year ended December 31, 2006; and (ii) the quarterly periods
      ended April 1 and July 1, 2007 and selected financial data and certain financial
      data in management’s discussion and analysis.  This Form 10-K
      also includes the Company’s consolidated financial statements as of and for the
      fiscal year ended December 30, 2007.




Contemporaneously
      with the filing of this Form 10-K, the Company is also filing with the
      Securities and Exchange Commission, or SEC, its Quarterly Report on
      Form 10-Q for the quarterly period ended September 30,
      2007.




Unless
      the context otherwise requires, references in this Form 10-K to "Isilon
      Systems," "the Company," "we," "us," or "our" refer to Isilon
      Systems, Inc., and its consolidated subsidiaries, unless the context
      otherwise dictates.




Restatement
      of Consolidated Financial
      Statements




On
      February 29, 2008, we announced that our Board of Directors, based upon the
      recommendation of the Audit Committee, determined that we should restate our
      financial statements for the fiscal year ended December 31, 2006, and for the
      first and second quarters of fiscal 2007, ended April 1, 2007 and July 1, 2007,
      respectively, as a result of errors in those financial statements.  As
      announced on November 8, 2007, our Audit Committee, assisted by independent
      forensic accountants and legal advisors, has been conducting an independent
      investigation of certain of our sales to resellers and other customers to
      determine whether commitments were made that have an impact on the timing and
      treatment of revenue recognition, and whether our internal controls relating
      to
      revenue recognition are sufficient.




Unless
      otherwise indicated, all financial information in this Form 10-K gives
      effect to the restatement. Information regarding the effect of the restatement
      on our financial position and results of operations is provided in Notes 3
      and 13(unaudited) of the Notes to Consolidated Financial Statements and Item
      6
      "Selected Financial Data". Our consolidated financial statements and the related
      notes appear beginning on page 51 within Item 8 of this
      Form 10-K.




Background
      of the Restatement




In
      late
      October 2007, as part of our finance department’s efforts to monitor our
      outstanding accounts receivable, our recently appointed Chief Financial Officer
      identified concerns regarding the recognition of revenue for certain sales
      to
      resellers and other customers.  These concerns were promptly
      communicated to the Chairman of the Audit Committee.  After receiving
      additional information from our Chief Financial Officer, on November 4, 2007,
      the Audit Committee decided to conduct an independent investigation of the
      issues identified by management and the Board of Directors concurred in that
      decision.  The Audit Committee subsequently retained independent legal
      counsel, Heller Ehrman LLP,  and independent forensic accounting
      experts, Huron Consulting Group, to assist in the investigation.




The
      Audit
      Committee and its advisors investigated certain sales to resellers and other
      customers to determine whether commitments were made that have an impact on
      the
      timing and treatment of revenue recognition and whether our internal controls
      related to revenue recognition were sufficient. The Audit Committee and its
      advisors also considered risk areas other than revenue recognition.




The
      investigation focused on revenue recorded in fiscal 2006 and the first three
      quarters of fiscal 2007.  During the course of the investigation, the
      Audit Committee and its advisors collected and reviewed more
      than 80,000 pages of hard copy documents from individual custodians,
      department files and central files, and also collected and searched more
      than 166 gigabytes of electronically stored information.  The
      Audit Committee and its advisors conducted more than 40 interviews of current
      and former employees and customers.  The information obtained through
      this investigation was analyzed in conjunction with accounts receivable aging
      reports, credit memos, return materials authorizations, evaluation agreements,
      sales return reserves, bad debt write-offs, and reserves for bad
      debts.    From this and other information, specific
      transactions were identified and tested for compliance with our revenue
      recognition policies.  Testing procedures included review of customer
      contracts, customer correspondence and emails, sales quotes, customer purchase
      orders, shipping documentation, invoices, and cash receipts.




On
      February 29, 2008, the Audit Committee presented its findings and
      recommendations to the Board of Directors, which are summarized below. Based
      on
      the Audit Committee’s recommendation, our Board of Directors concluded that as a
      result of the errors indentified, we should restate our financial statements
      for
      fiscal year 2006 and the first and second quarters of 2007, and that our
      previously filed financial statements for these periods should not be relied
      on.
      On February 29, 2008, we issued a press release announcing the restatement
      and
      non-reliance on our previously published financial information for those
      periods, and we filed a Current Report on Form 8-K with the SEC disclosing
      equivalent information.




On
      April 2, 2008, we filed this Form 10-K and our Quarterly Report on
      Form 10-Q for the quarter ended September 30, 2007. We also issued a press
      release and filed a Current Report on Form 8-K to announce the final
      restated financial information and conclusions of our Audit Committee's
      investigation.  In our Quarterly Report on Form 10-Q for the
      period-end September 30, 2007, we determined that our disclosure controls
      and procedures were ineffective.  Our Chief Executive Officer and
      Chief Financial Officer have concluded that the material weakness has been
      remediated and that our internal control over financial reporting was effective
      as of December 30, 2007.





3
 Table
            of Contents




Audit
      Committee Findings and Recommendations




Our
      Audit
      Committee determined that revenue was recognized prematurely on certain
      transactions and that revenue should not have been recognized on certain
      transactions.  Specifically, the following principal errors were
      identified:




Fourth
      Quarter Fiscal Year 2006




·
            A
                  single transaction with a reseller was identified for $1.1 million
                  where a
                  contingency related to the qualification of the product performing
                  to
                  certain specifications in the identified end user network existed
                  at the
                  time of sale. This qualification was not communicated to legal
                  and finance
                  personnel or the Company's independent registered public accounting
                  firm in order to facilitate a proper evaluation of the transaction
                  for revenue recognition purposes. The reseller paid for only a
                  portion of
                  the original transaction and the Company has since negotiated a
                  return for
                  the remaining product.




First
      and
      Second Quarters of Fiscal Year 2007




·
            In
                the first quarter of 2007, we recognized revenue in a transaction
                with a
                customer that included a commitment from us to acquire software from
                the
                customer. Based upon facts discovered during the investigation, we
                have
                now concluded that the end-user did not have the ability or intent to
                pay and revenue recognition was inconsistent with the accounting
                rules applicable to reciprocal sales
                transactions.




·
            In
                the first and second quarters of fiscal 2007, transactions with resellers
                were identified where the timing of revenue recognition was
                improper.  In certain instances, revenue was recognized when
                persuasive evidence of an end-user did not exist, when oral arrangements
                existed that would have precluded revenue recognition, or when resellers
                did not have the ability or intent to pay independent of payment
                by the
                end-user customer. Revenue from these transactions was adjusted and
                will
                only be recognized upon sell-through of the product to end-users
                and when
                collection is reasonably assured and all other criteria for the
                recognition of revenue are met.




·
            We
                originally recognized revenue in the second quarter of 2007 on a
                sale
                directly to an end-user customer for which the terms and conditions
                were
                not fixed or determinable. This revenue has now been recognized in
                the
                fourth quarter of 2007 when the terms became fixed or determinable
                and all
                other criteria for the recognition of revenue were
                met.




Summary
      of the Restatement Adjustments




The
      following tables summarize the impact of the restatement on our financial
      statements for the fourth quarter and year ended December 31, 2006 and
      the three months ended April 1, 2007 and three and six
      months ended July 1, 2007. Selected information about the impact of the
      restatement on our quarterly periods is provided in Note 13(unaudited)
      to our consolidated financial statements.




Three Months Ended
                
                
                Year EndedDecember 31, 2006
                
                
                December 31, 2006As previously
                  reported
                
                
                Adjustments
                
                
                As restated
                
                
                As previously
                  reported
                
                
                Adjustments
                
                
                As restatedStatement
                    of Operations
                
                (in
                  thousands, except per share data)
                
                
                (in
                  thousands, except per share data)Total
                    revenue
                
                $
                20,656
                
                
                $
                (1,073
                )
                
                $
                19,583
                
                
                $
                62,279
                
                
                $
                (1,073
                )
                
                $
                61,206Total
                    cost of revenue
                
                
                9,468
                
                
                
                (523
                )
                
                
                8,945
                
                
                
                29,331
                
                
                
                (523
                )
                
                
                28,808Total
                    operating expenses
                
                
                14,076
                
                
                
                —
                
                
                
                14,076
                
                
                
                48,325
                
                
                
                —
                
                
                
                48,325Loss
                    from operations
                
                
                (2,888
                )
                
                
                (550
                )
                
                
                (3,438
                )
                
                
                (15,377
                )
                
                
                (550
                )
                
                
                (15,927
                )Net
                    loss
                
                
                (10,409
                )
                
                
                (550
                )
                
                
                (10,959
                )
                
                
                (25,438
                )
                
                
                (550
                )
                
                
                (25,988
                )Net
                    loss per common share, basic and diluted
                
                $
                (0.72
                )
                
                $
                (0.03
                )
                
                $
                (0.75
                )
                
                $
                (3.02
                )
                
                $
                (0.07
                )
                
                $
                (3.09
                )




4
 Table
            of Contents




Three Months Ended
              
              
              Three Months EndedApril 1, 2007
              
              
              July 1, 2007As previously
                reported
              
              
              Adjustments
              
              
              As restated
              
              
              As previously
                reported
              
              
              Adjustments
              
              
              As restatedStatement
                  of Operations
              
              (in
                thousands, except per share data)
              
              
              (in
                thousands, except per share data)Total
                  revenue
              
              $
              21,607
              
              
              $
              (3,761
              )
              
              $
              17,846
              
              
              $
              25,116
              
              
              $
              (2,205
              )
              
              $
              22,911Total
                  cost of revenue
              
              
              9,837
              
              
              
              (569
              )
              
              
              9,268
              
              
              
              11,999
              
              
              
              (691
              )
              
              
              11,308Total
                  operating expenses
              
              
              16,645
              
              
              
              (86
              )
              
              
              16,559
              
              
              
              17,869
              
              
              
              (113
              )
              
              
              17,756Loss
                  from operations
              
              
              (4,875
              )
              
              
              (3,106
              )
              
              
              (7,981
              )
              
              
              (4,752
              )
              
              
              (1,401
              )
              
              
              (6,153
              )Net
                  loss
              
              
              (3,750
              )
              
              
              (3,106
              )
              
              
              (6,856
              )
              
              
              (3,621
              )
              
              
              (1,401
              )
              
              
              (5,022
              )Net
                  loss per common share, basic and diluted
              
              $
              (0.06
              )
              
              $
              (0.05
              )
              
              $
              (0.11
              )
              
              $
              (0.06
              )
              
              $
              (0.02
              )
              
              $
              (0.08
              )
   Six Months EndedJuly 1, 2007As previously
                reported
              
              
              Adjustments
              
              
              As restatedStatement
                  of Operations
              
              (in
                thousands, except per share data)Total
                  revenue
              
              $
              46,723
              
              
              $
              (5,966
              )
              
              $
              40,757Total
                  cost of revenue
              
              
              21,836
              
              
              
              (1,260
              )
              
              
              20,576Total
                  operating expenses
              
              
              34,514
              
              
              
              (199
              )
              
              
              34,315Loss
                  from operations
              
              
              (9,627
              )
              
              
              (4,507
              )
              
              
              (14,134
              )Net
                  loss
              
              
              (7,371
              )
              
              
              (4,507
              )
              
              
              (11,878
              )Net
                  loss per common share, basic and diluted
              
              $
              (0.12
              )
              
              $
              (0.07
              )
              
              $
              (0.19
              )




Our
      Audit
      Committee determined that no senior executives currently employed by the Company
      engaged in any improper practices or are otherwise responsible for improper
      revenue recognition.  The Audit Committee determined that no sales
      personnel currently employed by the Company directly participated in negotiating
      oral side arrangements or reciprocal sales transactions, though several sales
      personnel appear to have been aware of such transactions.  The Audit
      Committee found evidence that our former Chief Executive Officer, former Chief
      Financial Officer, and former Vice President of North America Sales participated
      directly in certain of the transactions for which adjustments are being
      recorded, but the Audit Committee concluded that the evidence about their roles,
      knowledge and intent is conflicting, disputed, and
      ultimately inconclusive.




As
      further discussed in Part II, Item 9A of this Form 10-K under the
      caption "Controls and Procedures," during the course of its investigation,
      our
      Audit Committee identified internal control deficiencies relating primarily
      to the failure to communicate complete information regarding certain sales
      transactions containing non-standard terms among sales, finance, accounting,
      legal and members of senior management and an ineffective risk assessment
      process.




As
      a
      result of its investigation, our Audit Committee has made recommendations to
      the
      Board of Directors and management and those recommendations have been
      approved.  These recommendations include: (i) the Board and senior
      management to consider possible remedial actions for any of our remaining
      personnel who may have been aware or involved in the subject transactions;
      (ii)
      expanding and clarifying our revenue recognition policy; (iii) conducting
      enhanced revenue recognition training for all sales, sales operations and
      accounting personnel as soon as practicable, instituting enhanced revenue
      recognition training for all new sales and sales operations personnel, and
      instituting enhanced annual revenue recognition training for all sales and
      sales
      operations personnel; (iv) documenting and communicating in writing to our
      sales
      force clearly stated revenue recognition policies; and (v) management, working
      with the Audit Committee, to further document our revenue recognition policy
      and
      further develop related procedures and controls to enhance and improve
      transaction related communications throughout our business.




In
      addition, with the concurrence of the Audit Committee, we have modified certain
      policies and procedures in an effort to avoid a recurrence of the issues that
      caused this restatement, including: (i) requiring documented evidence of
      sell-through for all sales transactions with certain resellers prior to
      revenue recognition; (ii) enhancing our process of requiring quarterly
      certifications by our sales force to note that they have disclosed all
      non-standard terms and conditions; (iii) revising our sales commission structure
      to defer commissions on transactions that include non-standard terms and
      conditions; and (iv) implementing enhanced processes to assess the
      creditworthiness of customers.




In
      our
      Quarterly Report on Form 10-Q for the period ended September 30, 2007, our
      Chief Executive Officer and our Chief Financial Officer determined that our
      internal control over financial reporting was not effective to provide
      reasonable assurance regarding the reliability of our financial reporting and
      the preparation of our consolidated financial statements for external purposes
      in accordance with generally accepted accounting principles in the United
      States. As of December 30, 2007, the material weakness in our internal control
      over financial reporting has been remediated.





Special
      Note Regarding Forward-Looking Statements




We
      have made forward-looking statements in this document, all of which are subject
      to risks and uncertainties. When we use words such as “may”, “anticipate,”
“expect,” “intend,” “plan,” “believe,” “seek,” and “estimate” or similar words,
      we are making forward-looking statements. Forward-looking statements include
      information concerning our possible or assumed future business success or
      financial results. These forward-looking statements include, but are not limited
      to statements regarding: our
      competitive environment; the
      anticipated growth of digital
      content; the
      expected demand for and benefits
      of our storage products; our
      future business plans and growth
      strategy; our
      ability to improve existing
      products and to develop new and future products; our
      anticipated revenue and
      expenses; our
      ability to add value-added
      resellers and distributors and to sell our products internationally; our
      ability to realize operating
      leverage and realize efficiencies in our sales model by leveraging partners
      and
      selling to existing customers; anticipated
      results of potential or
      actual litigation; statements relating to our financial restatement and the
      remediation of our internal controls; the
      anticipated sufficiency of our
      current office space and ability to find additional space as needed; anticipated
      development or
      acquisition of intellectual property and resulting benefits; expected
      impacts of changes in
      accounting rules, including the impact on deferred tax benefits; the
      impact of governmental
      regulation; employee
      hiring and retention,
      including anticipated reductions in force and headcount; the
      future payment of dividends; use
      of cash, cash needs and ability
      to raise capital; potential
      liability from contractual
      relationships . 
Our
      actual results could
      differ materially from those anticipated in these forward-looking statements
      for
      many reasons, including the risks faced by us and described in Part I, Item
      1A.
      of this Annual Report on Form 10-K.


On
      December 12,
      2006, we effected a 1-for-2.4 reverse split of our issued and outstanding common
      stock. Historical share numbers and prices throughout this report on
      Form 10-K are split-adjusted.




In
      this report, “Isilon Systems,” “the company,” “we,” “us,” and “our” refer to
      Isilon Sytems, Inc., and its consolidated subsidiaries, unless the context
      otherwise dictates.







5
 Table
            of Contents




I **TE** M 1.Business




Overview




We
      provide clustered storage systems for digital content, which includes video,
      audio, digital images, computer models, PDF files, scanned images, reference
      information, test and simulation data, and other unstructured data. We designed
      and developed our clustered storage systems specifically to address the needs
      of
      storing and managing digital content. Our systems are comprised of three or
      more
      nodes. Each node is a self-contained, rack-mountable device that contains
      industry standard hardware, including disk drives, a central processing unit,
      or
      CPU, memory chips and network interfaces, and is integrated with our proprietary
      OneFS® operating system software, which unifies a cluster of nodes into a single
      shared resource. Through the end of fiscal 2007, we have sold our clustered
      storage systems to more than 675 customers across a wide range of industries.
      We
      sell our products indirectly through a channel partner program that includes
      more than 150 value-added resellers and distributors, and directly through
      our
      field sales force.





We
        were
        incorporated in the State of Delaware on January 24, 2001.  Our
        principal corporate offices are located in Seattle, Washington.  Our
        corporate Internet address is www.isilon.com.  At the Investor
        Relations section of this website, we make available free of charge our Annual
        Report on Form 10-K, our Annual Proxy statement, our quarterly reports on
        Form
        10-Q, any Current Reports on Form 8-K, and any amendments to these reports,
        as
        soon as reasonably practicable after we electronically file them with, or
        furnish them to, the Securities and Exchange Commission, or the
        SEC.  The information found on our website is not part of this Form
        10-K.  In addition to our website, the SEC maintains an Internet site
        at www.sec.gov that contains reports, proxy and information statements, and
        other information regarding us and other issuers that file electronically
        with
        the SEC.





Industry
        Background
  Proliferation
        of Digital Content
  Information
        is increasingly recorded and communicated in images and pictures rather than
        text and words. This trend is resulting in the creation of innovative new
        applications in computer processing, digital imaging, video, satellite imagery,
        Internet services, business analysis, and visualization displays, modeling
        and
        simulation. These new applications, combined with higher levels of digital
        resolution and the adoption of high-bandwidth communication networks, are
        driving the widespread proliferation of digital content. As more business
        and
        consumer activities create and utilize digital content, the need for ways
        to
        store, manage and access this information is growing rapidly.




While
      the
      worldwide market for external disk storage systems is expected to grow at a
      steady rate from 2005 to 2010, the market for storage solutions dedicated to
      digital content is estimated to grow at a much faster rate. Certain industries
      including multimedia, oil and gas, scientific research, healthcare, personal
      Internet services and software development are expected to experience rapid
      growth in file-based storage capacity. For example, in disk-based digital
      archiving, which is one portion of the market our systems address, demand for
      storage capacity is estimated to grow from 377 petabytes in 2005 to nearly
      11,000 petabytes in 2010, representing a 96% compound annual growth rate, with
      the substantial majority of this stored information comprised of unstructured
      content, such as office documents, web pages, digital images and audio and
      video
      files.





Widespread
      and Increasing Use of Digital Content




The
      growth of digital content is fundamentally changing business processes and
      creating new market opportunities across a wide range of industries. Enterprises
      are utilizing digital content to create new products and services, generate
      new
      revenue streams, accelerate research and development cycles, and improve their
      overall competitiveness. As a result, digital content has become a critical
      economic asset in many industries. Industries that are being transformed by
      the
      proliferation of digital content include:





·
            Media
                and
                Entertainment.Digitization
                of production and delivery of content in the media and entertainment
                industry is driving significant increases in data storage and access
                requirements. Examples include the emergence of high-definition
                television, new digital video standards like Sony Blu-Ray, streaming
                media
                formats for online delivery of content and new high-resolution digital
                images used in movie production. As these and similar formats proliferate
                and the media industry moves towards an all-digital workflow that
                includes
                the creation, management, delivery and archiving of television programs,
                music, films and publishing materials, digital content storage
                requirements will continue to grow. In movie production, for example,
                ten
                seconds of high-resolution digital footage can require as many as
                12
                gigabytes of storage, and in the publishing industry, sophisticated
                digital cameras can take up to eight photos per second, each of which
                can
                create an image file of up to
                20 megabytes.





·
            Internet.Internet
                users upload and download millions of digital images, digital videos,
                music, documents and other web-based content daily. In addition,
                businesses that rely on the Internet as a distribution channel for
                their
                products or services often must accommodate millions of concurrent
                users
                accessing data, deliver 24x7x365 online availability, manage rapidly
                expanding amounts of digital content, and provide aggregate data
                throughput of multiple gigabytes per
                second.




·
            Cable
                and
                Telecommunications.  Cable, telecommunications and
                satellite television providers are seeking to offer consumers a “triple
                play” of video, voice and data services in a single bundled offering. In
                particular, the build-out of video-on-demand services has required
                and
                will continue to require many centralized and distributed storage
                systems
                to keep pace with the availability and distribution of new content,
                including DVD movies, on-demand digital television programming and
                digital
                music.





·
            Oil
                and
                Gas.  As the demand for and price of oil and natural gas
                increase, energy companies are investing in innovative exploration
                and
                development technologies to find new reserves and to extract more
                from
                existing reserves. New geo-seismic imaging applications process raw
                seismic data into two- and three-dimensional images, creating
                multidimensional visualization models that can result in the creation
                of
                data files exceeding one terabyte and total data stores ranging in
                size
                from hundreds of terabytes to tens of
                petabytes.





·
            Life
                Sciences.  Research and development in the life sciences
                and drug discovery fields are increasingly characterized by
                statistically-driven, information-based analyses using proteomic,
                genomic
                and DNA sequencing data. In addition, new digital microscopes can
                capture
                digital images with digital resolutions as high as 18 megapixels
                and
                three-dimensional display capability. As a result, life sciences
                professionals are storing, retrieving and analyzing increasingly
                large
                amounts of digital content. For instance, in the area of cancer research,
                an image of a single drop of blood analyzed by a mass spectrometer
                can
                create more than 60 gigabytes of data. As scientists build
                statistically significant sample sizes for research projects, they
                can
                collect tens of thousands and, ultimately, millions of patient data
                files
                in the form of digital content.





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·
            Manufacturing.New
                testing
                and digital simulation technologies used to enhance manufacturing
                processes are creating significant amounts of digital content and
                require
                high-performance storage systems. In some manufacturing applications,
                test
                instruments capture, write and analyze more than 100,000 data samples
                per
                second. In addition, as manufacturers increasingly incorporate digital
                design and automation technology into their workflows, they are creating
                a
                large number of files containing digital
                content.





·
            Federal
                Government.Advances
                in
                defense and intelligence technologies, such as the capture and analysis
                of
                high-resolution satellite images, digital video and audio feeds,
                and
                digital imaging, are fueling increased demand for storage capacity
                from
                the federal government. Defense initiatives, such as the use of unmanned
                aircraft and vehicles, rely on very large, high-resolution topographical
                maps, while civilian initiatives, such as hurricane and weather modeling,
                document scanning, and public health services, create large files
                and
                require large data stores.







Storage
      Challenges for Digital Content




Traditional
      storage system architectures were primarily designed for structured data
      applications such as transaction processing, email, accounting, databases and
      other front- and back-office business systems. Today, these traditional storage
      systems are also being used by default to store and manage digital content,
      despite the fact that they were neither designed nor intended to address the
      unique challenges associated with the storage and management of this type of
      content. We believe the distinctive characteristics and rapid growth of digital
      content have created a new set of technical, management and economic challenges
      that include:




·
            High
                Scalability.  Enterprises require a storage architecture
                that can increase in performance and capacity in a linear fashion
                and
                which can scale in parallel with the growth of their digital content.
                In
                order to scale to very large storage capacities, traditional systems
                rely
                on multiple separate file systems, or silos, of storage. Each of
                these
                silos is typically accessed and managed independently, which can
                result in
                operating inefficiencies. Enterprises also want the flexibility to
                scale
                either processing power or storage capacity separately as their business
                needs evolve. For example, an archive application where information
                is
                accessed infrequently might need more storage capacity relative to
                total
                data throughput, while an active development project might need greater
                data throughput relative to total storage capacity. In general,
                traditional storage systems do not provide the type of flexibility
                that
                will permit an enterprise to tailor a system to its unique capacity
                and
                performance requirements.





·
            High
                Performance.  Enterprises require a storage solution that
                can provide the data throughput necessary to enable multiple users
                to have
                concurrent read and write access to files. The rapid proliferation
                of
                digital content requires a file system architecture that enables
                multiple
                concurrent users to access and process files that can be megabytes,
                gigabytes or even terabytes in size. In accessing, delivering and
                processing digital content, traditional storage systems have inherent
                performance limitations associated with their inability to aggregate
                performance across multiple devices. In addition, traditional storage
                systems typically cannot deliver the same data for multiple concurrent
                users in a quick or efficient
                manner.





·
            Ease
                of
                Management.  Enterprises require a storage solution that
                simplifies and automates the management and monitoring of storage
                systems
                as they expand. Scaling traditional systems is a complex, labor-intensive,
                time-consuming process that frequently requires IT personnel to map
                applications to newly added storage resources and manually migrate
                data to
                ensure maximum storage utilization. This process typically requires
                system
                downtime or application downtime, which can interrupt critical business
                operations.





·
            Reliability.  Enterprises
                require a storage system that will preserve critical digital assets
                as
                well as ensure that customers and business units have uninterrupted
                access
                to those assets. As digital content becomes increasingly important
                to an
                enterprise’s success, and as data stores and disk density continue to
                increase, it becomes more critical and difficult to protect and quickly
                rebuild storage systems in the event of a disk drive or other hardware
                failure. Storage solutions for digital content must be fault tolerant
                and
                be able to analyze systems for potential hardware or software failures
                to
                ensure uninterrupted user access.





·
            Cost
                Efficiency.  Traditional storage systems are becoming
                increasingly complex and expensive to install and configure, which
                increases the upfront cost of storage for enterprises. Enterprises
                want
                storage systems that offer the capital expenditure benefits of modular
                clustered systems that allow a “pay-as-you-grow” capability and we believe
                are shifting their purchasing practices accordingly. Additionally,
                enterprises are looking for management and scalability benefits that
                reduce the overall cost of purchasing, storing and managing storage
                resources as they grow.







Need
      for a New Storage System Architecture




Traditional
      storage system architectures were designed primarily for use with structured
      data. As a consequence of the unique challenges associated with the storage
      and
      management of digital content, there is a need for a new storage architecture
      designed and optimized to address these challenges. Two key computing trends
      have enabled a new storage architecture:





·
            Clustered
                Computing
                Architectures.  Clustered computing architectures have
                been widely adopted in the enterprise server market. We believe a
                similar
                trend is beginning to occur with respect to clustered computing
                architectures in the storage systems market. Clustered computing
                systems
                use intelligent software to unify disparate computing resources and
                enable
                them to operate as a single system. Each device, or node, in a clustered
                system can operate independently or in concert with other nodes to
                create
                a distributed architecture that achieves higher levels of aggregate
                performance. A distributed architecture also enables an enterprise
                to
                scale its computing infrastructure commensurate with its needs by
                adding
                more nodes as necessary, maximizing cost efficiency. Clustered
                architectures also eliminate single points of failure by distributing
                data
                across independent nodes.





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·
            Industry
                Standard Computing
                Hardware.  The proliferation of high-performance industry
                standard hardware has been a key element in enabling the development
                and
                successful adoption of clustered server systems. This type of hardware
                minimizes integration risk and provides attractive price-performance
                attributes that were not previously achievable. As a result, clustered
                server architectures that use industry standard hardware can offer
                high
                levels of performance and reliability, making them an attractive
                alternative to traditional server
                systems.




As
      a
      consequence of these computing trends, the rapid growth of digital content
      and
      the unique challenges associated with storing and managing this content, we
      believe there is a significant market opportunity for a clustered storage
      solution optimized for storing and managing digital content.







Our
      Intelligent Clustered Storage Solutions




We
      believe we are the leading provider of clustered storage solutions for storing
      and managing digital content, based on customer adoption, breadth of product
      offerings and technology capabilities. We designed our storage solutions, based
      on our OneFS operating system software, to take advantage of the benefits of
      clustered systems built with industry standard hardware. We believe our
      clustered storage solutions enable data-intensive enterprises to manage digital
      content more efficiently and cost effectively than traditional storage
      systems.




Our
      Isilon IQ clustered storage systems combine our proprietary OneFS operating
      system software with industry standard hardware, including a storage server,
      a
      CPU, memory chips and network interfaces, in a self-contained, 3.5-inch and
      1.75-inch high, rack-mountable chassis. Our proprietary OneFS operating system
      software combines the three distinct layers of a traditional storage
      architecture, which typically consist of a file system, a volume manager and
      a
      redundant array of independent disks, or RAID, into a single unified software
      layer. As a result, Isilon IQ nodes automatically work together to aggregate
      their collective computing power into a single, unified storage system that
      is
      designed to withstand the failure of any piece of hardware, including disks,
      switches or even entire nodes. In addition, we provide platform extension
      products that enable customers to scale either performance or capacity
      incrementally based on their then-current needs.





Key
      benefits of our Isilon IQ clustered storage systems include:





·
            Scalability
                and
                Performance.  We believe our systems provide
                industry-leading scalability and performance. Our OneFS operating
                system
                software can currently combine up to 96 separate nodes and more than
                1,600 terabytes, or 1.6 petabytes, of storage capacity in a single
                cluster, and can deliver total data throughput of ten gigabytes per
                second
                from a single file system and single pool of storage, providing linear
                scalability in both storage capacity and performance. Our systems
                support Gigabit Ethernet front-side connectivity and high-performance
                InfiniBand interconnect for low-latency, high-bandwidth, intra-cluster
                communication. We are continually seeking to increase the storage
                capacity
                and performance of our storage
                systems.





·
            Reliability.  Our
                clustered storage systems have data protection capabilities, built-in
                redundancy and self-healing capabilities. Each Isilon IQ storage
                system is
                designed to withstand the failure of multiple disks or entire nodes
                so
                that a customer does not lose access to any files. Each node in an
                Isilon
                IQ cluster is a peer, and any node can handle a request from any
                application server to provide the file requested. Our OneFS operating
                system software allocates, or stripes, files and meta-data across
                nodes in
                a cluster so that, if one node or multiple nodes fail, any other
                node can
                perform the requested function, thereby preventing any single point
                of
                failure. In the event of one or more disk or node failures, OneFS
                automatically rebuilds files in parallel across all of the existing
                distributed free space in the cluster, eliminating the need to have
                the
                dedicated “hot spare drives” required with most traditional storage
                systems. We believe our Isilon IQ storage systems can utilize this
                free
                space, while also drawing on the multiple microprocessors and aggregate
                computing power of the cluster, to rebuild data from failed drives
                five to
                ten times faster than traditional storage systems, enabling a more
                reliable storage solution.





·
            Reduced
                Storage
                Cost.  Our customers can purchase our Isilon IQ storage
                systems on a “pay-as-you-grow” model that allows them to expand their
                storage capacity and performance commensurate with their needs. In
                contrast, traditional storage systems typically require the purchase
                of
                excess performance and capacity, which remains underutilized until
                an
                enterprise grows into it. Our modular product architecture enables
                each
                customer to purchase an initial combination of performance and capacity
                tailored to its current needs, and to add performance, capacity or
                both in
                incremental quantities to support the growth in its digital content.
                In
                contrast to traditional storage systems, our systems, which utilize
                industry standard hardware, can significantly lower the initial capital
                expenditures required for storage, as well as the cost of acquiring
                additional storage capacity or
                performance.




·
            Increased
                IT Operating
                Efficiency.  Our clustered storage systems enable
                customers to manage their growing amounts of digital content in an
                automated and efficient manner that is more cost-effective than
                traditional storage systems. Our Isilon IQ storage systems automatically
                balance data across nodes to enhance performance and optimize utilization,
                eliminating the need for the planned storage outages that are common
                during the manual data-balancing processes required with traditional
                storage systems. The simplicity, ease of use and automation of our
                Isilon
                IQ clustered storage systems have enabled individual customers to
                scale
                deployments from a few terabytes to more than 2,000 terabytes without
                any
                additional investment in IT staff. Each Isilon IQ storage system
                has been
                designed to interface with existing Ethernet networks, and our “plug and
                store” design automates many of the tasks that must be performed manually
                to deploy traditional storage systems. As a result, once installed
                in a
                rack and cabled, a 100 terabyte cluster can typically be configured
                and
                operational in less than 15 minutes. Additionally, capacity can typically
                be added to existing clusters in less than 60 seconds, without any
                downtime.





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·
            Enhanced
                Business Processes
                and Revenue Opportunities.  By providing faster data
                access, faster data processing and streamlined workflows, our systems
                enable customers to manage the rapid growth in their digital content,
                capitalize on new products and service models for delivering digital
                content and unlock new revenue opportunities. For example, NBC used
                Isilon
                IQ solutions to store, access and edit more than 1,200 broadcast
                hours over six networks during the 17 days of events at the 2004
                Summer Olympics, providing immediate access to all programming and
                tripling the number of broadcast hours compared with previous Olympics.
                Similarly, using our Isilon IQ storage system, a major aerospace
                and
                defense company unified its engine test results from previously disparate
                data sources into one large pool of storage, greatly improving the
                efficiency, speed and cost of its test
                operations.





·
            Complementary
                to Existing
                Solutions for Structured Data.  Our customers typically
                deploy our solutions specifically for digital content while maintaining
                their existing storage systems for structured data. Our use of industry
                standard hardware and standard file sharing protocols greatly eases
                integration with existing enterprise systems and substantially reduces
                the
                need to change existing data center infrastructures or use proprietary
                tools or software. In addition, our software enables our storage
                systems
                to be adaptable to technology that exists in our customers’ data center
                environments.




Our
      Strategy




Our
      strategic focus is to enhance our position as a leading provider of clustered
      storage solutions for digital content. Key elements of this strategy
      include:




·
            Focus
                on High-Growth,
                Data-Intensive Markets.  We intend to expand our customer
                base by focusing on markets where the storage and management of digital
                content are critical to the success of many enterprises. To date,
                our
                solutions have been deployed by customers in industries such as media
                and
                entertainment, Internet, cable and telecommunications, oil and gas,
                life
                sciences, and manufacturing, and by the federal government. We intend
                to
                invest in our direct sales force and channel partners to further
                penetrate
                these and other markets domestically and
                internationally.





·
            Continue
                to Enhance OneFS and
                Deliver Additional Software Applications.  Our OneFS
                operating system software is the core of our Isilon IQ clustered
                storage
                architecture. We intend to continue to enhance our OneFS operating
                system
                software with greater levels of automation, functionality and performance
                and to develop new software functionality in areas such as archiving,
                data
                protection and storage management.




·
            Leverage
                Trends in Commodity
                Hardware to Improve Price-Performance Attributes of Our
                Systems.  Our software-based architecture is designed to
                allow us to integrate quickly and easily into our systems technology
                improvements, including those in components such as CPUs, disk drives
                and
                memory chips. Our systems are built using industry standard hardware
                rather than proprietary hardware, enabling us to address our customers’
                needs in a cost-effective manner. As a result, our customers benefit
                as
                the price-performance attributes of these components improve over
                time. We
                intend to proactively incorporate advances in computing, storage
                and
                networking technologies into our storage
                systems.





·
            Optimize
                Repeat Order Business
                Model.  Because of the modular nature of our clustered
                storage systems, our customers have typically deployed our systems
                in an
                incremental fashion. We intend to continue to design our systems
                to take
                advantage of our modular architecture, enabling our customers to
                scale
                deployments in step with their growing capacity and performance
                needs.





·
            Utilize
                Channel Partners to
                Expand Global Market Penetration.  We
                received 55% of our total revenue in 2007 through indirect channels.
                We
                have established a distribution channel program that, as of December
                30,
                2007, had more than 150 value-added resellers and distributors worldwide.
                We believe the ease of use and installation of our systems makes
                them
                well-suited for distribution by channel partners. We believe the
                international opportunity for our systems is significant and we have
                expanded the number of our channel partners in Asia-Pacific and Europe.
                We
                intend to continue adding value-added resellers and distributors
                to expand
                the global distribution of our
                systems.







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Technology
      and Architecture




We
      have
      designed a clustered storage system architecture, which consists of independent
      nodes that are all integrated with our OneFS operating system software to form
      a
      single shared resource. Our clustered storage systems are designed to be
      installed easily in standard enterprise data center environments and are
      accessible to users and applications running Windows, Unix/Linux and Mac
      operating systems using industry standard file sharing protocols over standard
      Gigabit Ethernet networks. Nodes within our clustered storage systems
      communicate with each other over a dedicated back-end network comprised of
      either InfiniBand or standard Gigabit Ethernet. Our clustered architecture
      is
      designed so each node has full visibility and write/read access to or from
      one
      single expandable file system. We built our clustered storage system
      architecture with industry standard hardware, to take advantage of significant
      advances in performance or capacity. In addition to our clustered storage
      systems, we provide standalone software applications designed to operate with
      our OneFS operating system software and leverage our clustered storage
      architecture.




Our
      OneFS
      operating system software is the core technology of our Isilon IQ clustered
      storage architecture and provides a single unified operating system across
      our
      entire product family. The OneFS operating system software is designed with
      file-striping functionality across each node in a cluster, a fully-distributed
      lock manager, caching, fully-distributed meta-data, and a remote block manager
      to maintain global coherency and synchronization across an entire cluster.
      We
      have designed an intracluster protocol into our systems to further optimize
      scalability, throughput and reliability.




Our
      OneFS
      operating system software creates a single, expandable, shared pool of storage
      that can be used across a wide range of applications, including the production,
      analysis, delivery and archiving of digital content.





Our
      OneFS
      operating system software provides a number of key features
      including:




·
            AutoBalance.  Automatically
                balances data across all nodes in a cluster in real-time, reducing
                throughput bottlenecks, maximizing performance and storage utilization,
                and eliminating the downtime commonly associated with the manual
                data
                migrations required by traditional storage systems. AutoBalance
                automatically migrates and rebalances data as additional nodes are
                added
                to a cluster.





·
            FlexProtect-AP.  Provides
                the functionality that enables peering of nodes, incorporation of
                redundancy and reduction of the vulnerability of a cluster to any
                single
                point of failure. Its striping policies incorporated into OneFS are
                based
                on the Reed Solomon error correction code, span multiple nodes within
                a
                cluster and can be set at any level, including the cluster, directory,
                sub-directory or even individual file level. FlexProtect-AP is designed
                to
                re-build files automatically across the existing distributed free
                space in
                the cluster in parallel, eliminating the need to have disks dedicated
                solely to potential rebuild purposes, as is typically required with
                traditional storage architectures. It also identifies “at risk” disks and
                preemptively migrates relevant data from the “at risk” disks to available
                free space within other parts of the
                cluster.





·
            SmartCache.  Utilizes
                predictive software algorithms and the OneFS file-striping feature
                to
                enhance throughput for an Isilon IQ cluster. SmartCache is a
                globally-coherent memory cache that is optimized for digital content,
                can
                read and write data and is able to expand automatically as additional
                nodes are added to any Isilon IQ
                cluster.





·
            WebAdmin.  Configures,
                monitors and manages an Isilon IQ cluster using a single, web-based
                management interface. The central, web-based interface permits a
                real-time, single level of management for cluster performance, capacity
                utilization, quotas, monitoring, diagnostics and management of software
                applications such as our SyncIQ®
                replication
                software product. Using the web interface, users can add or remove
                nodes
                from the cluster with a click of the
                mouse.







Products




Our
      product family consists of
      clustered storage systems and related software applications. Our clustered
      storage systems combine our fourth-generation OneFS operating system software
      with our Isilon IQ platform nodes. OneFS contains integrated file system, volume
      manager and RAID functionality in a distributed file system architecture and
      improves storage capacity, data throughput and system manageability. Our
      customers can optimize system performance, capacity or both with our platform
      extension nodes: the Isilon IQ Accelerator and the Isilon EX 6000, EX 9000
      and
      EX 12000. We also offer five related software applications that extend the
      capabilities and functionality of our systems: SyncIQ replication software,
      SmartConnectTM
      load-balancing software, SnapshotIQTM protection software, SmartQuotasTM
management and provisioning software and MigrationIQTM tiered data storage
      migration software.





Isilon
      IQ Platform
      Nodes.  Our Isilon IQ platform nodes combine a storage server
      and, depending on the system, 1.92, 2.00, 3.00, 6.00, 9.00 or 12.00 terabytes
      of
      raw disk capacity in dense, self-contained storage nodes that work together
      in a
      single cluster. Each high-end enterprise line of Isilon IQ nodes is a 3.5-inch
      high server and has 12 SATA-II disk drives and 4.5 gigabytes of
      globally-coherent, read and write cache. A system requires a minimum of three
      nodes and can scale up to 96 nodes in a cluster. All nodes support both
      high-performance InfiniBand and standard Gigabit Ethernet interfaces for
      intra-cluster communication and provide front-side communication via standard
      Gigabit Ethernet. The Isilon IQ 200 model node is a 1.75 inches high server
      and has four SATA-II disk drives and 4.5 gigabytes of globally-coherent,
      read and write cache. An Isilon IQ 200 system requires a minimum of three nodes
      and can scale up to 24 nodes in a cluster. Isilon IQ 200 nodes support standard
      Gigabit Ethernet interfaces for intra-cluster communication and also provide
      front-side communication via standard Gigabit Ethernet.





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Isilon
      IQ
      Accelerator.  Our Isilon IQ Accelerator enables customers to
      increase the performance, or aggregate write and read throughput, of their
      data
      storage system modularly without adding storage capacity. Isilon IQ Accelerator
      nodes can be added to any Isilon IQ storage cluster in as little as 15 seconds
      and utilize InfiniBand networking to scale aggregate data throughput
      independently to ten gigabytes per second with no system downtime.




Isilon
      EX
      series.  Our Isilon EX 6000, EX 9000 and EX 12000 products
      enable customers to increase their data storage capacity modularly without
      the
      cost of adding additional performance. Designed as an extremely low cost, high
      capacity clustered storage product, each Isilon EX 6000 contains 6 terabytes
      of
      SATA-II disk capacity (9 terabytes for the EX 9000 and 12 terabytes for the
      EX
      12000) in a 2U form factor and utilizes state-of-the-art Serial Attached SCSI
      (SAS) technology to connect to an Isilon IQ 6000, IQ 9000 or IQ 12000 platform
      node.  Combining our OneFS operating system software with a high-speed
      SAS interconnect creates a high-density system that modularly scales from 60
      terabytes to more than 1,600 terabytes in a single data storage pool. This
      solution is designed to integrate quickly and easily within existing enterprise
      network infrastructures, communicate standard file sharing protocols over
      Gigabit Ethernet, and serve as a multi-tier storage solution for near-line,
      archive, disk-to-disk backup and restore, as well as remote disaster recovery
      applications.





SyncIQ
      Replication
      Software.  Our SyncIQ replication software application provides
      asynchronous file-based replication to one or more Isilon IQ clusters over
      any
      WAN/LAN IP network through a policy-based engine for disaster recovery
      disk-to-disk backup/recovery, and distributed workflow or delivery environments.
      Only those parts of a file system that have changed are replicated to the target
      cluster. In this manner, our SyncIQ replication software leverages its
      distributed file system architecture to maximize efficiency in the replication
      process.




SmartConnect
      Load-Balancing
      Software.  Our SmartConnect software application streamlines
      connection management by automatically distributing client connections across
      individual nodes in a cluster based on defined policies, such as CPU
      utilization, connection count and throughput, optimizing performance and
      simplifying the scaling of applications and storage resources. Client and
      application connections can be load-balanced across all Isilon IQ nodes within
      a
      cluster without installing client-side drivers or other network devices.
      Additionally, SmartConnect is designed to provide seamless failover for Unix
      and
      Linux clients during planned or unplanned outages.




SnapshotIQ
      Protection
      Software.  Our SnapshotIQ software application provides a
      simple, scalable and flexible way to enable enterprise-class protection for
      clustered storage. Isilon’s snapshots are locally retained, read-only and
      incorruptible point-in-time images of data that distribute an unlimited number
      of snapshots across multiple Isilon IQ clustered storage nodes. Isilon snapshots
      typically take less than one second to create and incur minimal performance
      overhead, regardless of the size of the file system or directory being snapshot.
      Additionally, only changes to blocks of data that make up a file are reflected
      in the snapshot, ensuring efficient snapshot storage utilization.




SmartQuotas
      DataManagement Software.OurSmartQuotas
      data
      management and provisioning software application gives enterprises the ability
      to control and limit storage usage across their organization, and provision
      a
      single pool of Isilon clustered storage to best meet their unique storage
      challenges. SmartQuotas enables storage administrators to assign quotas that
      seamlessly partition a highly scalable, single, shared pool of storage into
      easily managed segments.  SmartQuotas’ thin provisioning capability
      enables administrators to present more storage capacity to applications and
      users than is physically installed. Administrators can limit their actual
      physical storage resources to what is only needed today, and automatically
      add
      storage resources on-demand to meet changing business requirements
      tomorrow.





MigrationIQTiered
      Clustered StorageSoftware.Our
      MigrationIQ software
      application provides enterprises with the ability to automatically and easily
      migrate digital content between high-performance, Tier-1 clustered storage
      and
      high-capacity, Tier-2 nearline archive clustered storage, thereby streamlining
      workflows, optimizing storage resources and extracting maximum value from
      digital content assets at every point in the information lifecycle.





Customers




Through
      the end of fiscal 2007, we have sold our products worldwide to more than 675
      end
      customers in a variety of industries, including media and entertainment,
      Internet, cable and telecommunications, oil and gas, life sciences,
      manufacturing, and the federal government. Our systems are deployed in a wide
      range of organizations, from large global enterprises with hundreds or thousands
      of locations to small organizations with just one location. During 2007, Eastman
      Kodak Company accounted for 10% of our total revenue.  In 2006,
      Comcast Corporation, which purchased through one of our resellers, and Eastman
      Kodak Company accounted for 15% and 10%, respectively, of our total revenue.
      Both of these customers buy our products on a purchase order basis, and neither
      has a long-term contract or minimum purchase commitment. In 2007 and 2006,
      we
      derived 27% and 24%, respectively, of our total revenue from customers outside
      of the United States, primarily in Canada, Europe, Japan and other Asian
      countries. For further information about revenue recognized from international
      customers, see Note 11 to our consolidated financial statements included in
      Item 8.





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Sales
      and Marketing




We
      sell
      our products and services indirectly through channel partners and directly
      through our field sales force, targeting enterprises and government
      organizations that have the need to store significant amounts of digital
      content:




·
            Value-Added
                Resellers and
                Distributors.  We currently have more than 150 channel
                partners that resell and/or distribute our products in the United
                States
                and internationally. These partners help market and sell our products
                to a
                broad array of enterprises and government organizations across our
                core
                markets. We typically enter into non-exclusive, written distribution
                agreements with our channel partners, and these agreements generally
                have
                a one-year term with no minimum sales
                commitment.





·
            Field
                Sales
                Force.  Our field sales force is responsible for managing
                all direct and indirect sales within our geographic territories,
                including
                North America, France, Germany, Japan, Korea, China, Australia, and
                the
                United Kingdom.





·
            Original
                Equipment
                Manufacturers.  We have established partnerships with
                original equipment manufacturing, or OEM, companies that bundle their
                products with ours to address the challenges of a particular market
                or
                application. We have entered into OEM agreements with Harris Corporation,
                Schlumberger Corporation and Kodak
                Corporation.




We
      focus
      our marketing efforts on increasing brand awareness, communicating product
      advantages and generating qualified leads for our sales force and channel
      partners. We rely on a variety of marketing vehicles, including trade shows,
      advertising, public relations, industry research, our website, and collaborative
      relationships with technology vendors.




Support
      and Services




We
      offer
      tiered customer support programs tailored to the service needs of our customers.
      We typically grant customers rights to unspecified software updates and
      maintenance releases and patches that become available during the support
      period. Product support includes Internet access to technical content, as well
      as 24-hour telephone and email access to technical support personnel. Service
      contracts typically have a one-year or three-year term. Substantially all of
      our
      support personnel are based in Seattle, Washington and support is available
      seven days a week. In addition, we work with third parties to provide onsite
      hardware support, hardware replacement, spares inventory and other field
      services in Europe, Japan and North America. As we expand, we expect to continue
      to hire additional technical support personnel to service our domestic and
      international customer base.




We
      currently provide primary product support for our channel partners, although
      we
      anticipate that, in the future, we will train our partners to provide most
      of
      the primary product support and we will provide secondary support.




Manufacturing





We
      outsource the manufacturing of all our systems and currently rely on a single
      contract manufacturer.  On December 7, 2007, we provided notice to our
      initial contract manufacturer, Sanmina-SCI Corporation, of our intent to
      terminate for convenience the Manufacturing Services Agreement we entered into
      on February 17, 2006.  In an agreement dated August 30, 2007, we
      established a contract manufacturing relationship with Solectron Corporation,
      subsequently acquired by Flextronics International Ltd.  This
      agreement provides current terms and operating conditions while we are
      continuing to negotiate a master services agreement.  Since that time,
      we have utilized Flextronics to manufacture and assemble our products, procure
      components for our systems and help manage our supply chain, perform testing
      and
      manage delivery of our products.





Our
      contract manufacturer provides us with a wide range of operational and
      manufacturing services. We rely on Flextronics to procure a majority of the
      components for our systems, including disk drives, CPUs and power supplies.
       Flextronics purchases these components from multiple vendors in order to
      obtain competitive pricing. We work closely with Flextronics to ensure that
      we
      have the supply of products necessary to satisfy our product delivery schedule.
      This may include a requirement for Flextronics periodically to increase the
      amount of finished goods and component inventory that it carries in advance
      to
      meet anticipated customer product shipments. We purchase our finished goods
      inventory from Flextronics using purchase orders. Delivery on our Flextronics
      purchase orders occurs at the time that Flextronics ships products to our
      customers. This process is designed to minimize the amount of inventory that
      we
      are required to retain to meet customer demand.





Flextronics
      performs final test and
      assembly and manages the delivery of all of our products. We rely on
      Flextronics’ global distribution capabilities to optimize the delivery of our
      products.





We
      generally engage Flextronics to manufacture our products only after we receive
      orders from our customers. However, customers may cancel or reschedule
      orders, and delivery schedules requested by customers may vary based upon each
      customer’s particular needs. For these reasons, orders may not constitute a firm
      backlog and may not be a meaningful indicator of future revenue. We typically
      maintain with Flextronics a rolling 90-day firm order for products they
      manufacture for us, and these orders may only be rescheduled, modified or
      cancelled under certain circumstances.


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Research
      and Development




Our
      research and development organization is responsible for the design,
      development, testing and certification of our clustered storage systems, OneFS
      operating system software and related storage software applications. Our
      research and development group is mainly located at our headquarters in Seattle,
      Washington or in our office in Minneapolis, Minnesota. We also used a
      twelve-person software development team from a third-party contract engineering
      provider in Moscow, Russia. Our engineering efforts support product development
      across all major operating systems, hardware and software applications. We
      also
      test our products to certify and ensure interoperability with third-party
      hardware and software products. We have also made substantial investments in
      the
      automation of our product test and quality assurance laboratories. We plan
      to
      dedicate significant resources to these continued research and development
      efforts. Further, as we expand internationally, we may incur additional costs
      to
      conform our products to comply with local laws or local product
      specifications.




Our
      research and development expenses were $19.9 million in 2007, $16.5 million
      in 2006, and $12.5 million in 2005.




Competition




The
      data
      storage market is highly competitive and is characterized by rapidly changing
      technology. Our primary competitors include large traditional networked storage
      vendors including EMC Corporation, Hewlett-Packard Company, Hitachi Data Systems
      Corporation, International Business Machines Corporation, Network Appliance,
      Inc. and Sun Microsystems, Inc. In addition, we compete against internally
      developed storage solutions as well as combined third-party software and
      hardware solutions. Also, a number of new, privately held companies are
      currently attempting to enter our market, some of which may become significant
      competitors in the future.




We
      believe that the principal competitive factors affecting the data storage market
      include such storage system attributes as:




·
            scalability;





·
            performance,
                including the ability to provide high throughput as well as access
                for
                multiple concurrent users;





·
            ease
                of installation and management by IT
                personnel;





·
            reliability
                to ensure uninterrupted user
                access; and





·
            cost
                efficiency in acquisition, deployment and ongoing
                support.




Many
      of
      our current competitors have, and some of our potential competitors could have,
      longer operating histories, greater name recognition, larger customer bases
      and
      significantly greater financial, technical, sales, marketing and other resources
      than we have. Potential customers may prefer to purchase from their existing
      suppliers rather than a new supplier regardless of product performance or
      features. Some of our competitors, including EMC Corporation and Network
      Appliance, Inc., have made acquisitions of businesses that allow them to offer
      more directly competitive and comprehensive solutions than they had previously
      offered. Our current and potential competitors may also establish cooperative
      relationships among themselves or with third parties. As a result, we cannot
      assure you that our products will compete favorably, and any failure to do
      so
      could seriously harm our business, operating results and financial
      condition.




Intellectual
      Property




Our
      success depends in part upon our ability to protect our core technology and
      intellectual property. To accomplish this, we rely on a combination of
      intellectual property rights, including patents, trade secrets, copyrights
      and
      trademarks, and contractual protections.





We
      have two issued U.S. patents, and 35 pending U.S. patent
      applications. Of these pending applications,
      four are continuation applications.  One of
      the pending applications has been allowed and is expected to
      issue as a patent.  Six of the pending applications have
      received examiner office actions.  The remaining 28 pending
      applications are awaiting a first examiner office action.  We have
      also filed four applications through the Patent Cooperation Treaty, or PCT.
      Two of these PCT applications have entered the national phase
      in China, Europe, and Japan. The other two PCT
      applications have not yet entered the national
      phase.





We
      are
      the owner of four registered trademarks in the United States: ISILON, ISILON
      SYSTEMS, ONEFS and SYNCIQ, along with a pending but approved trademark
      application for HOW BREAKTHROUGHS BEGIN. We are the owner of international
      trademark registrations for ISILON in the European Union, Australia and Canada;
      ISILON SYSTEMS in the European Union, Australia, Canada, Japan and Singapore;
      ONEFS and SYNCIQ in the European Union, Australia, Canada, Japan, Korea and
      Singapore; and HOW BREAKTHROUGHS BEGIN in the European Union and Australia.
      Isilon is the owner of pending international trademark applications for ISILON
      in China, Japan, Korea and Singapore; ISILON SYSTEMS in China and Korea; ONEFS
      in China; and HOW BREAKTHROUGHS BEGIN in Canada, Japan, Korea and
      Singapore.





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In
      addition to the foregoing protections, we generally control access to and use
      of
      our proprietary software and other confidential information through the use
      of
      internal and external controls, including contractual protections with
      employees, contractors, customers and partners, and our software is protected
      by
      United States and international copyright laws.




Despite
      our efforts to protect our trade secrets and proprietary rights through
      intellectual property rights and license and confidentiality agreements,
      unauthorized parties may still copy or otherwise obtain and use our software
      and
      technology. In addition, we intend to expand our international operations,
      and
      effective patent, copyright, trademark and trade secret protection may not
      be
      available or may be limited in foreign countries. If we fail to protect our
      intellectual property and other proprietary rights, our business could be
      harmed.




Third
      parties could claim that our products or technologies infringe their proprietary
      rights. The data storage industry is characterized by the existence of a large
      number of patents, trademarks and copyrights and by frequent litigation based
      on
      allegations of infringement or other violations of intellectual property rights.
      We expect that infringement claims may further increase as the number of
      products and competitors in our market increase. We have not, to date, been
      involved in any litigation related to intellectual property.





Governmental
      Regulation




Various
      international laws regulate the use and disposal of certain hazardous materials
      incorporated in our products, and various national laws regulate the export
      and
      import of our products across international borders. The requirement to comply
      with environmental regulations or export and import controls could cause us
      to
      incur substantial costs or subject us to business interruptions. For more
      information, refer to “Risk Factors — Our business is subject to
      increasingly complex environmental legislation that has increased both our
      costs
      and the risk of noncompliance” and “Risk Factors — We are subject to
      governmental export and import controls that could impair our ability to compete
      in international markets.”





Employees




As
      of
      December 30, 2007, we had 321 employees worldwide, including 141 in sales
      and marketing, 103 in research and development, 33 in support and services,
      and
      44 in finance, legal, administration and operations. None of our
      employees are represented by a labor union, and we consider current
      employee relations to be good.





Geographic
      Information




During
      our last three fiscal years, the majority of our revenue was generated within
      the United States, and primarily all of our long-lived assets are located within
      the United States.





Year
                      EndedDecember 30,
                  
                  
                  December 31,
                  
                  
                  January 1,2007
                  
                  
                  2006
                  
                  
                  2006Restated(1)(Dollars
                      in thousands)Revenue
                      by geography:Domestic
                  
                  $
                  64,936
                  
                  
                  $
                  46,465
                  
                  
                  $
                  17,559International
                  
                  
                  24,062
                  
                  
                  
                  14,741
                  
                  
                  
                  3,524Total
                      revenue
                  
                  $
                  88,998
                  
                  
                  $
                  61,206
                  
                  
                  $
                  21,083%
                      revenue by geography:Domestic
                  
                  
                  73
                  %
                  
                  
                  76
                  %
                  
                  
                  83
                  %International
                  
                  
                  27
                  
                  
                  
                  24
                  
                  
                  
                  17Total
                  
                  
                  100
                  %
                  
                  
                  100
                  %
                  
                  
                  100
                  %




(1)
            See
                  Note 3, "Restatement of Consolidated Financial Statements," of the
                  Notes to Consolidated Financial
                  Statements.





Segment
      Information


As
      discussed in Note 11 to our consolidated financial statements, our business
      is
      organized within one reportable segment.





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Executive
      Officers and Directors





The
      following table provides information regarding our executive officers and
      directors:





Name
            
            Age
            
            Position(s)Executive
                Officers:Sujal
                M. Patel
            
            33
            
            President,
                Chief Executive Officer and DirectorWilliam
                D. Richter
            
            33
            
            Interim
                Chief Financial OfficerKeenan
                M. Conder
            
            45
            
            Vice
                President General Counsel and Corporate SecretarySteven
                D. Fitz
            
            43
            
            Senior
                Vice President Worldwide SalesPaul
                G. Rutherford
            
            51
            
            Chief
                Technology OfficerBrett
                L. Helsel
            
            48
            
            Senior
                Vice President EngineeringBrett
                G. Goodwin
            
            40
            
            Vice
                President Marketing and Business DevelopmentGwen
                E. Weld
            
            50
            
            Vice
                President Human Resources and Organizational
                DevelopmentDirectors:Barry
                J. Fidelman
            
            67
            
            DirectorElliott
                H. Jurgensen, Jr.
            
            63
            
            DirectorGregory
                L. McAdoo
            
            43
            
            DirectorMatthew
                S. McIlwain
            
            43
            
            DirectorJames
                G. Richardson
            
            50
            
            DirectorWilliam
                D. Ruckelshaus
            
            75
            
            Chairman
                of the Board of Directors and DirectorPeter
                H. van Oppen
            
            55
            
            Director





Sujal
      M. Patel is one of
      Isilon’s founders and has served as a director since 2001 and as our President
      and Chief Executive Officer since October 2007. Mr. Patel also served as our
      Chief Technology Officer from 2001 to March 2008 and as President and Chief
      Executive Officer since the founding of Isilon in 2001 until August 2003. Prior
      to joining us, from 1996 to 2001, Mr. Patel served in various engineering
      roles at RealNetworks, Inc., a provider of Internet media delivery software
      and
      services, most recently as Development Manager, RealSystem Products, in which
      capacity he was the chief architect for the second generation of RealSystem
      products. Mr. Patel received a Bachelor of Science degree in computer
      science from the University of Maryland at College Park.




William
      D. Richterhas served
      as
      Isilon’s interim Chief Financial Officer since October 2007 and as our
      Controller since December 2006. Prior to joining us, from August 2005 to
      December 2006, Mr. Richter served at Amazon.com, Inc., an e-commerce company,
      most recently as Director of Accounting and Finance. From 1997 to August
      2005, Mr. Richter served in various roles at PricewaterhouseCoopers, LLP, an
      accounting firm, most recently as a Senior Manager in the Audit
      department. Mr. Richter received a Bachelor of Arts degree in business
      administration from the University of Washington and is a Washington State
      Licensed and Certified Public Accountant.





Keenan
      M. Conderhas served
      as Isilon’s Vice President, General Counsel and Corporate Secretary since
      June 2007. Prior to joining us, from March 2004 to August 2006, Mr.
      Conder served as Senior Vice President, General Counsel and Secretary of
      Expedia, Inc., an online travel agency. From May 2002 to February 2004,
      Mr. Conder served as Senior Vice President and General Counsel of
      Travelocity.com LP, an online travel agency, and from June 2000
      through April 2002 as its Vice President and Associate General Counsel.
      From 1996 to 2000, Mr. Conder held various positions in the legal
      department at Sabre Inc., most recently as Senior Managing Attorney. Prior
      to
      Sabre, Mr. Conder was an attorney in the legal department of American
      Airlines and, prior to that, an attorney with Munsch, Hardt, Kopf,
      Harr & Dinan, a Dallas law firm. Mr. Conder received a Bachelor of
      Arts degree in Economics from the University of North Carolina and a Juris
      Doctor degree from Wake Forest University.





Steven
      D. Fitz has served as
      Isilon’s Senior Vice President Worldwide Sales since April 2007. Prior to
      joining us, from 1993 to April 2007, Mr. Fitz served in various positions at
      EMC
      Corporation, a developer and provider of information infrastructure technology
      and solutions, including Divisional Vice President from 2000 to 2002 and as
      President of Asia Pacific/Japan from 2002 to April 2007. Prior to EMC, Mr.
      Fitz
      was a major account manager at Storagetek Corporation (subsequently purchased
      by
      Sun Microsystems, Inc.) and, prior to that, an account executive at
      EMC. Mr. Fitz received a Bachelor of Arts degree in business administration
      from the University of Massachusetts.





Paul
      G. Rutherfordhas served
      as Isilon’s Chief Technology Officer since March 2008. Mr. Rutherford also
      served as our Vice President of Engineering from April 2007 to March 2008 and
      as
      our Director of Engineering from October 2005 to April 2007. Prior to joining
      us, from 1999 to October 2005, Mr. Rutherford served as Chief Technology
      Officer of Advanced Digital Information Corporation (subsequently acquired
      by
      Quantum Corporation), a supplier of automated tape systems, after its
      acquisition of EMASS, the tape storage division of Raytheon Corporation. From
      1995 to 1998, Mr. Rutherford served as General Manager and Vice President of
      Software Engineering at EMASS. From 1987 to 1993, Mr. Rutherford held various
      positions at Cray Research, Inc. (subsequently merged with Silicon Graphics),
      a
      supercomputer manufacturer, most recently as Director of Storage Systems
      Development. Mr. Rutherford received a Bachelor of Science degree in computer
      science from the University of Minnesota.





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Brett
        L. Helsel has served as
        Isilon’s Senior Vice President of Engineering since March 2008. Prior to joining
        us, from September 2003 to March 2008, Mr. Helsel served as Chairman and
        Chief
        Executive Officer of Lockdown Networks, Inc., a provider of network access
        control appliances. From 1998 to June 2003, Mr. Helsel served at F5 Networks,
        Inc., an application traffic management company, as Chief Technology Officer
        and
        Senior Vice President of Product Development. From 1997 to 1998, Mr. Helsel
        served as Vice President, Product Development at Cybersafe, Inc. From 1994
        to
        1997, Mr. Helsel served as Site Development Manager for Wall Data Inc.
        (subsequently acquired by NetManage Inc.). Mr. Helsel received Bachelor of
        Science degrees in geophysics and oceanography from the Florida Institute
        of
        Technology and is a graduate of the University of Washington’s Executive
        Management Program.





Brett
      G. Goodwin has
      served as Isilon’s Vice President of Marketing and Business Development
      since October 2002, after joining us in March 2002 as our Vice President of
      Business Development. Prior to joining us, Mr. Goodwin served in various
      positions from 1996 to March 2002 at RealNetworks, Inc., including Group Product
      Manager and most recently as General Manager of Corporate Development. From
      1994
      to 1996, Mr. Goodwin served as a Senior Product Marketing Manager at
      AT&T Wireless Services. From 1989 to 1992, Mr. Goodwin worked for Booz,
      Allen & Hamilton, a consulting firm, as a management consultant.
      Mr. Goodwin received a Bachelor of Arts degree in mathematical economics
      from Pomona College and a Master of Business Administration degree from the
      Stanford Graduate School of Business.




Gwen
      E. Weld has served as
      Isilon’s Vice President of Human Resources and Organizational Development since
      June 2006. Prior to joining us, Ms. Weld served in various senior human
      resources positions from 1985 to April 2004 at Microsoft Corporation, most
      recently overseeing Microsoft’s worldwide recruiting and alternative staffing as
      its General Manager, Staffing. Ms. Weld also served as General Manager of
      Microsoft HR, managing the human resources agenda for the sales, corporate
      marketing, human resources, finance, legal and operations groups globally.
      Ms. Weld also served as Director of International Business Development for
      CarPoint and Director of Business Strategy and Management for Interactive
      Services, both divisions of Microsoft. Ms. Weld studied business
      administration at Pace University.




Barry
      J. Fidelman has served
      as a director since May 2003. Mr. Fidelman has been a Partner of Atlas
      Venture, a venture capital firm, since 1988. Prior to Atlas Venture,
      Mr. Fidelman held senior executive positions for Data General, Apollo
      Computer and Alliant Computer. Mr. Fidelman also currently serves on the
      boards of directors of several private companies. Mr. Fidelman received a
      Bachelor of Science degree in electrical engineering from Massachusetts
      Institute of Technology and a Master of Business Administration degree from
      Harvard Business School.




Elliott
      H.
      Jurgensen, Jr. has served as a director since April 2006.
      Mr. Jurgensen retired from KPMG LLP, an accounting firm, in January 2003
      after 32 years as an auditor, including 23 years as a partner.
      Mr. Jurgensen held a number of leadership roles with KPMG, including
      national partner in charge of its hospitality industry practice from 1981 to
      1993, Managing Partner of the Bellevue office from 1982 to 1991 and Managing
      Partner of the Seattle office from 1993 to October 2002. Mr. Jurgensen
      currently serves on the boards of directors of BSquare Corporation,
      McCormick & Schmick’s Seafood Restaurants, Inc., and Varolii
      Corporation. Mr. Jurgensen received a Bachelor of Science degree in
      accounting from San Jose State University.




Gregory
      L. McAdoo has served
      as a director since July 2002. Mr. McAdoo has been a Partner of Sequoia
      Capital, a venture capital firm, since 2000. Prior to Sequoia Capital,
      Mr. McAdoo served as President and Chief Executive Officer of Sentient
      Networks, a circuit emulation company that was acquired by Cisco Systems, Inc.
      in 1999. Mr. McAdoo has more than 17 years of engineering and
      management experience in the networking industry and has held senior engineering
      and executive level management positions at Cisco Systems, Inc., Sourcecom,
      Micom Communications and Datability Systems. Mr. McAdoo also serves on the
      boards of directors of flipt, Inc. and PowerFile, Inc. Mr. McAdoo received
      a Bachelor of Science degree in electrical engineering from Stevens Institute
      of
      Technology.




Matthew
      S. McIlwain has
      served as a director since February 2008 and also served as a director from
      May
      2001 to April 2007. Since June 2002, Mr. McIlwain has served as a Managing
      Director of Madrona Venture Group, a venture capital firm, which he joined
      in
      May 2000. Prior to joining Madrona, Mr. McIlwain served as Vice President
      of Business Process for Genuine Parts Company. Previously, Mr. McIlwain
      served as an Engagement Manager at McKinsey & Company, where he focused on
      strategy and marketing in technology-driven industries, and also worked in
      investment banking at Credit Suisse First Boston. Mr. McIlwain currently
      serves on the boards of directors of several private companies.
      Mr. McIlwain received a Bachelor of Arts degree in government and economics
      from Dartmouth College, a Master of Arts degree in public policy from
      Harvard University’s Kennedy School of Government and a Master of Business
      Administration degree from Harvard Business School.




James
      G. Richardson has
      served as a director since October 2006. Mr. Richardson has been with Cisco
      Systems, Inc. since 1990, where he began his career as the founder of Cisco’s
      Canadian operations. Mr. Richardson has served as Cisco’s Senior Vice
      President, Commercial Business since January 2006 and has held numerous other
      senior leadership positions at Cisco, including Vice President of North American
      Operations; President of EMEA and Senior Vice President; Senior Vice President
      of the Enterprise Line of Business and Internet Communications Software Group;
      and Senior Vice President, Chief Marketing Officer. Mr. Richardson received
      a Bachelor of Commerce degree in marketing and finance from Queen’s University
      in Kingston, Ontario.





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William
      D. Ruckelshaus has
      served as a director since October 2004 and as Chairman of the Board of
      Directors since August 2006. Mr. Ruckelshaus has served in a consultative
      capacity to the Madrona Venture Group as a non-management strategic director
      since 1999. From 1988 to 1995, Mr. Ruckelshaus served as Chairman and Chief
      Executive Officer of Browning-Ferris Industries, and from 1995 to 1999 he served
      as Chairman. Mr. Ruckelshaus served as the founding Administrator of the
      U.S. Environmental Protection Agency in 1970 and has served as Acting
      Director of the Federal Bureau of Investigation and Deputy Attorney General
      of
      the U.S. Department of Justice. Mr. Ruckelshaus served as Senior Vice
      President for Law and Corporate Affairs for the Weyerhaeuser Company and again
      served as EPA Administrator in the mid-1980s before joining Perkins Coie LLP,
      a
      private law firm, where he worked as an attorney. Mr. Ruckelshaus has
      previously served on the boards of directors of several corporations, including
      Cummins Engine Company, Nordstrom and the Weyerhaeuser Company.
      Mr. Ruckelshaus is a member of the board of directors of World Resources
      Institute in Washington, D.C. and is a member of the U.S. Commission
      on Ocean Policy. Mr. Ruckelshaus received a Bachelor of Arts degree in
      politics from Princeton University and a Juris Doctorate degree from
      Harvard Law School.




Peter
      H. van Oppenhas served
      as a director since February 2008. Mr. van Oppen most recently served as
      Chief Executive Officer and Chairman of the Board for Advanced Digital
      Information Corporation (ADIC) for twelve years, from 1994 through its
      acquisition by Quantum Corp. in 2006. Prior to ADIC, van Oppen served as
      President and Chief Executive Officer of Interpoint from 1989 until its
      acquisition by Crane Co. in October 1996, and has also been a managing
      consultant at Price Waterhouse LLP and Bain & Company. Mr. van Oppen
      received a Bachelor of Arts degree in political science from
      Whitman College and a Master of Business Administration degree from
      Harvard Business School, where he was a Baker Scholar.





Our
      executive officers are appointed by, and serve at the discretion of, our board
      of directors. There are no family relationships among any of our directors
      or
      executive officers.





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FACTORS
      AFFECTING OUR OPERATING RESULTS,


BUSINESS
      PROSPECTS AND MARKET PRICE OF STOCK




ITEM 1A.Risk
      Factors




This
      Annual Report on Form 10-K, or Form 10-K, including any information
      incorporated by reference herein, contains forward-looking statements within
      the
      meaning of Section 27A of the Securities Act of 1933, as amended, referred
      to as the Securities Act, and Section 21E of the Securities Exchange Act of
      1934, as amended, referred to as the Exchange Act. In some cases, you can
      identify forward-looking statements by terms such as "may," "will," "should,"
      "expect," "plan," "intend," "forecast," "anticipate," "believe," "estimate,"
      "predict," "potential," "continue" or the negative of these terms or other
      comparable terminology. The forward-looking statements contained in this
      Form 10-K involve known and unknown risks, uncertainties and situations
      that may cause our or our industry's actual results, level of activity,
      performance or achievements to be materially different from any future results,
      levels of activity, performance or achievements expressed or implied by these
      statements. These factors include those listed below in this Item 1A and
      those discussed elsewhere in this Form 10-K. We encourage investors to
      review these factors carefully. We may from time to time make additional written
      and oral forward-looking statements, including statements contained in our
      filings with the SEC. We do not undertake to update any forward-looking
      statement that may be made from time to time by or on behalf of us.




Before
      you invest in our securities,
      you should be aware that our business faces numerous financial and market risks,
      including those described below, as well as general economic and business risks.
      The following discussion provides information concerning the material risks
      and
      uncertainties that we have identified and believe may adversely affect our
      business, our financial condition and our results of operations. Before you
      decide whether to invest in our securities, you should carefully consider these
      risks and uncertainties, together with all of the other information included
      in
      this Annual Report on Form 10-K.





Risks
      Related to Our Restatement





Matters
      relating to or arising from our recent restatement and weaknesses in our
      internal controls, including adverse publicity and potential concerns from
      our
      customers and prospective customers, regulatory inquiries, and litigation
      matters, could have a material adverse effect on our business, revenues,
      operating results, or financial condition.





As
      more
      fully described in the explanatory note on page 3 of this Annual
      Report on Form 10-K, in November 2007, our Audit Committee initiated an
      independent investigation of certain of our sales to resellers and other
      customers to determine whether commitments were made that have an impact on
      the
      timing and treatment of revenue recognition, and whether our internal controls
      relating to revenue recognition are sufficient.  Our Audit Committee
      conducted its investigation and review with the assistance of independent
      counsel and an independent forensic accounting advisor.





On
      April
      2, 2008, we announced the completion of the investigation and filed this Annual
      Report on Form 10-K for the year ended December 30, 2007, which we refer to
      as
      the Form 10-K and which, includes our restated financial statements for the
      fiscal year ended December 31, 2006, and our restated financial information
      for
      the first and second quarters of fiscal 2007, ended April 1, 2007 and July
      1,
      2007, respectively.   The circumstances and findings of our Audit
      Committee’s investigation are more fully described in the explanatory note on
      page 3 of this Form 10-K.





The
      investigation and resulting restatement could have a material adverse effect
      on
      our relationships with customers and customer prospects, has already resulted
      in
      the initiation of securities class action litigation and derivative litigation,
      and could result in other civil litigation or formal or informal regulatory
      inquiries or litigation, any of which could have a material adverse effect
      on
      our business, revenues, operating results, or financial
      condition.  Under Delaware law, our bylaws, and certain
      indemnification agreements, we may have an obligation to indemnify certain
      current and former officers and directors in relation to these
      matters.  Such indemnification may have a material adverse effect on
      our business, results of operations, and financial condition to the extent
      insurance does not cover our costs.  The insurance carriers that
      provide our directors’ and officers’ liability policies may seek to rescind or
      deny coverage with respect to those pending investigations or actions in whole
      or in part, or we may not have sufficient coverage under such policies, in
      which
      case our business, results of operations, and financial condition may be
      materially and adversely affected.





Impact
      on our
      Business





As
      a
      result of the investigation, we filed our Quarterly Report on Form 10-Q for
      the
      quarter ended September 30, 2007, approximately five months late.  Our
      non-compliance with public reporting obligations also subjected us to delisting
      proceedings from the NASDAQ Global Market.  We believe that our
      competitors have sought and will continue to seek to leverage the restatement
      and investigation to try and raise concerns about us in the minds of our
      customers and customer prospects.  Our delinquency, the restatement,
      resulting litigation, any regulatory inquiries, and other adverse publicity
      could affect our relationships with customers and customer prospects and could
      have a material adverse effect on our business, revenues, operating results,
      and
      financial condition and cash flows.





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Litigation
      and Regulatory
      Matters





As
      further described in Part I, Item 3 of this Form 10-K, we and certain of our
      executive officers are defendants in a consolidated federal securities class
      action.  Although a consolidated complaint has not yet been filed, the
      pre-consolidation complaint alleged that defendants violated section 10(b)
      and
      20(a) of the Exchange Act and rule 10b-5 promulgated under the Exchange Act
      by
      making false or misleading statements and claims.  In addition, on
      March 18, 2008, a shareholder derivative action was filed in the Superior Court
      of the State of Washington (King County), allegedly on behalf of and for
      the benefit of the Company, against certain of our current and former directors
      and officers.  The Company was also named as a nominal defendant.  A
      substantially similar complaint was filed in the same court on March 24, 2008.
      The derivative complaints allege that the individual defendants breached
      fiduciary duties owed to the Company by publicly misrepresenting Isilon’s
      business prospects, and by failing to properly account for certain revenues
      earned in our fiscal year ended December 31, 2006, and first and second quarters
      in fiscal 2007.





Both
      these matters are in preliminary stages.  We cannot predict the
      claims, allegations, class period, or outcome of these matters.  In
      addition, we cannot provide any assurances that the final outcome of the
      securities lawsuit or the derivative lawsuits will not have a material adverse
      effect on our business, results of operations, or financial
      condition.  We may become subject to additional litigation, regulatory
      inquires, including potential SEC inquiries, or other proceedings or actions
      arising out of our Audit Committee’s investigation and the related restatement
      of our historic financial statements.   Litigation and any
      potential regulatory actions or proceedings can be time-consuming and expensive
      and could divert management time and attention from our business, which could
      have a material adverse effect on our revenues and results of
      operations.  The adverse resolution of any specific lawsuit or
      potential regulatory action or proceeding could have a material adverse effect
      on our business, results of operations, financial condition, and cash
      flows.




If
      we fail to establish and maintain proper and effective internal controls, our
      ability to produce accurate financial statements on a timely basis could be
      impaired, which would adversely affect our consolidated operating results,
      our
      ability to operate our business and investors’ views of us.




Ensuring
      that we have adequate internal financial and accounting controls and procedures
      in place to produce accurate financial statements on a timely basis is a costly
      and time-consuming effort that needs to be re-evaluated frequently. Failure
      on
      our part to have effective internal financial and accounting controls would
      cause our financial reporting to be unreliable, could have a material adverse
      effect on our business, operating results, and financial condition and could
      cause the trading price of our common stock to fall dramatically. In our
      Quarterly Report on Form 10-Q for the period-ended September 30, 2007, our
      Chief Executive Officer and Chief Financial Officer determined that our internal
      control over financial reporting was not effective.




Our
      Audit
      Committee's investigation of revenue recognition issues identified internal
      control weaknesses relating primarily to the failure to communicate complete
      information regarding certain sales transactions containing non-standard terms
      among finance, accounting, legal, sales and senior management personnel and
      an ineffective risk assessment process. This material weakness was
      remediated as of December 30, 2007. Remedying our material weakness has required
      substantial management time and attention and incremental expenses.  Any failure to maintain
      the remediation of our identified
      control deficiencies or any additional errors or delays in our financial
      reporting, whether or not resulting from a failure to remedy the deficiencies
      that resulted in the current restatement, would have a material adverse effect
      on our business and results of operations and could have a substantial adverse
      impact on the trading price of our common stock and our relationships with
      customers.




O ur
      management is responsible for establishing and maintaining adequate internal
      control over financial reporting to ensure that information regarding the
      reliability of our financial reporting and the preparation of financial
      statements for external purposes in accordance with generally accepted
      accounting principles in the United States. Our management does not expect
      that
      our internal control over financial reporting will prevent or detect all errors
      and all fraud. A control system, no matter how well designed and operated,
      can
      provide only reasonable, not absolute, assurance that the control system's
      objectives will be met. Because of the inherent limitations in all control
      systems, no evaluation of controls can provide absolute assurance that
      misstatements due to error or fraud will not occur or that all control issues
      and instances of fraud, if any, within the company will have been detected.
      As
      discussed in this Form 10-K, our Audit Committee and management have
      identified control deficiencies in the past and may identify additional
      deficiencies in the future.




We
      will
      continue to be required to comply with Section 404 of the Sarbanes-Oxley
      Act of 2002.  In complying with the Act in connection with this Annual
      Report on Form 10-K for our year ended December 30, 2007, we have
      expended significant resources in developing the necessary documentation and
      testing procedures required by Section 404 of the Sarbanes-Oxley Act and
      expect to continue to expend significant resources in maintaining this
      compliance.  We cannot be certain that the actions we have taken to
      improve our internal control over financial reporting will be sufficient or
      that
      we will be able to maintain and continue to implement and improve our processes
      and procedures in the future, which could cause us to be unable to produce
      accurate financial statements on a timely basis. Any of the foregoing could
      cause investors to lose confidence in the reliability of our consolidated
      financial statements, which could cause the market price of our common stock
      to
      decline and make it more difficult for us to finance our operations and
      growth.





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Risks
      Related to Our Business and Industry





We
      have a history of losses, and we may not achieve profitability in the
      future.




We
      have
      not been profitable in any fiscal period since we were formed. We experienced
      a
      net loss of $26.9 million in 2007 and $26.0 million in 2006. As of
      December 30, 2007, our accumulated deficit was $102.6 million. We expect to
      make significant expenditures related to the development of our products and
      expansion of our business, including expenditures for additional sales and
      marketing and research and development personnel. We may encounter unforeseen
      difficulties, complications and delays and other unknown factors that require
      additional expenditures. As a result of these increased expenditures, we will
      have to generate and sustain substantially increased revenue to achieve
      profitability. Our revenue growth trends in prior periods are not likely to
      be
      sustainable. Accordingly, we may not be able to achieve or maintain
      profitability and we may continue to incur significant losses in the
      future.




We
      face intense competition and expect competition to increase in the future,
      which
      could reduce our revenue and customer base.




The
      storage market is highly competitive and we expect competition to intensify
      in
      the future. This competition could make it more difficult for us to sell our
      products, and result in increased pricing pressure, reduced profit margins,
      increased sales and marketing expenses and failure to increase, or the loss
      of,
      market share, any of which would likely seriously harm our business, operating
      results and financial condition. For instance, the decrease in the price of
      disk
      drives and other industry standard hardware components has resulted in increased
      pricing pressure and a reduction in the price per megabyte of
      storage.




Currently,
      we face competition from a number of established companies, including EMC
      Corporation, Hewlett-Packard Company, Hitachi Data Systems Corporation,
      International Business Machines Corporation, Network Appliance, Inc. and Sun
      Microsystems, Inc. We also face competition from a large number of private
      companies and recent market entrants. Many of our current competitors have,
      and
      some of our potential competitors could have, longer operating histories,
      greater name recognition, larger customer bases and significantly greater
      financial, technical, sales, marketing and other resources than we have.
      Potential customers may prefer to purchase from their existing suppliers rather
      than a new supplier regardless of product performance or features.




We
      expect
      increased competition from other established and emerging companies, including
      companies such as networking infrastructure and storage management companies
      that provide complementary technology and functionality. In addition, third
      parties currently selling our products could market products and services that
      compete with ours. Some of our competitors, including EMC and Network Appliance,
      have made acquisitions of businesses that allow them to offer more directly
      competitive and comprehensive solutions than they had previously offered. Our
      current and potential competitors may also establish cooperative relationships
      among themselves or with third parties. If so, new competitors or alliances
      that
      include our competitors may emerge that could acquire significant market share.
      We expect these trends to continue as companies attempt to strengthen or
      maintain their market positions in an evolving industry. In addition, large
      operating system and application vendors, such as Microsoft Corporation, have
      introduced and may in the future introduce products or functionality that
      include some of the same functions offered by our products. In the future,
      further development by these vendors could cause our products to become
      obsolete. In addition, we compete against internally developed storage solutions
      as well as combined third-party software and hardware solutions. Any of these
      competitive threats, alone or in combination with others, could seriously harm
      our business, operating results and financial condition.





Our
      operating results may fluctuate significantly, which makes our future results
      difficult to predict and could cause our operating results to fall below
      expectations.




Our
      operating results may fluctuate due to a variety of factors, many of which
      are
      outside of our control. As a result, comparing our operating results on a
      period-to-period basis may not be meaningful. You should not rely on our past
      results as an indication of our future performance. In addition, a significant
      portion of our quarterly sales typically occurs near the end of the quarter.
      As
      a result, small delays can make our operating results difficult to predict.
      If
      our revenue or operating results fall below the expectations of investors or
      any
      securities analysts that follow our company, the price of our common stock
      would
      likely decline.




Factors
      that may affect our operating results include:




·
            the
                timing and magnitude of shipments and timing of installations of
                our
                products in each quarter;





·
            our
                ability to build and expand our direct sales operations and reseller
                distribution channels;





·
            our
                ability to build sales backlogs and improve sales
                linearity;





·
            reductions
                in customers’ budgets for information technology purchases, delays in
                their purchasing cycles or deferments of their product purchases
                in
                anticipation of new products or updates from us or our
                competitors;





·
            the
                rates at which customers purchase additional storage systems from
                us and
                renew their service contracts with
                us;





·
            the
                timing of recognizing revenue as a result of revenue recognition
                rules;





·
            fluctuations
                in demand, sales cycles and prices for our products and
                services;





·
            our
                ability to develop, introduce and ship in a timely manner new products
                and
                product enhancements that meet customer
                requirements;





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·
            the
                timing of product releases, upgrades or announcements by us or our
                competitors;





·
            any
                change in competitive dynamics, including new entrants or discounting
                of
                product prices;





·
            our
                ability to control costs, including our operating expenses and the
                costs
                of the components we use in our
                products;





·
            the
                possibility of seasonality of demand for our
                products;





·
            volatility
                in our stock price, which may lead to higher stock compensation expenses
                pursuant to Statement of Financial Accounting Standards
                No. 123(R),Share-Based
                Payment, or SFAS 123(R), which first became effective for us in the
                first quarter of 2006 and requires that employee stock-based compensation
                be measured based on its fair value on the grant date and recorded
                as an
                expense in our financial statements over the recipient’s service
                period;





·
            future
                accounting pronouncements and changes in accounting policies;
                and





·
            geopolitical
                events such as war or incidents of
                terrorism.





Our
      limited operating history in an emerging market sector makes it difficult to
      evaluate our current business and future prospects, and may increase the risk
      of
      your investment.




Our
      company has only been in existence since January 2001. We first began
      shipping products in January 2003 and much of our growth has occurred since
      October 2005. Our limited operating history in an emerging market sector
      makes it difficult to evaluate our current business and our future prospects.
      We
      have encountered and will continue to encounter risks and difficulties
      frequently experienced by growing companies in rapidly changing industries,
      such
      as the risks described in this report. If we do not address these risks
      successfully, our business will be harmed.





Our
      future financial performance depends on growth in the storage of unstructured,
      digital content. If growth in the storage of unstructured, digital content
      does
      not continue at the rate that we forecast, our operating results would be
      materially and adversely impacted.




Our
      products are designed to address the growth in storage of unstructured, digital
      content. This is a new and emerging category. Accordingly, our future financial
      performance will depend in large part on growth in this new category and on
      our
      ability to adapt to emerging demands. Changes in technologies could adversely
      affect the demand for storage systems. For example, advances in file compression
      technology could result in smaller file sizes and reduce the demand for storage
      systems. A reduction in demand for storage of unstructured, digital content
      caused by lack of customer acceptance, weakening economic conditions, competing
      technologies and products, decreases in corporate spending or otherwise, would
      result in decreased revenue or a lower revenue growth rate. We cannot assure
      you
      that growth in the storage of unstructured, digital content will continue or
      that we will be able to respond adequately to changes in the
      future.





If
      we are unable to maintain or replace our relationships with customers or to
      increase the diversification of our customer base, it would be more difficult
      to
      maintain or grow our revenue and our growth might be limited.




Historically,
      a significant portion of our total revenue has come from a limited number of
      customers in a small number of industries, particularly media and entertainment
      and Internet companies.  For example, our largest customer for 2007,
      Eastman Kodak Company, accounted for approximately 10% of our total revenue,
      and
      our two largest customers for 2006, Comcast Corporation, which purchased through
      one of our resellers, and Eastman Kodak Company, together accounted for
      approximately 25% of our total revenue. Because of concentrated purchases by
      certain new and existing customers, our largest customers have historically
      varied from quarter to quarter. As a consequence of the concentrated nature
      of
      our customers’ purchasing patterns, the proportion of our total revenue derived
      from a small number of customers may be even higher in any future quarter.
      We
      cannot provide any assurance that we will be able to sustain our revenue from
      these customers because our revenue has largely been generated in connection
      with these customers’ decisions to deploy large-scale storage installations and
      their capacity requirements may have been met. In addition, our customers,
      including Comcast Corporation and Eastman Kodak Company, generally buy systems
      on a purchase order basis and generally do not enter into long-term contracts
      or
      minimum purchase commitments. If we are unable to sustain our revenue from
      these
      customers or to replace it with revenue from new or existing customers, our
      growth may be limited. If economic conditions change for the industries in
      which
      our largest customers do business, or if we are unable to attract significant
      numbers of customers in other targeted industries, including government, oil
      and
      gas, and life sciences, our ability to maintain or grow our revenue would be
      adversely affected.




If
      we are unable to develop and introduce new products and respond to technological
      changes, if our new products do not achieve market acceptance or if we fail
      to
      manage product transitions, we may fail to increase, or may lose, market
      share.




Our
      future growth depends on the successful development and introduction of new
      systems and software products. Due to the complexity of storage systems, these
      products are subject to significant technical risks that may impact our ability
      to introduce these products successfully. Our new products also may not achieve
      market acceptance. In addition, our new products must respond to technological
      changes and evolving industry standards. If we are unable, for technological
      or
      other reasons, to develop and introduce new products in a timely manner in
      response to changing market conditions or customer requirements, or if these
      products do not achieve market acceptance, our operating results could be
      materially and adversely affected.




Product
      introductions by us in future periods may also reduce demand for our existing
      products. As new or enhanced products are introduced, we must successfully
      manage the transition from older products in order to minimize disruption in
      customers’ ordering patterns, avoid excessive levels of older product
      inventories and ensure that sufficient supplies of new products can be delivered
      to meet customer demand.





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We
      rely on value-added resellers and other distribution partners to sell our
      products, and disruptions to, or our failure to develop and manage, our
      distribution channels and the processes and procedures that support them could
      result in these resellers and partners discontinuing the marketing and
      distribution of our products and services.




Our
      future success is highly dependent upon establishing and maintaining successful
      relationships with a variety of value-added resellers and other distribution
      partners, which we collectively refer to as channel partners. A significant
      portion of our total revenue is currently derived through our channel partners.
      Therefore, our ability to maintain or grow our revenue will likely depend,
      in
      part, on our ability to maintain our arrangements with our existing channel
      partners and to establish and expand arrangements with new channel partners,
      and
      any failure to do so could have a material adverse effect on our future revenue.
      Additionally, by relying on channel partners, we may have less contact with
      the
      ultimate users of our products, thereby making it more difficult for us to
      establish brand awareness, ensure proper delivery and installation of our
      products, service ongoing customer requirements and respond to evolving customer
      needs.




Recruiting
      and retaining qualified channel partners and training them in our technology
      and
      product offerings require significant time and resources. In order to develop
      and expand our distribution channel, we must continue to scale and improve
      our
      processes and procedures that support our channel partners, including
      investments in systems and training. Those processes and procedures may become
      increasingly complex and difficult to manage.




We
      typically enter into non-exclusive, written distribution agreements with our
      channel partners that generally have a one-year term, have no minimum sales
      commitment and do not prohibit them from offering products and services that
      compete with ours. Accordingly, our channel partners may choose to discontinue
      offering our products and services or may not devote sufficient attention and
      resources toward selling our products and services. Our competitors may provide
      incentives to our existing and potential channel partners to use or purchase
      their products and services or to prevent or reduce sales of our products and
      services. Some of our channel partners possess significant resources and
      advanced technical abilities and may, either independently or jointly with
      our
      competitors, develop and market products and related services that compete
      with
      our offerings. If this were to occur, these channel partners might discontinue
      marketing and distributing our products and services. In addition, these channel
      partners would have an advantage over us when marketing their competing products
      and related services because of their existing customer relationships. The
      occurrence of any of these events would likely materially adversely affect
      our
      business, operating results and financial condition.





Claims
      by others that we infringe their proprietary technology could cause us to incur
      substantial costs, distract our management and, if these claims are successful,
      require us to pay substantial damages or prevent us from offering our
      products.




Third
      parties could claim that our products or technologies infringe their proprietary
      rights. The data storage industry is characterized by the existence of a large
      number of patents, trademarks and copyrights and by frequent litigation based
      on
      allegations of infringement or other violations of intellectual property rights.
      We expect that infringement claims may further increase as the number of
      products and competitors in our sector increases. Although
      we have not to date been involved in any litigation related to intellectual
      property, we received a letter on July 31, 2006, from counsel to SeaChange
      International, Inc. suggesting that our products may be infringing certain
      SeaChange patents.  Since that time we have exchanged some
      correspondence with SeaChange’s legal counsel, the latest of which was our
      letter of August 31, 2007, which pointed out that there appears to be no
      reasonable basis for SeaChange to claim that Isilon infringes any of the
      SeaChange patents.  We have received no further correspondence from
      SeaChange. If we are unable to reach an amicable resolution of this dispute,
      it
      is possible that litigation with SeaChange may result. The outcome of any
      litigation is inherently unpredictable, and accordingly, we cannot assure you
      that, in the future, a court would not find that our products infringed these
      patents. We cannot assure you that we do not currently infringe, or that we
      will
      not in the future infringe, upon any third-party patents or other proprietary
      rights.




Any
      claim
      of infringement by a third party, even one without merit, could cause us to
      incur substantial costs defending against the claim, and could distract our
      management from our business. Further, a party making such a claim, if
      successful, could secure a judgment that requires us to pay substantial damages.
      A judgment could also include an injunction or other court order that could
      prevent us from offering our products. In addition, we might be required to
      seek
      a license for the use of the infringed intellectual property, which might not
      be
      available on commercially reasonable terms or at all. Alternatively, we might
      be
      required to develop non-infringing technology, which could require significant
      effort and expense and might ultimately be unsuccessful. Any of these events
      could seriously harm our business, operating results and financial condition.
      Third parties may also assert infringement claims against our customers and
      channel partners. Any of these claims would require us to initiate or defend
      potentially protracted and costly litigation on their behalf, regardless of
      the
      merits of these claims, because we generally indemnify our customers and channel
      partners from claims of infringement of proprietary rights of third parties.
      If
      any of these claims succeeds, we might be forced to pay damages on behalf of
      our
      customers or channel partners, which could have a material adverse effect on
      our
      business, operating results and financial condition.





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Our
      sales cycles can be long and unpredictable, and our sales development efforts
      require considerable time and expense. As a result, our sales are difficult
      to
      predict and may vary substantially from quarter to quarter, which may cause
      our
      operating results to fluctuate significantly.




The
      timing of our revenue is difficult to predict. Our sales efforts involve
      building and expanding our direct sales operations and reseller distribution
      channels, improving our ability to build sales backlogs and improve sales
      linearity, and educating our customers about the use and benefits of our
      products, including their technical capabilities and potential cost savings
      to
      an organization. Customers typically undertake a significant evaluation process
      that in the past has resulted in a lengthy sales cycle, in some cases more
      than
      12 months. We spend substantial time and resources on our sales efforts
      without any assurance that our efforts will produce any sales. In addition,
      product purchases are frequently subject to budget constraints, multiple
      approvals and unplanned administrative processing and other delays. If we do
      not
      realize expected sales from a specific customer for a particular quarter in
      that
      quarter or at all, our business, operating results and financial condition
      could
      be harmed.





We
      derive substantially all of our total revenue from sales of our Isilon IQ
      product family and related services, and a decline in demand for our Isilon
      IQ
      product family would cause our revenue to grow more slowly or to
      decline.




We
      derive
      substantially all of our total revenue from sales of our Isilon IQ product
      family and customer and technical support services associated with this product
      family. As a result, we are vulnerable to fluctuations in demand for this
      product family, whether as a result of competition, product obsolescence,
      technological change, customer budgetary constraints or other factors. If demand
      for our Isilon IQ product family were to decline, our financial condition would
      be harmed.





If
      we are unable to continue to create valuable innovations in software, we may
      not
      be able to generate additional high-margin revenue to increase our gross
      margins.




Our
      industry has a history of declining storage hardware prices as measured on
      a
      cost per gigabyte of storage capacity basis. In order to maintain or increase
      our gross margins, we will need to continue to create valuable software that
      is
      included with our clustered storage systems and/or sold as separate standalone
      software applications. Any new feature or application that we develop or acquire
      may not be introduced in a timely or cost-effective manner and may not achieve
      the broad market acceptance necessary to help increase our overall gross margin.
      If we are unable to successfully develop or acquire, and then market and sell,
      additional software functionality, such as our SmartConnect, SnapshotIQ,
      Migration IQ, SmartQuotas and SyncIQ software applications,  our
      ability to maintain or increase our high-margin revenue and gross margin will
      be
      adversely affected.




We
      currently rely
      on a single contract manufacturer to assemble our products, and our failure
      to
      forecast demand for our products accurately or manage our relationship with
      our
      contract manufacturer successfully could negatively impact our ability to sell
      our products.




We
      currently rely on a single contract manufacturer. On December 7, 2007, we
      provided notice to our initial contract manufacturer, Sanmina-SCI Corporation,
      of our intent to terminate for convenience the Manufacturing Services Agreement
      we entered into on February 17, 2006.  In an agreement dated August
      30, 2007, we established a contract manufacturing relationship with Solectron
      Corporation, subsequently acquired by Flextronics International
      Ltd.  This agreement provides current terms and operating conditions
      while we are continuing to negotiate a master services
      agreement.  Since that time, we have utilized Flextronics to
      manufacture and assemble our products, procure components for our systems and
      help manage our supply chain, perform testing and manage delivery of our
      products.   Our reliance on Flextronics reduces our control over
      the assembly process, exposing us to risks, including reduced control over
      quality assurance, production costs and product supply. If we fail to manage
      our
      relationship with Flextronics effectively, or if Flextronics experiences delays,
      disruptions, capacity constraints or quality control problems in its operations,
      our ability to ship products to our customers could be impaired and our
      competitive position and reputation could be harmed. If we and Flextronics
      are
      unable to negotiate with suppliers for reduced component costs, our operating
      results would be harmed.  If we are unable to finalize the master
      services agreement or are otherwise required to change contract manufacturers
      or
      assume internal manufacturing operations, we may lose revenue, incur increased
      costs and damage our customer relationships. Qualifying a new contract
      manufacturer and commencing volume production are expensive and time-consuming.
      We provide forecasts to Flextronics regarding product demand and production
      levels. If we inaccurately forecast demand for our products, we may have excess
      or inadequate inventory or incur cancellation charges or penalties, which could
      adversely impact our operating results.





We
      intend
      to introduce new products and product enhancements, which could require us
      to
      achieve volume production rapidly by coordinating with Flextronics and component
      suppliers. We may need to increase our component purchases, contract
      manufacturing capacity, and internal test and quality functions if we experience
      increased demand. The inability of Flextronics to provide us with adequate
      supplies of high-quality products, or an inability to obtain adequate quantities
      of components, could cause a delay in our order fulfillment, and our business,
      operating results and financial condition would be adversely
      affected.





We
      rely on a limited number of suppliers, and in some cases single-source
      suppliers, and any disruption or termination of these supply arrangements could
      delay shipments of our products and could materially and adversely affect our
      relationships with current and prospective customers.




We
      rely
      on a limited number of suppliers for several key components utilized in the
      assembly of our products. We purchase several of our required components, such
      as chassis and disk drives, from a single supplier. This reliance on a limited
      number of suppliers involves several risks, including:





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·
            supplier
                capacity constraints;





·
            price
                increases;





·
            timely
                delivery; and





·
            component
                quality.





Component
      quality is particularly significant with respect to our suppliers of disk
      drives. In order to meet product capacity requirements, we must obtain disk
      drives of extremely high quality and capacity. We cannot assure you that we
      will
      be able to obtain enough of these components in the future or that prices of
      these components will not increase. In addition, problems with respect to yield
      and quality of these components and timeliness of deliveries could occur.
      Disruption or termination of the supply of these components could delay
      shipments of our products and could materially and adversely affect our
      relationships with current and prospective customers. These delays could also
      materially and adversely affect our operating results.





If
      we fail to manage future growth effectively, we may not be able to market and
      sell our products and services successfully.




We
      have
      expanded our operations significantly since inception and anticipate that
      further significant expansion will be required. Our future operating results
      depend to a large extent on our management’s ability to manage expansion and
      growth successfully, including, but not limited to, hiring, training and
      developing our sales personnel to become productive and generate revenue,
      forecasting revenue, controlling expenses, implementing and enhancing
      infrastructure, systems and processes, addressing new markets and expanding
      international operations. A failure to manage our growth effectively could
      materially and adversely affect our ability to market and sell our products
      and
      services.





Our
      products incorporate components that are obtained in spot markets, and, as
      a
      result, our cost structure and our ability to respond in a timely manner to
      customer demand are sensitive to volatility in the market prices for these
      components.




A
      significant portion of our expenses is directly related to the pricing of
      commoditized components utilized in the manufacture of our products, such as
      memory chips, disk drives and CPUs. As part of our procurement model, we do
      not
      enter into long-term supply contracts for these components, but instead have
      our
      contract manufacturer purchase these components on our behalf. In some cases,
      our contract manufacturer does so in a competitive-bid purchase order
      environment with suppliers or on the open market at spot prices. As a result,
      our cost structure is affected by price volatility in the marketplace for these
      components, especially for disk drives. This volatility makes it difficult
      to
      predict expense levels and operating results and may cause them to fluctuate
      significantly. Furthermore, if we are successful in growing our business, we
      may
      not be able to continue to procure components on the spot market, which would
      require us to enter into contracts with component suppliers to obtain these
      components. This could increase our costs and decrease our gross
      margins.





We
      maintain relatively low inventory and acquire components only as needed; as
      a
      result, if shortages of these components arise, we may not be able to secure
      enough components to build new products to meet customer demand.




We
      maintain relatively low inventory and acquire components only as needed, and
      neither we nor our contract manufacturer enter into long-term supply contracts
      for these components. As a result, our ability to respond to customer orders
      efficiently may be constrained by the then-current availability or terms and
      pricing of these components. Our industry has experienced component shortages
      and delivery delays in the past, and we may experience shortages or delays
      of
      critical components in the future as a result of strong demand in the industry
      or other factors. For example, disk drives can represent a significant portion
      of our cost of revenue, and both the price and availability of various kinds
      of
      disk drives are subject to substantial volatility in the spot market. In the
      past, we have encountered situations where we paid higher prices than we had
      anticipated for disk drives or had to use a larger-size drive as a replacement.
      Likewise, in the past, the industry experienced a shortage of selected memory
      chips, which caused some of our motherboard suppliers to reduce or suspend
      shipments to us. This delayed our ability to ship selected configurations to
      some of our customers, and in some cases accelerated a transition by us to
      other
      components. In addition, new generations of disk drives are often in short
      supply and are subject to industry allocations that may limit our ability to
      procure these disk drives. Many of the other components required to build our
      systems are occasionally in short supply and subject to industry allocations.
      If
      shortages or delays arise, the prices of these components may increase or the
      components may not be available at all. We may not be able to secure enough
      components at reasonable prices or of acceptable quality to build new products
      to meet customer demand, which could adversely affect our business, operating
      results and financial condition.





If
      we lose key personnel, if key personnel are distracted or if we are unable
      to
      attract and retain highly-qualified personnel on a cost-effective basis, it
      would be more difficult for us to manage our existing business operations and
      to
      identify and pursue new growth opportunities.




Our
      future performance depends on the continued service of our key technical, sales,
      services, and management personnel. We rely on our executive officers and senior
      management to manage our existing business operations and to identify and pursue
      new growth opportunities. The loss of key employees could result in significant
      disruptions to our business, and the integration of replacement personnel could
      be time-consuming, cause additional disruptions to our business or be
      unsuccessful.   The loss of the services of key executives for
      any reason could adversely affect our business, operating results and financial
      condition.




Our
      future success also depends on our continued ability to attract and retain
      highly-qualified technical, sales, services, and management personnel. In
      particular, our ability to enhance and maintain our technology requires talented
      software development engineers with specialized skills in areas such as
      distributed computing, file systems and operating systems. If we are not able
      to
      recruit and retain these engineers, the quality and speed with which our
      products are developed would likely be seriously compromised, and our reputation
      and business would suffer as a result. Competition for these and the other
      personnel we require, particularly in the Seattle metropolitan area, is intense,
      and we may fail to retain our key technical, sales, services and management
      employees or to attract or retain other highly-qualified technical, sales,
      services, and management personnel in the future.




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Our
      ability to sell our products is highly dependent on the quality of our customer
      service offerings, and our failure to offer high-quality customer service
      offerings would have a material adverse effect on our ability to market and
      sell
      our products and services.




After
      our
      products are deployed within our customers’ networks, our customers depend on
      our services organization to resolve issues relating to our products.
      High-quality customer support services are critical for the successful marketing
      and sale of our products. If we or our channel partners do not effectively
      assist our customers in deploying our products, succeed in helping our customers
      to resolve post-deployment issues quickly, and provide ongoing support, it
      would
      adversely affect our ability to sell our products to existing customers and
      could harm our prospects with potential customers. In addition, as we expand
      our
      operations internationally, our customer services organization will face
      additional challenges, including those associated with delivering services,
      training and documentation in languages other than English. As a result, our
      failure to maintain high-quality customer support services could have a material
      adverse effect on our business, operating results and financial
      condition.





Our
      products are highly technical and may contain undetected software or hardware
      defects, which could cause data unavailability, loss or corruption that might,
      in turn, result in liability to our customers and harm to our reputation and
      business.




Our
      storage products are highly technical and complex and are often used to store
      information critical to our customers’ business operations. Our products have
      contained and may contain undetected errors, defects or security vulnerabilities
      that could result in data unavailability, loss or corruption or other harm
      to
      our customers. Some errors in our products may only be discovered after they
      have been installed and used by customers. Any errors, defects or security
      vulnerabilities discovered in our products after commercial release, as well
      as
      any computer virus or human error on the part of our customer support or other
      personnel resulting in a customer’s data unavailability, loss or corruption
      could result in a loss of revenue or delay in revenue recognition, a loss of
      customers or increased service and warranty costs, any of which could adversely
      affect our business, operating results and financial condition. In addition,
      we
      could face claims for product liability, tort or breach of warranty, including
      claims relating to changes to our products made by our channel partners. Our
      contracts with customers contain provisions relating to warranty disclaimers
      and
      liability limitations, which may be difficult to enforce. Defending a lawsuit,
      regardless of its merit, would be costly and might divert management’s attention
      and adversely affect the market’s perception of us and our products. In
      addition, if our business liability insurance coverage proves inadequate with
      respect to a claim or future coverage is unavailable on acceptable terms or
      at
      all, our business, operating results and financial condition could be adversely
      impacted.




Our
      international sales and operations subject us to additional risks that may
      adversely affect our international operations and reduce our international
      sales.




We
      derived approximately 27% and 24% of our total revenue from customers outside
      the United States in 2007 and 2006, respectively. We have sales and technical
      support personnel in several countries worldwide. We expect to continue to
      add
      personnel in additional countries.  Our various international
      operations subject us to a variety of risks, including:




·
            the
                difficulty of managing and staffing international offices and the
                increased travel, infrastructure and legal compliance costs associated
                with multiple international
                locations;





·
            difficulties
                in enforcing contracts and collecting accounts receivable, and longer
                payment cycles, especially in emerging
                markets;





·
            the
                challenge of managing development teams in geographically disparate
                locations;





·
            tariffs
                and trade barriers and other regulatory or contractual limitations
                on our
                ability to sell or develop our products in various foreign
                markets;





·
            increased
                exposure to foreign currency exchange rate
                risk;





·
            reduced
                protection for intellectual property rights in some countries ;
                and





·
            political
                and economic instability.




As
      we
      expand our business globally, our success will depend, in large part, on our
      ability to anticipate and effectively manage these risks. Our failure to manage
      any of these risks successfully could harm our international operations and
      reduce our international sales, adversely affecting our business, operating
      results and financial condition.





If
      we are unable to protect our intellectual property rights, our competitive
      position could be harmed or we could be required to incur significant expenses
      to enforce our rights.




Our
      success is dependent in part on obtaining, maintaining and enforcing our patent
      and other proprietary rights. We rely on trade secret, patent, copyright and
      trademark laws, and confidentiality agreements with employees and third parties,
      all of which offer only limited protection. The steps we have taken to protect
      our proprietary rights may not be adequate to prevent misappropriation of our
      proprietary information or infringement of our intellectual property rights,
      and
      our ability to prevent this misappropriation or infringement is uncertain,
      particularly in countries outside of the United States. Further, with respect
      to
      patent rights, we do not know whether any of our pending patent applications
      will result in the issuance of a patent or whether the examination process
      will
      require us to narrow our claims. To date, we have obtained one issued United
      States patent and this patent, as well as any additional patents that may be
      issued to us may be contested, circumvented, found unenforceable or invalidated,
      and we may not be able to prevent third parties from infringing them. Moreover,
      the rights granted under any issued patents may not provide us with proprietary
      protection or competitive advantages, and, as a result, our competitors may
      be
      able to develop technologies similar or superior to ours.




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Protecting
      against the unauthorized use of our products, trademarks and other proprietary
      rights is expensive and difficult. Litigation may be necessary in the future
      to
      enforce or defend our intellectual property rights, to protect our trade secrets
      or to determine the validity and scope of the proprietary rights of others.
      Any
      such litigation could result in substantial costs and diversion of management
      resources, either of which could harm our business, operating results and
      financial condition. Further, many of our current and potential competitors
      have
      the ability to dedicate substantially greater resources to enforcing their
      intellectual property rights than we have. Accordingly, we may not be able
      to
      prevent third parties from infringing upon or misappropriating our intellectual
      property.




Our
      use of open source and third-party software could impose unanticipated
      conditions or restrictions on our ability to commercialize our
      products.




We
      incorporate open source software into our products. Although we monitor our
      use
      of open source software to avoid subjecting our products to conditions we do
      not
      intend, the terms of many open source licenses have not been interpreted by
      United States courts, and there is a risk that these licenses could be construed
      in a manner that could impose unanticipated conditions or restrictions on our
      ability to commercialize our products. In this event, we could be required
      to
      seek licenses from third parties in order to continue offering our products,
      to
      make generally available, in source code form, proprietary code that links
      to
      certain open source modules, to re-engineer our products, or to discontinue
      the
      sale of our products if re-engineering could not be accomplished on a timely
      basis, any of which could adversely affect our business, operating results
      and
      financial condition.




We
      may
      also find that we need to incorporate certain proprietary third-party
      technologies, including software programs, into our products in the future.
      However, licenses to relevant third-party technology may not be available to
      us
      on commercially reasonable terms, or at all. Therefore, we could face delays
      in
      product releases until equivalent technology can be identified, licensed or
      developed, and integrated into our current products. These delays, if they
      occur, could materially adversely affect our business, operating results and
      financial condition.




Our
      products must interoperate with many software applications that are developed
      by
      others and if we are unable to devote the necessary resources to ensure that
      our
      products interoperate with those applications, we may fail to increase, or
      we
      may lose, market share and we may experience a weakening demand for our
      products.




Our
      products must interoperate with many software applications that are developed
      by
      others. When new or updated versions of these software applications are
      introduced, we must sometimes develop updated versions of our software so that
      they interoperate properly with these applications. We may not accomplish these
      development efforts quickly, cost-effectively or at all. These development
      efforts require substantial capital investment and the devotion of substantial
      employee resources. For example, our products currently interoperate with a
      number of data protection applications marketed by vendors such as Symantec
      Corporation and EMC. If we fail to maintain compatibility with these
      applications, our customers may not be able to protect adequately the data
      resident on our products and we may, among other consequences, fail to increase,
      or we may lose, market share and experience a weakening in demand for our
      products, which would adversely affect our business, operating results and
      financial condition.





Our
      products must interoperate with various data-access protocols and, if we are
      unable to ensure that our products interoperate with these protocols, our
      products might become less competitive.




Our
      products interoperate with servers and software applications predominantly
      through the use of protocols, many of which are created and maintained by
      independent standards organizations. However, some of these protocols that
      exist
      today or that may be created in the future are or could be proprietary
      technology and therefore require licensing the proprietary protocol’s
      specifications from a third party or implementing the protocol without
      specifications, which might entail significant effort on our part. If we fail
      to
      obtain a license to these specifications from third-party vendors on reasonable
      terms or at all, and we are not able to implement the protocol in the absence
      of
      these specifications, our products might become less competitive, which would
      harm our business. For example, Microsoft Corporation maintains and enhances
      the
      Common Internet File System, or CIFS, a proprietary protocol that our products
      use to communicate with the Windows operating system, the most popular computer
      operating system in the world. Although our products are currently compatible
      with CIFS, at present we do not license the specifications to this proprietary
      protocol. If we are not able to continue to maintain adequate compatibility
      with
      CIFS or if we are not able to license adequate specifications to this protocol
      on reasonable terms, our products would likely be less competitive in the
      marketplace, which would adversely affect our business, operating results and
      financial condition.





If
      our products do not interoperate with our customers’ networks, servers or
      software applications, installations would be delayed or cancelled.




Our
      products must interoperate with our customers’ existing infrastructure,
      specifically their networks, servers and software applications. This
      infrastructure often utilizes multiple protocol standards, products from
      multiple vendors and a wide range of storage features. If we find, as we have
      in
      the past, defects in the existing software or hardware used in our customers’
infrastructure or an incompatibility or deficiency in our software, we may
      have
      to modify our software so that our products will interoperate with our
      customers’ infrastructure. This could cause longer sales and implementation
      cycles for our products and could cause order cancellations, either of which
      would adversely affect our business, operating results and financial
      condition.





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We
      may engage in future acquisitions that could disrupt our business, cause
      dilution to our stockholders, reduce our financial resources and result in
      increased expenses.




In
      the
      future, we may acquire other businesses, products or technologies. We have
      not
      made any acquisitions to date. Accordingly, our ability as an organization
      to
      make acquisitions is unproven. We may not be able to find suitable acquisition
      candidates, and we may not be able to complete acquisitions on favorable terms,
      if at all. If we do complete acquisitions, we may not strengthen our competitive
      position or achieve our goals, or these acquisitions may be viewed negatively
      by
      customers, financial markets or investors. In addition, any acquisitions that
      we
      make could lead to difficulties in integrating personnel, technologies and
      operations from the acquired businesses and in retaining and motivating key
      personnel from these businesses. Acquisitions may disrupt our ongoing
      operations, divert management from day-to-day responsibilities, increase our
      expenses and adversely impact our business, operating results and financial
      condition. Future acquisitions may reduce our cash available for operations
      and
      other uses, and could result in an increase in amortization expense related
      to
      identifiable assets acquired, potentially dilutive issuances of equity
      securities or the incurrence of debt.





Changes
      in financial accounting standards or practices may cause adverse, unexpected
      financial reporting fluctuations and affect our reported results of
      operations.




A
      change
      in accounting standards or practices can have a significant effect on our
      operating results and may affect our reporting of transactions completed before
      the change is effective. New accounting pronouncements and varying
      interpretations of existing accounting pronouncements have occurred and may
      occur in the future. Changes to existing rules or the questioning of current
      practices may adversely affect our reported financial results or the way we
      conduct our business. For example, as a result of SFAS 123(R), our results
      of
      operations in 2006 and 2007 reflect expenses that are not reflected in prior
      periods, making it more difficult for investors to evaluate our 2006 and 2007
      results of operations relative to prior periods.





Our
      business is subject to increasingly complex environmental legislation that
      has
      increased both our costs and the risk of noncompliance.




We
      face
      increasing complexity in our product design and procurement operations as we
      adjust to new and upcoming requirements relating to the materials composition
      of
      many of our products. The European Union, or EU, has adopted certain directives
      to facilitate the recycling of electrical and electronic equipment sold in
      the
      EU, including the Restriction on the Use of Certain Hazardous Substances in
      Electrical and Electronic Equipment, or RoHS, directive. The RoHS directive
      restricts the use of lead, mercury and certain other substances in electrical
      and electronic products placed on the market in the EU after July 1,
      2006.




In
      connection with our compliance with these environmental laws and regulations,
      we
      could incur substantial costs, including reserves taken for excess component
      inventory, and be subject to disruptions to our operations and logistics. In
      addition, we will need to ensure that we can manufacture compliant products
      and
      that we can be assured a supply of compliant components from suppliers. Similar
      laws and regulations have been proposed or may be enacted in other regions,
      including in the United States, China and Japan. Other environmental regulations
      may require us to reengineer our products to utilize components that are
      compatible with these regulations, and this reengineering and component
      substitution may result in additional costs to us. We cannot assure you that
      existing laws or future laws will not have a material adverse effect on our
      business.





We
      are subject to governmental export and import controls that could impair our
      ability to compete in international markets.




Because
      we incorporate encryption technology into our products, our products are subject
      to United States export controls and may be exported outside the United States
      only with the required level of export license or through an export license
      exception. In addition, various countries regulate the importation of certain
      encryption technology and have enacted laws that could limit our ability to
      distribute our products or could limit our customers’ ability to implement our
      products in those countries. Changes in our products or changes in export and
      import regulations may create delays in the introduction of our products in
      international markets, prevent our customers with international operations
      from
      deploying our products throughout their global systems or, in some cases,
      prevent the export or import of our products to certain countries altogether.
      Any change in export or import regulations or related legislation, shift in
      approach to the enforcement or scope of existing regulations or change in the
      countries, persons or technologies targeted by these regulations could result
      in
      decreased use of our products by, or in our decreased ability to export or
      sell
      our products to, existing or potential customers with international
      operations.




If
      we need additional capital in the future, it may not be available to us on
      favorable terms, or at all.




We
      have
      historically relied on outside financing and customer payments to fund our
      operations, capital expenditures and expansion. We may require additional
      capital from equity or debt financing in the future to fund our operations
      or
      respond to competitive pressures or strategic opportunities. We may not be
      able
      to secure timely additional financing on favorable terms, or at all. The terms
      of any additional financing may place limits on our financial and operating
      flexibility. If we raise additional funds through further issuances of equity,
      convertible debt securities or other securities convertible into equity, our
      existing stockholders could suffer significant dilution in their percentage
      ownership of our company, and any new securities we issue could have rights,
      preferences and privileges senior to those of holders of our common stock.
      If we
      are unable to obtain adequate financing or financing on terms satisfactory
      to
      us, if and when we require it, our ability to grow or support our business
      and
      to respond to business challenges could be significantly limited.





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Our
      business is subject to the risks of earthquakes and other natural catastrophic
      events, and to interruption by man-made problems such as computer viruses or
      terrorism.




Our
      corporate headquarters are located in Seattle, Washington, an area that is
      at
      heightened risk of earthquake and volcanic events. We may not have adequate
      business interruption insurance to compensate us for losses that may occur
      from
      any such significant events. A significant natural disaster, such as an
      earthquake or volcanic eruption, could have a material adverse impact on our
      business, operating results and financial condition. Also, our servers are
      vulnerable to computer viruses, break-ins and similar disruptions from
      unauthorized tampering with our computer systems. In addition, acts of terrorism
      could cause disruptions in our or our customers’ business or the economy as a
      whole. To the extent that these disruptions result in delays or cancellations
      of
      customer orders or the deployment of our products, our business, operating
      results and financial condition would be adversely affected.






Risks
      Related to Ownership of Our Common Stock





The
      trading price of our common stock is likely to be volatile.




The
      trading prices of the securities of technology companies have been highly
      volatile. Further, our common stock has a limited trading history. Since our
      initial public offering in December 2006 through March 20, 2008, our stock
      price
      has fluctuated from a high of $28.50 to a low of $4.51. Factors affecting the
      trading price of our common stock, some of which are outside our control,
      include:




·
            variations
                in our operating results or those of our
                competitors;





·
            announcements
                of technological innovations, new products or product enhancements,
                strategic alliances or significant agreements by us or by our
                competitors;





·
            the
                gain or loss of significant
                customers;





·
            the
                level of sales in a particular
                quarter;





·
            lawsuits
                threatened or filed against us;





·
            the
                recruitment or departure of key
                personnel;





·
            changes
                in the estimates of our operating results or changes in recommendations
                by
                any securities analysts who elect to follow our common
                stock;





·
            market
                conditions in our industry, the industries of our customers and the
                economy as a whole; and





·
            the
                adoption or modification of regulations, policies, procedures or
                programs
                applicable to our business.





In
      addition, if the market for technology stocks or the stock market in general
      experiences loss of investor confidence, the trading price of our common stock
      could decline for reasons unrelated to our business, operating results or
      financial condition. The trading price of our common stock might also decline
      in
      reaction to events that affect other companies in our industry even if these
      events do not directly affect us. Each of these factors, among others, could
      have a material adverse effect on an investment in our common stock. Some
      companies that have had volatile market prices for their securities have had
      securities class actions filed against them. If a suit were filed against us,
      regardless of its merits or outcome, it would likely result in substantial
      costs
      and divert management’s attention and resources. This could have a material
      adverse effect on our business, operating results and financial condition.





If
      securities or industry analysts cease publishing research or publish inaccurate
      or unfavorable research about our business, our stock price and trading volume
      could decline.




The
      trading market for our common stock depends in part on any research and reports
      that securities or industry analysts publish about us or our business. In the
      event one or more of these analysts downgrade our stock, cease publishing or
      publish inaccurate or unfavorable research about our business, our stock price
      would likely decline. If one or more of these analysts cease coverage of our
      company or fail to publish reports on us regularly, demand for our stock could
      decrease, which could cause our stock price and trading volume to
      decline.





Future
      sales of shares by existing stockholders could cause our stock price to
      decline.




We
      completed our initial public offering in December 2006, and the contractual
      lock-up applicable to our equity holders at the time of our initial public
      offering expired in June 2007.  As a result, additional shares of our
      common stock have become eligible for sale in the public market, including
      shares held by directors, executive officers and other affiliates.  In
      addition, outstanding warrants and options to purchase shares of our common
      stock under our 2001 Stock Plan, 2006 Equity Incentive Plan or 2006 Employee
      Stock Purchase Plan, as well as additional shares reserved for issuance
      under our 2006 Equity Incentive Plan have become, and will continue
      to become, eligible for sale in the public market subject to certain
      legal and contractual limitations. If a significant portion of these shares
      are
      sold, or if it is perceived that they will continue to be sold, the
      trading price of our common stock could decline
      substantially.





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Insiders
      continue to have substantial control over us and will be able to influence
      corporate matters.




As
      of
      December 30, 2007, our directors and executive officers and their
      affiliates beneficially own, in the aggregate, approximately 48.5% of our
      outstanding common stock. As a result, these stockholders will be able to
      exercise significant influence over all matters requiring stockholder approval,
      including the election of directors and approval of significant corporate
      transactions, such as a merger or other sale of our company or its assets.
      This
      concentration of ownership could limit other stockholders’ ability to influence
      corporate matters and may have the effect of delaying or preventing a third
      party from acquiring control over us.




Provisions
      in our certificate of incorporation and bylaws and Delaware law might
      discourage, delay or prevent a change of control of our company or changes
      in
      our management and, therefore, depress the trading price of our common
      stock.




Our
      certificate of incorporation and bylaws contain provisions that could depress
      the trading price of our common stock by acting to discourage, delay or prevent
      a change in control of our company or changes in our management that the
      stockholders of our company may deem advantageous. These
      provisions:





·
            establish
                a classified board of directors so that not all members of our board
                are
                elected at one time;





·
            provide
                that directors may only be removed “for
                cause;”





·
            authorize
                the issuance of “blank check” preferred stock that our board of directors
                could issue to increase the number of outstanding shares and to discourage
                a takeover attempt;





·
            eliminate
                the ability of our stockholders to call special meetings of
                stockholders;





·
            prohibit
                stockholder action by written consent, which has the effect of requiring
                all stockholder actions to be taken at a meeting of
                stockholders;





·
            provide
                that the board of directors is expressly authorized to make, alter
                or
                repeal our bylaws; and





·
            establish
                advance notice requirements for nominations for election to our board
                of
                directors or for proposing matters that can be acted upon by stockholders
                at stockholder meetings.





In
      addition, Section 203 of the Delaware General Corporation Law may
      discourage, delay or prevent a change in control of our company by prohibiting
      stockholders owning in excess of 15% of our outstanding voting stock from
      merging or combining with us unless certain approvals are obtained.








ITEM 1B.Unresolved
      Staff
      Comments





There
      are
      currently no unresolved issues with respect to any SEC staff written comments
      that were received at least 180 days before the end of the Company’s fiscal
      year to which this report relates and that relate to the Company’s periodic or
      current reports under the Act.







ITEM 2.Properties




Our
      principal administrative, sales, marketing, customer support and research and
      development facility is located at our headquarters in Seattle, Washington.
      We
      currently lease approximately 66,000 square feet of office space in the
      Seattle facility and an additional approximately 21,000 square feet of lab
      space in the same building under a lease expiring on June 30, 2014. We also
      lease space in various locations throughout the United States and in multiple
      locations worldwide, primarily for sales and services personnel. We believe
      that
      our current facilities are adequate to meet our current needs and that suitable
      additional or substitute space will be available as needed to accommodate
      expansion of our operations.







ITEM 3.Legal
      Proceedings




On
      November 1, 2007, a putative class action complaint was filed in the U.S.
      District Court for the Western District of Washington against the Company and
      certain of its current and former directors and officers. The complaint
      asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act
      of
      1934, as amended, and Rule 10b-5 promulgated there under, as well as under
      Sections 11 and 15 of the Securities Act of 1933. Substantially similar
      complaints were filed in the same court on December 12, 2007 and December
      17, 2007. These cases, which were subsequently consolidated, purport to be
      brought on behalf of a class of purchasers and acquirers of our stock during
      the
      period December 16, 2006 to October 3, 2007. Plaintiffs allege that the
      defendants violated the federal securities laws during this period of time
      by,
      among other things, issuing a false and misleading registration statement and
      prospectus in connection with our December 16, 2006 initial public offering,
      and
      by thereafter publicly misrepresenting our current and prospective business
      and
      financial results. Plaintiffs claim that, as a result of these alleged
      wrongs, our stock price was artificially inflated during the purported class
      period. Plaintiffs are seeking unspecified compensatory damages, interest,
      an
      award of attorneys' fees and costs, and injunctive relief. Plaintiffs have
      until April 18, 2008 to file a consolidated amended complaint.





29
 Table
            of Contents





In
      addition, on March 18, 2008, a shareholder derivative action was filed in the
      Superior Court of the State of Washington (King County), allegedly on behalf
      of
      and for the benefit of Isilon, against certain of our current and former
      directors and officers.  Isilon was named as a nominal defendant.  The
      derivative complaint alleges that the individual defendants breached fiduciary
      duties owed to the Company by publicly misrepresenting Isilon’s business
      prospects, and by failing to properly account for certain revenues earned in
      our
      fiscal year ended December 31, 2006, and first and second quarters in fiscal
      2007.  Asubstantially
      similar complaint was filed in the same court on March 24, 2008.  The
      revenues referenced in the complaintswere the subject of our February
      29, 2008 announcement that it would restate its financial statements for those
      periods.  The complaint seeks unspecified damages and equitable relief,
      disgorgement of compensation, attorneys’ fees, costs, and expenses. 
Because the complaints are derivative in nature they do not seek monetary
      damages from the Company.  However, we may be required throughout the
      course of the action to advance the legal fees and costs incurred by the
      individual defendants.





We
      are unable to predict the outcome of these cases.  A court
      determination against us could result in significant liability and could have
      a
      material adverse effect on our consolidated financial position, results of
      operations or cash flows.




The
      Company has also provided information on a voluntary basis to the Enforcement
      Division of the Securities and Exchange Commission concerning the Audit
      Committee's independent review and the Company's financial
      restatement.




ITEM 4.Submission
      of Matters to
      a Vote of Security Holders




No
      matters were submitted for a vote of
      our shareholders during the fourth quarter of 2007.




30




PART II




ITEM 5.Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
      of Equity Securities






Market
      Information




Our
      common stock is traded on The Nasdaq Global Market under the symbol “ISLN.” On
      December 14, 2006, a registration statement on Form S-1 was declared
      effective for our initial public offering. The following table sets forth the
      high and low selling prices of our common stock for the period December 15,
      2006
      through December 30, 2007, as reported by The Nasdaq Global
      Market.




High
            
            
            LowYear
                ended December 31, 2006:Fourth
                quarter
            
            $
            28.50
            
            
            $
            23.00Year
                ended December 30, 2007:First
                quarter
            
            $
            27.87
            
            
            $
            16.14Second
                quarter
            
            
            18.94
            
            
            
            11.48Third
                quarter
            
            
            16.98
            
            
            
            7.56Fourth
                quarter
            
            
            7.95
            
            
            
            4.55




Dividend
      Policy




We
      have
      never declared or paid cash dividends on our capital stock and do not expect
      to
      pay any dividends in the foreseeable future.




Holders




As of March 17, 2008, there were approximately 176 stockholders of record,
      which
      does not reflect the persons or entities whose shares are held in nominee or
      “street” name through various banks and brokerage firms.




Equity
      Compensation Plan




Please
      see Part III, Item 12 of this report for disclosure relating to our
      equity compensation plans. Such information is incorporated by reference from
      our proxy statement.





Stock
      Performance Graph




The
      following graph compares the cumulative total stockholder return on our common
      stock with the cumulative total return of the NASDAQ Composite Index and the
      NASDAQ Computer Index from December 15, 2006, the date of our initial
      public offering, through December 28, 2007, the last trading day of our
      2007 fiscal year.  Both indices include our common stock.




The
      graph reflects an investment of $100 in our common stock, the NASDAQ Composite
      Index and the NASDAQ Computer Index, on December 15, 2006, and the
      reinvestment of dividends, if any.  The stockholder return shown on
      the graph below is not necessarily indicative of future performance, and we
      do
      not make or endorse any predictions as to future stockholder
      returns.





Comparison
      of 13 Month Cumulative Total Return


Among
      Isilon Systems, the NASDAQ Composite Index and the NASDAQ Computer
      Index









31
 Table
            of Contents




12/15/06
            
            
            12/29/06
            
            
            3/30/07
            
            
            6/29/07
            
            
            9/28/07
            
            
            12/28/07Isilon
                Systems, Inc.
            
            $
            100.00
            
            
            $
            118.48
            
            
            $
            70.00
            
            
            $
            66.75
            
            
            $
            33.33
            
            
            $
            21.65NASDAQ
                Composite
            
            $
            100.00
            
            
            $
            98.29
            
            
            $
            98.55
            
            
            $
            105.94
            
            
            $
            109.94
            
            
            $
            108.84NASDAQ
                Computer
            
            $
            100.00
            
            
            $
            97.66
            
            
            $
            97.07
            
            
            $
            106.91
            
            
            $
            112.61
            
            
            $
            126.26





Note:
      This graph shall not be deemed "filed" for purposes of Section 18 of the
      Securities and Exchange Act of 1934 (the "Exchange Act") or otherwise subject
      to
      the liabilities of that section nor shall it be deemed incorporated by reference
      in any filing under the Securities Act of 1933 or the Exchange Act, regardless
      of any general incorporation language in such filing.





Recent
      Sales of Unregistered Securities




During
        the quarter ended
        December 30, 2007, we did not issue or sell any shares of our common stock
        or other equity securities pursuant to unregistered transactions in reliance
        upon an exemption from the registration requirements of the Securities Act
        of
        1933, as amended.




Use
      of Proceeds from Public Offering of Common Stock




On
      December 14, 2006, our registration statement (No. 333-137078) on
      Form S-1 was declared effective for our initial public offering, pursuant
      to which we sold 8,940,717 shares of common stock and certain selling
      stockholders sold 661,783 shares, including the underwriters’
over-allotment, at $13.00 per share. The offering closed on
      December 20, 2006, and, as a result, we received net proceeds of
      approximately $105.7 million (after underwriters’ discounts of
      $8.1 million and additional offering-related costs of approximately
      $2.4 million). The managing underwriters were Morgan Stanley & Co.
      Incorporated and Merrill Lynch, Pierce, Fenner & Smith
      Incorporated.




No
      payments for such expenses were made directly or indirectly to (i) any of
      our officers or directors or their associates, (ii) any persons owning 10%
      or more of any class of our equity securities, or (iii) any of our
      affiliates. We did not receive any proceeds from the sale of shares in the
      initial public offering by the selling stockholders. In December 2006, we
      used approximately $12.5 million of the net proceeds to repay the
      outstanding balances under the revolving line of credit with Silicon Valley
      Bank
      and subordinated debt financing with Horizon Technology Funding Company LLC.
      We
      expect to use the remaining net proceeds for working capital and other general
      corporate purposes, including capital expenditures, product development,
      expansion of our manufacturing, engineering, operations, marketing and sales
      departments, and building our international sales and marketing teams.
      Additionally, we may choose to expand our current business through acquisitions
      of, or investments in, other complementary businesses, products or technologies.
      Pending the uses described above, we intend to invest the net proceeds in a
      variety of short-term, interest-bearing, investment grade securities. There
      has
      been no material change in the planned use of proceeds from our initial public
      offering from that described in the final prospectus filed with the SEC pursuant
      to Rule 424(b).




Issuer
      Purchases of Equity Securities




We
      did
      not make any purchases of our outstanding common stock during the three months
      ended December 30, 2007.





32
 Table
            of Contents




ITEM 6.Selected
      Financial
      Data





The
      following selected consolidated financial data is qualified by reference to,
      and
      should be read in conjunction with, our Consolidated Financial Statements and
      notes thereto in Part II, Item 8 and “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations” in Part II,
      Item 7, of this report on Form 10-K. Our historical results are not
      necessarily indicative of the results to be expected in any future
      period.




Year
                        EndedDecember 30,
                    
                    
                    December 31,
                    
                    
                    January 1,
                    
                    
                    January 2,
                    
                    
                    December 31,2007
                    
                    
                    2006
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2003Restated(3)(In
                        thousands)Consolidated
                        Statements of Operations Data:Total
                        revenue
                    
                    $
                    88,998
                    
                    
                    $
                    61,206
                    
                    
                    $
                    21,083
                    
                    
                    $
                    7,653
                    
                    
                    $
                    1,293Total
                        cost of revenue(1)
                    
                    
                    42,736
                    
                    
                    
                    28,808
                    
                    
                    
                    11,575
                    
                    
                    
                    4,163
                    
                    
                    
                    861Gross
                        profit
                    
                    
                    46,262
                    
                    
                    
                    32,398
                    
                    
                    
                    9,508
                    
                    
                    
                    3,490
                    
                    
                    
                    432Operating
                        expenses:Research
                        and development(1)
                    
                    
                    19,903
                    
                    
                    
                    16,524
                    
                    
                    
                    12,478
                    
                    
                    
                    7,446
                    
                    
                    
                    4,410Sales
                        and marketing(1)
                    
                    
                    42,595
                    
                    
                    
                    24,390
                    
                    
                    
                    12,377
                    
                    
                    
                    6,305
                    
                    
                    
                    2,742General
                        and administrative(1)
                    
                    
                    14,945
                    
                    
                    
                    7,411
                    
                    
                    
                    3,681
                    
                    
                    
                    2,300
                    
                    
                    
                    1,647Total
                        operating expenses
                    
                    
                    77,443
                    
                    
                    
                    48,325
                    
                    
                    
                    28,536
                    
                    
                    
                    16,051
                    
                    
                    
                    8,799Loss
                        from operations
                    
                    
                    (31,181
                    )
                    
                    
                    (15,927
                    )
                    
                    
                    (19,028
                    )
                    
                    
                    (12,561
                    )
                    
                    
                    (8,367
                    )Total
                        other income (expense), net(2)
                    
                    
                    4,470
                    
                    
                    
                    (9,952
                    )
                    
                    
                    (68
                    )
                    
                    
                    18
                    
                    
                    
                    103Loss
                        before income tax expense and cumulative effect of change
                        in accounting
                        principle
                    
                    
                    (26,711
                    )
                    
                    
                    (25,879
                    )
                    
                    
                    (19,096
                    )
                    
                    
                    (12,543
                    )
                    
                    
                    (8,264
                    )Income
                        tax expense
                    
                    
                    (221
                    )
                    
                    
                    (109
                    )
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Loss
                        before cumulative effect of change in accounting principle
                    
                    
                    (26,932
                    )
                    
                    
                    (25,988
                    )
                    
                    
                    (19,096
                    )
                    
                    
                    (12,543
                    )
                    
                    
                    (8,264
                    )Cumulative
                        effect of change in accounting principle(2)
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    (89
                    )
                    
                    
                    —
                    
                    
                    
                    —Net
                        loss
                    
                    $
                    (26,932
                    )
                    
                    $
                    (25,988
                    )
                    
                    $
                    (19,185
                    )
                    
                    $
                    (12,543
                    )
                    
                    $
                    (8,264
                    )Net
                        loss per common share, basic and diluted
                    
                    $
                    (0.44
                    )
                    
                    $
                    (3.09
                    )
                    
                    $
                    (3.95
                    )
                    
                    $
                    (3.61
                    )
                    
                    $
                    (3.30
                    )Shares
                        used in computing basic and diluted net loss per common
                        share
                    
                    
                    61,514
                    
                    
                    
                    8,423
                    
                    
                    
                    4,852
                    
                    
                    
                    3,474
                    
                    
                    
                    2,502(1)
                        Includes stock-based compensation expense* as follows:Cost
                        of revenue
                    
                    $
                    149
                    
                    
                    $
                    24
                    
                    
                    $
                    —
                    
                    
                    $
                    —
                    
                    
                    $
                    —Research
                        and development
                    
                    
                    702
                    
                    
                    
                    160
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Sales
                        and marketing
                    
                    
                    1,601
                    
                    
                    
                    198
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —General
                        and administrative
                    
                    
                    1,526
                    
                    
                    
                    258
                    
                    
                    
                    5
                    
                    
                    
                    4
                    
                    
                    
                    2









*
            Note:
                On January 2, 2006, we adopted SFAS 123(R),Share-Based
                Payment.





(2)
            On
                July 4, 2005, we adopted FASB Staff Position No. 150-5,Issuer’s Accounting under
                FASB Statement No. 150 for Freestanding Warrants and Other Similar
                Instruments on Shares That Are Redeemable.  Amounts
                for the years ended December 31, 2006 and January 1, 2006
                include related warrant revaluation expense of $8.4 million and
                $52,000, respectively, and a cumulative effect of change in accounting
                principle of $89,000 for the year ended January 1,
                2006.


(3)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.









33
 Table
          of Contents





As
                  ofDecember 30,
              
              
              December 31,
              
              
              January 1,
              
              
              January 2,
              
              
              December 31,2007
              
              
              2006
              
              
              2006
              
              
              2005
              
              
              2003Restated(1)(In
                  thousands)Consolidated
                  Balance Sheet Data:Cash,
                  cash equivalents and marketable securities
              
              $
              85,861
              
              
              $
              99,899
              
              
              $
              12,656
              
              
              $
              8,618
              
              
              $
              5,203Working
                  capital
              
              
              87,251
              
              
              
              108,519
              
              
              
              7,332
              
              
              
              7,204
              
              
              
              4,569Total
                  assets
              
              
              131,538
              
              
              
              136,734
              
              
              
              28,241
              
              
              
              17,550
              
              
              
              7,209Preferred
                  stock warrant liability
              
              
              —
              
              
              
              —
              
              
              
              367
              
              
              
              —
              
              
              
              —Current
                  and long-term notes payable and capital lease obligations
              
              
              —
              
              
              
              —
              
              
              
              7,543
              
              
              
              1,474
              
              
              
              238Convertible
                  preferred stock
              
              
              —
              
              
              
              —
              
              
              
              59,549
              
              
              
              39,736
              
              
              
              23,253Common
                  stock and additional paid-in capital
              
              
              191,255
              
              
              
              185,948
              
              
              
              324
              
              
              
              158
              
              
              
              27Total
                  stockholders’ equity (deficit)
              
              
              88,589
              
              
              
              110,207
              
              
              
              (49,375
              )
              
              
              (30,327
              )
              
              
              (17,914
              )


`




(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.





34
 Table
            of Contents






ITEM 7.Management’s
      Discussion
      and Analysis of Financial Condition and Results of
      Operations







The
      following should be read in conjunction with our Consolidated Financial
      Statements and the notes thereto included in Part II, Item 8,
“Financial Statements and Supplementary Data,” Part I, Item 1.
“Business,” and Part II, Item 6. “Selected Financial Data,” of this
      Annual Report on Form 10-K. We report financial results on a fiscal year of
      52 or 53 weeks ending on the Sunday closest to December 31 of that
      year. For ease of reference within this section, 2007 refers to the fiscal
      year
      ended December 30, 2007, 2006 refers to the fiscal year ended December 31,
      2006, and 2005 refers to the fiscal year ended January 1,
      2006.





Restatement
      of Previously Issued Consolidated Financial Statements




On
      February 29, 2008, we announced that our Board of Directors, based upon the
      recommendation of the Audit Committee, determined that we should restate our
      financial statements for the fiscal year ended December 31, 2006, and for the
      first and second quarters of fiscal 2007 ended, April 1, 2007 and July 1, 2007,
      respectively, as a result of errors in the financial statements.  As
      announced on November 8, 2007, our Audit Committee, assisted by independent
      forensic accountants and legal advisors, has been conducting an independent
      investigation of certain of our sales to resellers and other customers to
      determine whether commitments were made that have an impact on the timing and
      treatment of revenue recognition, and whether our internal controls relating
      to
      revenue recognition are sufficient.




Summary
      of the Restatement Adjustments




As
      a
      result of the Audit Committee’s review, we identified errors in our previous
      recognition of revenue.  For fiscal 2006, as shown in the table below,
      restated revenues are $61.2 million compared to previously reported revenues
      of
      $62.3 million and net loss per share increased to $3.09 from $3.02. The
      restatement adjustments did not affect our previously reported cash, cash
      equivalents, or short-term investment balances in any of the periods being
      restated. See Note 3 to the notes to the consolidated financial statements
      for
      more information.





Year EndedDecember 31, 2006As previously
                reported
              
              
              Adjustments
              
              
              As restatedStatement
                  of Operations
              
              (in
                  thousands, except per share data)Total
                  revenue
              
              $
              62,279
              
              
              $
              (1,073
              )
              
              $
              61,206Total
                  cost of revenue
              
              
              29,331
              
              
              
              (523
              )
              
              
              28,808Total
                  operating expenses
              
              
              48,325
              
              
              
              —
              
              
              
              48,325Loss
                  from operations
              
              
              (15,377
              )
              
              
              (550
              )
              
              
              (15,927
              )Net
                  loss
              
              
              (25,438
              )
              
              
              (550
              )
              
              
              (25,988
              )Net
                  loss per common share, basic and diluted
              
              $
              (3.02
              )
              
              $
              (0.07
              )
              
              $
              (3.09
              )







Overview




We
      were
      founded in January 2001 specifically to create a solution that addressed the
      unique challenges associated with the storage and management of digital content.
      From January 2001 to January 2003, we were focused on designing and developing
      our OneFS operating system software used in all of our storage systems. We
      began
      commercial shipments of our first systems in January 2003, and since then we
      have been focused on optimizing our solution to meet our customers’ needs and
      establishing development, manufacturing and marketing partnerships. Today,
      our
      solution includes a suite of systems, software and services.




We
      sell
      clustered storage systems that consist of three or more storage nodes. Each
      node
      is comprised of our proprietary OneFS operating system software and industry
      standard hardware components integrated into a self-contained, 3.5-inch and
      1.75-inch high, rack-mountable chassis. Customers can scale our clustered
      storage systems incrementally as their needs grow by purchasing additional
      nodes
      or clusters of nodes from us to enhance storage capacity, performance or both.
      Our future revenue growth will depend upon further penetration of our existing
      customers as well as expansion of our customer base in existing and other
      industries that depend upon digital content. We consider the development of
      direct and indirect sales channels in domestic and international markets a
      key
      to our future revenue growth and the global acceptance of our products. We
      also
      are dependent on the development, adoption and acceptance of new software and
      systems to increase our overall margins and achieve
      profitability.




Our
      product revenue growth rate will depend significantly on continued growth in
      our
      target industries and our ability to continue to attract new customers in those
      industries. Our growth in services revenue will depend upon increasing the
      number of systems under service contracts. Any such increases will depend on
      a
      growing customer base and our customers renewing existing service
      contracts.





35
 Table
            of Contents





Our
      ability to achieve and sustain profitability will also be affected by the extent
      to which we incur additional expenses to expand our sales, marketing, product
      development and general and administrative capabilities. Personnel costs
      constitute the largest component of our operating expenses. Personnel costs
      consist of salaries, benefits, incentive compensation, including commissions
      for
      sales personnel, and, beginning in 2006, stock-based compensation expense.
      To
      achieve and sustain profitability, we must control expenses while continuing
      to
      attract and retain qualified personnel and grow our revenue.




We
      believe our operations are more efficient and flexible because we outsource
      manufacturing and international back office functions, as well as certain
      research and development and support activities, which we believe will assist
      us
      in achieving and sustaining profitability. Overall, we expect our operating
      expenses to continue to grow in absolute dollars but to decrease as a percentage
      of our total revenue.




As
      a
      consequence of the rapidly evolving nature of our business and our limited
      operating history, we believe that period-to-period comparisons of revenue
      and
      operating results, including gross margin and operating expenses as a percentage
      of our total revenue, are not necessarily meaningful and should not be relied
      upon as indications of future performance. Although we have experienced
      significant percentage growth in our total revenue, we do not believe that
      our
      historical growth rates are likely to be sustainable or indicative of future
      growth.




We
      are
      headquartered in Seattle, Washington. Our personnel and operations are also
      located in Australia, Canada, China, France, Germany, Japan, Korea, the United
      Kingdom and throughout the United States. We expect to continue to add personnel
      in the United States and internationally to provide additional geographic sales
      and technical support coverage.





Key
      Business Metrics




We
      monitor a number of key metrics to help forecast growth, establish budgets,
      measure the effectiveness of our sales and marketing efforts, and measure
      operational effectiveness.





New
      Customers and Repeat Sales
      Orders. Our goal is to attract a significant number of new customers and
      to encourage existing customers to purchase additional products, specifically
      our higher margin software applications, SyncIQ, SnapshotIQ, SmartConnect,
      Migration IQ, and SmartQuotas. A majority of our customers buy our storage
      systems and later add additional nodes or software applications as the need
      arises under our ‘pay-as-you-grow’ model.




Channel
      Leverage. We are
      actively growing our relationships with channel partners to further penetrate
      our targeted markets domestically and internationally. We track our sales orders
      by direct or indirect customers with the goal of increasing revenue from channel
      partners.





Gross
      Margin. Our goal is to
      grow our gross margin to increase the profitability of our business. Some of
      the
      key factors affecting our gross margin are average sales prices of our systems,
      the revenue attributable to software applications as a percentage of total
      revenue, the rate at which our customers adopt our higher margin products,
      the
      timing of component cost reductions through product redesign, the timing of
      supplier cost reductions, the ability to manage inventory levels, the ability
      to
      control costs associated with servicing our customers, and overall market
      conditions. We consider our ability to monitor and manage these factors to
      be a
      key aspect of attaining and expanding our profitability.





Operating
      Cash Flows. We
      closely monitor operating cash flows as a measure of our business performance.
      Some of the key factors affecting operating cash flows are our ability to
      generate net income and manage working capital. Increasing inventory turns
      and
      reducing days sales outstanding in accounts receivable are both contributors
      to
      improving working capital. Our goal is to maximize cash flows while continuing
      to invest in our business. Our close tracking of operating cash flows allows
      us
      to better manage the cash needs of our business.




Critical
      Accounting Policies and Estimates




Our
      consolidated financial statements are prepared in accordance with United States
      generally accepted accounting principles, or GAAP. These accounting principles
      require us to make certain estimates and judgments that can affect the reported
      amounts of assets and liabilities as of the dates of the consolidated financial
      statements, the disclosure of contingencies as of the dates of the consolidated
      financial statements, and the reported amounts of revenue and expenses during
      the periods presented. Although we believe that our estimates and judgments
      are
      reasonable under the circumstances, actual results may differ from those
      estimates.




We
      believe the following to be our critical accounting policies because they are
      important to the portrayal of our financial condition and results of operations
      and they require critical management estimates and judgments about matters
      that
      are uncertain:




·
            revenue
                recognition;





·
            allowance
                for doubtful accounts;





·
            stock-based
                compensation;





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·
            estimation
                of fair value of warrants to purchase convertible preferred
                stock;





·
            inventory
                valuation; and





·
            accounting
                for income taxes.




If
      actual
      results or events differ materially from those contemplated by us in making
      these estimates, our reported financial condition and results of operations
      for
      future periods could be materially affected. See “Risk Factors” for certain
      matters that may affect our future financial condition or results of
      operations.





Revenue
      Recognition




We
      derive
      our revenue from sales of our products and services. Product revenue consists
      of
      revenue from sales of systems and software. Shipping charges billed to customers
      are included in product revenue and the related shipping costs are included
      in
      cost of product revenue.




Our
      software is integrated with industry standard hardware and is essential to
      the
      functionality of the integrated system product. We provide unspecified software
      updates and enhancements related to its products through service contracts.
      As a
      result, we account for revenue in accordance with AICPA Statement of Position
      No. 97-2,Software
      Revenue Recognition, or SOP 97-2, as amended by Statement of
      Position No. 98-9,Modification of SOP 97-2, Software Revenue Recognition,
      With Respect to
      Certain Transactions, or SOP 98-9, for all transactions involving
      the sale of software. We recognize product revenue when it has entered into
      an
      arrangement with a customer, delivery has occurred, the fee is deemed fixed
      or determinable and free of contingencies and significant uncertainties, and
      collection is reasonably assured.




On
      sales
      to channel partners, we evaluate whether fees are considered fixed or
      determinable by considering a number of factors, including our ability to
      estimate returns, the geography in which a sales transaction originates, payment
      terms and our relationship and past history with the particular channel
      partner.  If fees are not considered fixed or determinable at the time of
      sale to a channel partner, revenue recognition is deferred until there is
      persuasive evidence indicating product has sold-through to an end-user. 
Persuasive evidence of sell-through may include reports from channel partners
      documenting sell-through activity, copies of end-user purchase orders, data
      indicating an order has shipped to an end-user, cash payments or letters of
      credit guaranteeing cash payments or other similar information.




At
      the
      time of shipment, we record revenue reserves for estimated sales returns and
      stock rotation arrangements.  Sales returns and stock rotation reserves are
      estimated based on historical activity and expectations of future
      experience.  We monitor and analyze actual experience and adjust these
      reserves on a quarterly basis.




Substantially
      all of our products are sold in combination with services, which primarily
      consist of hardware and software support. Software support provides customers
      with rights to unspecified software updates and to maintenance releases and
      patches released during the term of the support period. Hardware support
      includes Internet access to technical content through Isilon Insight, our
      knowledge database, repair or replacement of hardware in the event of breakage
      or failure, and telephone and Internet access to technical support personnel
      during the term of the support period. Installation services, when provided,
      are
      also included in services revenue.




Sales
      generally consist solely of hardware and software products and support services.
      We have established vendor specific objective evidence, or VSOE, for the fair
      value of its support services as measured by the renewal prices offered to
      and
      paid by its customers. We use the residual method, as allowed by SOP 98-9,
      to determine the amount of product revenue to be recognized. Under the residual
      method, the fair value of the undelivered element, support services, is deferred
      and the remaining portion of the sales amount is recognized as product revenue.
      This product revenue is recognized upon shipment, based on freight terms,
      assuming all other criteria for recognition discussed above have been met.
      The
      fair value of the support services is recognized as services revenue on a
      straight-line method over the term of the related support period, which is
      typically one to three years.




Allowance
      for Doubtful Accounts




We
      review
      our allowance for doubtful accounts quarterly by assessing individual accounts
      receivable over a specific age and amount, and all other balances on a pooled
      basis based on historical collection experience and economic risk assessment.
      Accordingly, the amount of this allowance will fluctuate based upon changes
      in
      revenue levels, collection of specific balances in accounts receivable and
      estimated changes in customer credit quality or likelihood of collection. Our
      allowance for doubtful accounts was $324,000 and $501,000 as of
      December 30, 2007 and December 31, 2006, respectively.







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Stock-Based
      Compensation




Effective
      January 2, 2006, we adopted the fair value recognition provisions of
      SFAS No. 123(R),Share-Based Payment , or SFAS 123(R), using the prospective
      transition method, which requires us to apply the provisions of SFAS No.
      123(R) only to awards granted, modified, repurchased or cancelled after the
      adoption date. Under this transition method, our stock-based compensation
      expense recognized beginning January 2, 2006 is based on the grant date
      fair value of stock option awards we grant or modify after January 1, 2006.
      We recognize this expense on a straight-line basis over the optionees’ requisite
      service periods. We estimate the grant date fair value of stock option awards
      under the provisions of SFAS 123(R) using the Black-Scholes option
      valuation model, which requires, among other inputs, an estimate of the fair
      value of the underlying common stock on the date of grant for options granted
      prior to our initial public offering in December 2006 and the expected
      volatility of the stock over the expected term of the related
      grants.





Prior
      to
      January 2, 2006, we accounted for employee stock options using the
      intrinsic value method in accordance with Accounting Principles Board Opinion
      No. 25,Accounting for Stock
      Issued to Employees, or APB 25, and Financial Accounting Standards
      Board, or FASB, Interpretation No. 44,Accounting for Certain
      Transactions
      Involving Stock Compensation, an Interpretation of APB No. 25, and
      had adopted the disclosure-only provisions of SFAS No. 123,Accounting for
      Stock-Based Compensation, or SFAS 123, and
      SFAS No. 148,Accounting for
      Stock-Based Compensation — Transition and Disclosure.  In
      accordance with APB 25, we recognized no stock-based compensation expense
      for options granted with an exercise price equal to or greater than the fair
      value of the underlying common stock on the date of grant.




We
      determined that it was not practicable to calculate the expected volatility
      of
      our share price since our securities have been publicly traded for a limited
      period of time, we have limited information on our own past volatility, and
      we
      are a high-growth technology company whose future operating results are not
      comparable to prior operating results. Therefore, we estimated our expected
      volatility based on reported market value data for a group of publicly traded
      companies, which we selected from market indices that we believed would be
      indicators of its future stock price volatility, after consideration of their
      size, stage of lifecycle, profitability, growth, risk and return on investment.
      We used the average expected volatility rates reported by the comparable group
      for an expected term that approximated the expected term that we
      estimated.





In
      2007,
      we recorded non-cash stock-based compensation expense of $4.0 million in
      accordance with SFAS 123(R) based on the related options having an expected
      term of approximately four years. In future periods, stock-based compensation
      expense is expected to increase as we issue additional equity-based awards
      to
      continue to attract and retain key employees. Additionally, SFAS 123(R)
      requires that we recognize compensation expense only for the portion of stock
      options that are expected to vest. If the actual number of forfeitures differs
      from that estimated, we may be required to record adjustments to stock-based
      compensation expense in future periods. As of December 30, 2007, our total
      unrecognized compensation expense related to stock-based awards granted in
      accordance with SFAS 123(R) since January 2, 2006 was
      $19.9 million.





We
      account for stock-based compensation arrangements with non-employees in
      accordance with FASB Emerging Issues Task Force No. 96-18,Accounting for Equity Instruments
      That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
      Selling, Goods or Services, or EITF 96-18, using a fair value
      approach. The fair value of the stock options granted to non-employees was
      estimated using the Black-Scholes option valuation model. This model utilizes
      the estimated fair value of our common stock, the contractual term of the
      option, the expected volatility of the price of our common stock, risk-free
      interest rates, and the expected dividend yield of our common stock. Stock-based
      compensation expense during 2007 relating to awards to non-employees was
      $56,000. As of December 30, 2007, our total unrecognized compensation
      expense related to stock-based awards granted in accordance with EITF 96-18
      was $41,000.








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Estimation
      of Fair Value of Warrants to Purchase Convertible Preferred Stock




On
      July 4, 2005, we adopted FASB Staff Position No. 150-5,Issuer’s Accounting under FASB
      Statement No. 150 for Freestanding Warrants
      and Other
      Similar Instruments on Shares That Are Redeemable, or FSP 150-5. FSP
      150-5 provides that the warrants we have issued to purchase shares of our
      convertible preferred stock are subject to the requirements in FSP 150-5, which
      requires us to classify these warrants as current liabilities and to adjust
      the
      value of these warrants to their fair value at the end of each reporting period.
      At the time of adoption, we recorded an expense of $89,000 for the cumulative
      effect of this change in accounting principle, to reflect the estimated fair
      value of these warrants as of that date. We recorded $52,000 and
      $8.4 million of additional expense in other income (expense), net, for the
      remainder of 2005 and during 2006, respectively, to reflect further increases
      in
      the estimated fair value of the warrants. We estimated the fair value of these
      warrants at the respective balance sheet dates using the Black-Scholes option
      valuation model. This model utilizes the estimated fair value of the underlying
      convertible preferred stock at the valuation measurement date, the remaining
      contractual term of the warrant, risk-free interest rates, and expected
      dividends and expected volatility of the price of the underlying convertible
      preferred stock. We utilized recommended estimates prepared by Duff &
Phelps, LLC in determining the fair value of the underlying convertible
      preferred stock in determining the valuation of these warrants.




Upon
      the
      closing of our initial public offering, these warrants converted into warrants
      to purchase shares of our common stock and, as a result, no longer are subject
      to FSP 150-5. The current aggregate fair value of these warrants was
      reclassified from current liabilities to additional paid-in capital, a component
      of stockholders’ equity (deficit), and we ceased to record any related periodic
      fair value adjustments.





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Inventory
      Valuation




Inventories
      primarily consist of finished systems and are stated at the lower of cost,
      on
      the average cost method, which approximates first-in, first-out, or FIFO, or
      market value. A large portion of our inventory also relates to evaluation units
      located at customer locations, as some of our customers test our equipment
      prior
      to purchasing. The number of evaluation units has increased due to our overall
      growth and an increase in our customer base. Inventory valuation reserves are
      established to reduce the carrying amounts of our inventories to their net
      estimated realizable values. Inventory valuation reserves are based on
      historical usage, expected demand and evaluation unit conversion rate and age.
      Inherent in our estimates of market value in determining inventory valuation
      reserves are estimates related to economic trends, future demand for our
      products and technological obsolescence of our products. If future demand or
      market conditions are less favorable than our projections, additional inventory
      valuation reserves could be required and would be reflected in cost of product
      revenue in the period in which the reserves are taken. Inventory valuation
      reserves were $934,000 and $1.1 million as of December 30, 2007 and
      December 31, 2006, respectively.




Accounting
      for Income Taxes




At
      December 30, 2007, we had $73.7 million of net operating loss carryforwards
      available to offset future taxable income for federal and state purposes. These
      net operating loss carryforwards expire for federal purposes from 2021 to 2026.
      As part of the process of preparing our consolidated financial statements,
      we
      are required to estimate our income taxes in each of the jurisdictions in which
      we operate. We record this amount as a provision or benefit for taxes in
      accordance with SFAS No. 109,Accounting for Income
      Taxes.  This process involves estimating our actual current tax
      exposure, including assessing the risks associated with tax audits, and
      assessing temporary differences resulting from different treatment of items
      for
      tax and accounting purposes. These differences result in deferred tax assets
      and
      liabilities. As of December 30, 2007, we had gross deferred tax assets of $33.8
      million, which were primarily related to federal and state net operating loss
      carryforwards and research and development expenses capitalized for tax
      purposes. We assess the likelihood that our deferred tax assets will be
      recovered from future taxable income and, to the extent that we believe recovery
      is not likely, we establish a valuation allowance. Due to the uncertainty of
      our
      future profitability, we have recorded a valuation allowance equal to the $33.8
      million of gross deferred tax assets as of December 30, 2007. Accordingly,
      we have not recorded an income tax benefit in our statement of operations for
      any of the periods presented. If we determine in the future that these deferred
      tax assets are more-likely-than-not to be realized, a release of all or a
      portion of the related valuation allowance would increase income in the period
      in which that determination is made.




Results
      of Operations




Revenue.  We
      derive
      our revenue from sales of our products and services. Our customers typically
      purchase a cluster of our storage devices comprised of three or more nodes.
      Each
      node includes our OneFS operating system software and industry standard
      hardware. We offer various systems to meet customer-specific storage capacity
      and performance requirements. In addition, customers may purchase separate
      additional software applications for enhanced functionality. Pricing of our
      products depends, in part, on our cost of goods at the time we determine the
      overall pricing of our products and the size of the cluster and software modules
      purchased. We may periodically change the list prices of our storage system
      products.




Our
      total
      revenue has grown from $21.1 million in 2005, to $61.2 million in 2006 and
      to $89.0 million in 2007. This growth has been driven primarily by an
      increase in sales of our Isilon IQ product family to new customers, resulting
      in
      an increase in the size of our customer base. Our customer base increased by
      230% from January 2, 2005 to January 1, 2006, by 151% from
      January 1, 2006 to December 31, 2006, and by 87% from January 1, 2007
      to December 30, 2007. We expect our customer base to increase in size over
      time
      if we are successful in increasing market penetration in target industries
      and
      expanding our distribution channels within the United States. In addition,
      if we
      are successful in expanding our international distribution channels, we expect
      that revenue from customers located outside the United States will increase
      as a
      percentage of our total revenue.





A
      majority of our customers that buy our storage systems later add to their
      storage cluster.  Over the past three years, the average size of
      repeat orders has been at least as large as the average size of initial orders
      in the same period.  Overall average order size increased by 26% from
      2004 to 2005 and 14% from 2005 to 2006.  Overall average order size
      decreased 2% from 2006 to 2007 mainly due to increased diversification of
      customers and product mix, specifically a greater number of new customers
      purchasing our entry level IQ 200 system.




The
      growth in our revenue has also been driven by new product introductions. We
      introduced five new products in 2005, 2006 and 2007. These new products
      offer new features and functionality that allow us to market to a broader array
      of customers. Revenue from our new customers as a percentage of total revenue
      was 42% and 31% in 2007 and 2006, respectively. Reorder revenue from our
      existing customers as a percentage of total revenue was 58% and 69% in 2007
      and
      2006, respectively.




A
      key
      aspect of our business strategy is the development and sale of new complementary
      software applications. We began marketing two of our three software
      applications, SmartConnect and SnapshotIQ, in the later part of 2006 and added
      two new software applications, SmartQuotas and Migration IQ in 2007. To date,
      sales of software applications have constituted less than 10% of total revenue.
      With the introduction of these and future new software applications, we
      anticipate that revenue from software applications will represent a growing
      percentage of total revenue.





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Additionally,
      we sell support services to our customers. The percentage of our total revenue
      derived from support services was 11% in 2005, 13% in 2006, and 16% in 2007.
      We
      anticipate that support services will continue to be purchased by new and
      existing customers and that services revenue will range over time to between
      15%
      and 20% of our total revenue.




We
      sell
      our products and services directly through our field sales force and indirectly
      through channel partners such as value-added resellers and distributors. Total
      revenue through channel partners increased from 27% in 2005 to 44% in 2006
      and
      55% in 2007.




Year
                  EndedDecember 30,
              
              
              December 31,
              
              
              January 1,2007
              
              
              2006
              
              
              2006Restated(1)(Dollars
                  in thousands)Revenue
                  by type:Product
              
              $
              74,434
              
              
              $
              53,137
              
              
              $
              18,709Services
              
              
              14,564
              
              
              
              8,069
              
              
              
              2,374Total
                  revenue
              
              $
              88,998
              
              
              $
              61,206
              
              
              $
              21,083%
                  revenue by type:Product
              
              
              84
              %
              
              
              87
              %
              
              
              89
              %Services
              
              
              16
              
              
              
              13
              
              
              
              11Total
              
              
              100
              %
              
              
              100
              %
              
              
              100
              %Revenue
                  by geography:Domestic
              
              $
              64,936
              
              
              $
              46,465
              
              
              $
              17,559International
              
              
              24,062
              
              
              
              14,741
              
              
              
              3,524Total
                  revenue
              
              $
              88,998
              
              
              $
              61,206
              
              
              $
              21,083%
                  revenue by geography:Domestic
              
              
              73
              %
              
              
              76
              %
              
              
              83
              %International
              
              
              27
              
              
              
              24
              
              
              
              17Total
              
              
              100
              %
              
              
              100
              %
              
              
              100
              %Revenue
                  by sales channel:Direct
              
              $
              40,464
              
              
              $
              34,431
              
              
              $
              15,464Indirect
              
              
              48,534
              
              
              
              26,775
              
              
              
              5,619Total
                  revenue
              
              $
              88,998
              
              
              $
              61,206
              
              
              $
              21,083%
                  revenue by sales channel:Direct
              
              
              45
              %
              
              
              56
              %
              
              
              73
              %Indirect
              
              
              55
              
              
              
              44
              
              
              
              27Total
              
              
              100
              %
              
              
              100
              %
              
              
              100
              %




(1)
            See
                  Note 3, "Restatement of Consolidated Financial Statements," of the
                  Notes to Consolidated Financial
                  Statements.





Cost
      of Revenue and Gross
      Margin.  Cost of product revenue consists primarily of amounts
      paid to our contract manufacturer in connection with the procurement of hardware
      components and assembly of those components into our systems, costs of shipping
      and logistics, and valuation reserves taken for excess and obsolete inventory.
      The components that are used in the assembly of our products include disk
      drives, memory chips and CPUs. Our contract manufacturer
      does not enter into long-term contracts for any of these components; thus,
      prices for these components are subject to fluctuations in the spot market,
      which can cause our cost of product revenue to fluctuate.Cost of
      services revenue is primarily comprised of salaries and employee benefits and
      third-party costs in providing technical and logistical support.





Our
      gross
      margin has been and will continue to be affected by a variety of factors,
      including average sales prices of our systems, the revenue attributable to
      sales
      of software applications as a percentage of total revenue, the rate at which
      our
      customers adopt our higher margin products such as higher density systems and
      software applications, the timing of component cost reductions through product
      redesign, the timing of supplier cost reductions that might result from volume
      discount pricing, and overall market conditions.





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Year
                  EndedDecember 30,
              
              
              December 31,
              
              
              January 1,2007
              
              
              2006
              
              
              2006Restated(1)(Dollars
                  in thousands)Revenue:Product
              
              $
              74,434
              
              
              $
              53,137
              
              
              $
              18,709Services
              
              
              14,564
              
              
              
              8,069
              
              
              
              2,374Total
                  revenue
              
              $
              88,998
              
              
              $
              61,206
              
              
              $
              21,083Cost
                  of revenue:Product
              
              $
              33,761
              
              
              $
              25,186
              
              
              $
              10,388Services
              
              
              8,975
              
              
              
              3,622
              
              
              
              1,187Total
                  cost of revenue
              
              $
              42,736
              
              
              $
              28,808
              
              
              $
              11,575Gross
                  margin:Product
              
              
              55
              %
              
              
              53
              %
              
              
              44
              %Services
              
              
              38
              %
              
              
              55
              %
              
              
              50
              %Total
                  gross margin
              
              
              52
              %
              
              
              53
              %
              
              
              45
              %




(1)
            See
                  Note 3, "Restatement of Consolidated Financial Statements," of the
                  Notes to Consolidated Financial
                  Statements.




Research
      and Development
      Expenses.  Research and development expenses primarily include
      personnel costs, prototype expenses, facilities expenses and depreciation of
      equipment used in research and development. In addition to our United States
      development teams, we used an offshore development team from a third-party
      contract engineering provider in Moscow, Russia. Research and development
      expenses are recorded when incurred. We are devoting substantial resources
      to
      the development of additional functionality for existing products and the
      development of new systems and software products. We intend to continue to
      invest significantly in our research and development efforts because we believe
      they are essential to maintaining and improving our competitive position.
      Accordingly, we expect research and development expenses to continue to increase
      in total dollars and as a percent of revenue in the near term, although we
      expect these expenses to decrease as a percentage of total revenue over the
      next
      several years.




Year
                  EndedDecember 30,
              
              
              December 31,
              
              
              January 1,2007
              
              
              2006
              
              
              2006(Dollars
                  in thousands)Research
                  and development expenses
              
              
              19,903
              
              
              $
              16,524
              
              
              $
              12,478Percent
                  of total revenue
              
              
              22
              %
              
              
              27
              %
              
              
              59
              %




Sales
      and Marketing
      Expenses.  Sales and marketing expenses primarily include
      personnel costs, sales commissions, professional services fees, trade shows,
      marketing programs, depreciation, and facilities expenses. We plan to continue
      to invest heavily in sales and marketing by increasing the size of our field
      sales force and the number of our channel partners to allow us to expand into
      existing and new geographic and vertical markets. We also plan to continue
      to
      invest in expanding our domestic and international sales and marketing
      activities and building brand awareness. We expect that sales and marketing
      expenses will increase in absolute dollars, grow at a faster rate than our
      research and development expenses and thus remain our largest expense category.
      However, we expect sales and marketing expenses to decrease as a percentage
      of
      total revenue in the future due to our expected growth and attainment of
      economies of scale. Generally, sales personnel are not immediately productive
      and thus sales and marketing expenses do not immediately result in revenue.
      Hiring additional sales personnel reduces short-term operating margins until
      the
      sales personnel become productive and generate revenue. Accordingly, the timing
      of sales personnel hiring and the rate at which they become productive will
      affect our future performance.




Year
                    EndedDecember 30,
                
                
                December 31,
                
                
                January 1,2007
                
                
                2006
                
                
                2006(Dollars
                    in
                    thousands)Sales
                    and marketing expenses
                
                $
                42,595
                
                
                $
                24,390
                
                
                $
                12,377Percent
                    of total revenue
                
                
                48
                %
                
                
                40
                %
                
                
                59
                %




General
      and Administrative
      Expenses.  General and administrative expenses primarily
      include personnel costs, bad debt expense, facilities expenses related to our
      executive, finance, human resources, information technology and legal
      organizations, and fees for professional services such as legal, accounting,
      compliance and information systems. Since the initial public offering, we have
      incurred and will continue to incur significant additional accounting and
      compliance costs as well as additional insurance, investor relations and other
      costs associated with being a public company. Also included in general and
      administrative expenses are legal costs to defend ourselves against lawsuits
      as
      well as costs associated with our Audit Committee investigation. We expect
      general and administrative expenses to continue to increase in total dollars
      although we expect these expenses to decrease as a percentage of total revenue
      over the next several years and to potentially increase as a percentage of
      revenue in early 2008 through the end of our Audit Committee investigation
      and financial statement restatement process.





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Year
                EndedDecember 30,
            
            
            December 31,
            
            January 1,2007
            
            
            2006
            
            2006(Dollars
                in thousands)General
                and administrative expenses
            
            $
            14,945
            
            
            $
            7,411
            
            
            $
            3,681Percent
                of total revenue
            
            
            17
            %
            
            
            12
            %
            
            
            17
            %




Other
      Income (Expense),
      Net.  Other income (expense), net primarily includes interest
      income on cash, cash equivalents and marketable securities balances and interest
      expense on our outstanding debt. It also includes realized gain (loss) on
      short-term investments. In addition, in 2006 and 2005, other income (expense),
      net, included the adjustment we made to record our preferred stock warrants
      at
      fair value in accordance with FSP 150-5. We adopted FSP 150-5 and accounted
      for
      the related cumulative effect of the change in accounting principle on
      July 4, 2005.




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006(In
                thousands)Interest
                income and other
            
            $
            4,470
            
            
            $
            230
            
            
            $
            314Interest
                expense
            
            
            —
            
            
            
            (1,751
            )
            
            
            (330
            )Warrant
                revaluation expense
            
            
            —
            
            
            
            (8,431
            )
            
            
            (52
            )Other
                income (expense), net
            
            $
            4,470
            
            
            $
            (9,952
            )
            
            $
            (68
            )







Fiscal
      2007 Compared With Fiscal 2006(restated)




Revenue.  Total
      revenue was $89.0 million in 2007 compared to $61.2 million in 2006,
      an increase of 45%. Revenue increased in 2007, primarily due the expansion
      of
      our customer base, an increase in repeat orders and the number of product
      offerings available to our customers offset by a decrease in average order
      sizes. Our customer base grew 87% from 2007 to 2006 and the number of new
      customers added in 2007 was 320, representing a 44% increase over the number
      of
      new customers added in the comparable period in the prior year.  This
      increase was primarily due to better penetration in our target markets, our
      expanded sales force and traction in international markets. In 2007, reorders
      from existing customers represented approximately 58% of total revenue, compared
      to 69% in 2006. The average initial order size increased 6% from 2007 to
      2006, while the average reorder size decreased by 10% in the same
      comparative period. The decrease in overall average order size of  2%
      year-over-year is attributable to increased diversification of customers and
      product mix, specifically a greater number of new customers purchasing our
      entry
      level IQ 200 system.




In
      2007,
      Eastman Kodak Company was our only customer with revenues greater than 10%
      accounting for 10% of our total revenue. In 2006, Comcast Corporation, which
      purchased through one of our resellers, accounted for 15% of our total revenue
      and Eastman Kodak Company accounted for 10% of our total
      revenue.




In
      2007,
      we derived 55% of our total revenue from indirect channels compared to 44%
      in
      2006. This increase in indirect channel revenue was due to the growing market
      for our products and our increased focus on expanding our indirect channel
      sales
      by hiring dedicated sales managers and expanding our group of value-added
      resellers. Computer Design and Integration LLC, the reseller that sold to
      Comcast, is the only reseller that accounted for more than 10% of our total
      revenue in 2006 . We generated 27% of our total revenue in 2007 from
      international locations, compared to 24% in 2006. We plan to continue to expand
      into international locations and introduce our products in new markets directly
      and indirectly through channel partners.




Services
      revenue increased $6.5 million, or 80%, to $14.6 million in 2007 from
      $8.1 million in 2006. The increase in services revenue was a result of
      increased product sales and first-year technical support sales combined with
      the
      renewal of service contracts by existing customers. As our installed customer
      base grows and since substantially all of our customers continue to renew their
      service contracts, we expect services revenues to continue to grow.





Gross
      Margin.  Gross margin decreased 100 basis points to 52% in 2007
      from 53% in 2006. Gross margin for product revenue increased 200 basis points
      to
      55% in 2007 from 53% in 2006. The increase in product revenue gross margin
      was
      primarily due to customer adoption of our new generation of products released
      in
      2007 and 2006, which have more favorable gross margins as a result of reduced
      product component costs and an increase in software sales. Some of our new
      generation products were designed, among other things, to deliver a higher
      amount of storage capacity within each node. This higher capacity has resulted
      in increased gross margins even as price per megabyte of storage charged to
      our
      customers has decreased. Since the latter part of 2006, we released four new
      software applications, SnapshotIQ, SmartConnect, Migration IQ and SmartQuotas,
      which carry a higher gross margin than our margin on our overall product
      revenue. During 2007, more than 50% of our new customers purchased one or
      more of our five software applications.  The growth in product margins
      was offset by reserves for adverse purchase commitments and increased servicing
      costs for our pool of evaluation inventory.





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            of Contents





We
      expect
      to continue to experience pricing pressures within our industry as the price
      per
      megabyte of storage decreases year over year. The downward pricing pressure
      is
      primarily due to the decreasing prices of disk drives and other industry
      standard hardware components. Depending on the product type, disk drives can
      represent approximately one-fourth of our material cost. Historically, disk
      drives have decreased in price approximately 30% from year to
      year.




Gross
      margin for services revenue decreased 17 percentage points to 38% in 2007 from
      55% in 2006. Services revenue includes support services for both our software
      and our hardware products. Software support provides customers with software
      updates, maintenance releases and patches, which have minimal costs. Hardware
      support includes Internet access to our technical knowledge database and to
      technical support personnel, and third-party costs in providing technical
      support. During 2007, we continued to make investments in our customer service
      and support structure, including hiring new personnel, expanding our service
      organization geographically to enhance the reliability and responsiveness for
      our customers. As a result, gross margin for services revenue for the year
      ended
      2007 decreased from the comparable period in the prior year.





Research
      and Development
      Expenses.  Research and development expenses increased
      $3.4 million, or 20%, to $19.9 million in 2007 from $16.5 million
      in 2006. Research and development employees increased to 103 at December 30,
      2007 from 98 at December 31, 2006. The increase in expenses year over year
      was primarily due to an increase in salaries and benefits, professional
      services, and stock-based compensation expense. Stock-based compensation expense
      related to research and development increased to $702,000 in 2007 from $160,000
      in 2006. As a percent of 2007 revenue, research and development expense fell
      to
      22% from 27% in 2006.




Sales
      and Marketing
      Expenses.  Sales and marketing expenses increased
      $18.2 million, or 75%, to $42.6 million in 2007 from $24.4 million in
      2006. Sales and marketing employees increased to 141 at December 30, 2007 from
      101 at December 31, 2006. The year over year increase in sales and
      marketing expenses was primarily due to an increase in headcount-related costs,
      trade shows, marketing programs, travel expenses, sales commissions, and
      stock-based compensation expense. Stock-based compensation expense included
      in
      sales and marketing expenses was $1.6 million in 2007 compared with $198,000
      in
      2006. As a percent of 2007 revenue, sales and marketing expense increased to
      48%
      from 40% in 2006.




General
      and Administrative
      Expenses.  General and administrative expenses increased
      $7.5 million, or 102%, to $14.9 million in 2007 from $7.4 million in
      2006. General and administrative employees increased to 44 at December 30,
      2007
      from 40 at December 31, 2006. The increase year over year was primarily due
      to an increase in salaries and benefits, professional service fees, insurance,
      bad debt expense, stock-based compensation expense, facilities and depreciation
      expenses. Included in general and administrative expenses are $1.5 million
      in
      professional service fees associated with our Audit Committee investigation.
      Also, the additional personnel and professional services fees were primarily
      the
      result of our ongoing efforts to build the legal, financial, human resources
      and
      information technology functions required of a public company, including costs
      to comply with the Sarbanes-Oxley Act of 2002. Stock-based compensation expense
      included in general and administrative expenses increased to $1.5 million in
      2007 from $258,000 in 2006. As a percent of 2006 revenue, general and
      administrative expense increased to 17% from 12% in 2006.




Other
      Income (Expense),
      Net.  Other income (expense), net increased $14.4 million to
      $4.5 million in income in 2007 from $10.0 million in expense in
      2006.  The increase was due to an increase in our interest income of
      $4.2 million related to our higher average cash, cash equivalents and marketable
      securities balances during 2007 from the comparable period in the prior year
      and
      a reduction in interest expense and warrant revaluation expense of $1.8 million
      and $8.4 million, respectively, in 2007. The higher average cash, cash
      equivalents and marketable securities balance during the year ended 2007
      resulted from the proceeds received from our initial public offering in December
      2006.




Fiscal
      2006(restated) Compared With Fiscal 2005




Revenue.  Total
      revenue was $61.2 million in 2006 compared with $21.1 million in 2005,
      an increase of 190%. Revenue increased in 2006, primarily due the expansion
      of
      our customer base, an increase in average deal size, an increase in repeat
      orders and the number of product offerings available to our customers. Our
      customer base grew 151% from 2005 to 2006, primarily due to better penetration
      in our target markets, our expanded sales force and traction in international
      markets. In 2006, reorders from existing customers represented approximately
      69%
      of total revenue, compared with 39% in 2005. The average initial order size
      increased by 19% in 2006 from 2005 and the average reorder size increased by
      10%
      in the same comparative period. The increases in reorders and average order
      size
      are attributable to greater acceptance of our existing products and the
      introduction of new product offerings.




In
      2006,
      Comcast Corporation, which purchased through one of our resellers, accounted
      for
      15% of our total revenue and Eastman Kodak Company accounted for 10% of our
      total revenue. In 2005, Eastman Kodak Company accounted for 20% of our total
      revenue. Both of these customers buy our products on a purchase order basis,
      and
      neither has a long-term contract or minimum sales commitment.





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In
      2006,
      we derived 44% of our total revenue from indirect channels compared with 27%
      in
      2005. This increase in indirect channel revenue was due to the growing market
      for our products and our increased focus on expanding our indirect channel
      sales
      by hiring dedicated sales managers and expanding our group of value-added
      resellers. Computer Design and Integration LLC, the reseller that sold to
      Comcast, is the only reseller that accounted for more than 10% of our total
      revenue in both 2006 and 2005. We generated 24% of our total revenue in 2006
      from international locations, compared with 17% in 2005. We plan to continue
      to
      expand into international locations and introduce our products in new markets
      directly and indirectly through channel partners.




Services
      revenue increased $5.7 million, or 240%, to $8.1 million in 2006 from
      $2.4 million in 2005. The increase in services revenue was a result of
      increased product sales and first-year technical support sales combined with
      the
      renewal of service contracts by existing customers. As our installed customer
      base grows and since substantially all of our customers continue to renew their
      service contracts, we expect our proportion of services revenue to continue
      to
      increase as a percentage of total revenue from its 13% level in
      2006.




Gross
      Margin.  Gross margin increased eight percentage points to 53%
      in 2006 from 45% in 2005. Gross margin for product revenue also increased nine
      percentage points to 53% in 2006 from 44% in 2005. These increases in gross
      margin were primarily due to customer adoption of our new generation of products
      released in 2005 and 2006, which have more favorable gross margins as a result
      of reduced product component costs and an increase in software sales. Some
      of
      our new generation products were designed, among other things, to deliver a
      higher amount of storage capacity within each node. This higher capacity has
      resulted in increased gross margins even as price per megabyte of storage
      charged to our customers has decreased. During the latter part of 2006, we
      released two new software applications, SnapshotIQ and SmartConnect, which
      carry
      a higher gross margin than our margin on our overall product revenue. In the
      fourth quarter of 2006, more than one in three new customers purchased one
      or
      more of our three software applications.




We
      expect
      to continue to experience pricing pressures within our industry as the price
      per
      megabyte of storage decreases year over year. The downward pricing pressure
      is
      primarily due to the decreasing prices of disk drives and other industry
      standard hardware components. Depending on the product type, disk drives can
      represent approximately one-fourth of our material cost. Historically, disk
      drives have decreased in price approximately 30% from year to year. Thus, the
      decline in product prices that we experienced was more than offset by a greater
      percentage decrease in cost of product revenue on a per node basis resulting
      in
      an overall increase in product gross margin in 2006 compared with
      2005.




Gross
      margin for services revenue increased five percentage points to 55% in 2006
      from
      50% in 2005. Services revenue includes support services for both our software
      and our hardware products. Software support provides customers with software
      updates, maintenance releases and patches, which have minimal costs. Hardware
      support includes Internet access to our technical knowledge database and
      Internet access to technical support personnel. Costs to maintain the technical
      knowledge database and to maintain our technical support group have not
      increased at the same rate as services revenue. As a result, gross margin for
      services revenue increased due to our services revenue growing more rapidly
      than
      these fixed costs associated with the services performed.




Research
      and Development
      Expenses.  Research and development expenses increased
      $4.0 million, or 32%, to $16.5 million in 2006 from $12.5 million
      in 2005. Research and development employees increased to 98 at December 31,
      2006 from 75 at January 1, 2006. The increase year over year was primarily
      due to an increase in salaries and benefits, facilities, depreciation expenses
      and professional services offset by a decrease in new product prototype
      expenses. Stock-based compensation expense related to research and development
      increased to $160,000 in 2006 from none in 2005. As a percent of 2006 revenue,
      research and development expense fell to 27% from 59% in 2005.




Sales
      and Marketing
      Expenses.  Sales and marketing expenses increased
      $12.0 million, or 97%, to $24.4 million in the 2006 from
      $12.4 million in 2005. Sales and marketing employees increased to 101 at
      December 31, 2006 from 74 at January 1, 2006. The year over year
      increase in sales and marketing expenses was primarily due to an increase in
      headcount-related costs, trade shows, marketing programs, travel expenses and
      sales commissions. Stock-based compensation expense included in sales and
      marketing expenses was $198,000 in 2006 compared with none in 2005. As a percent
      of 2006 revenue, sales and marketing expense fell to 40% from 59% in
      2005.




General
      and Administrative
      Expenses.  General and administrative expenses increased
      $3.7 million, or 101%, to $7.4 million in 2006 from $3.7 million
      in 2005. General and administrative employees increased to 40 at
      December 31, 2006 from 21 at January 1, 2006. The increase year over
      year was primarily due to an increase in salaries and benefits, professional
      service fees, facilities and depreciation expenses. The additional personnel
      and
      professional services fees were primarily the result of our ongoing efforts
      to
      build the legal, financial, human resources and information technology functions
      required of a public company. We expect to incur significant additional expenses
      as a result of operating as a public company, including costs to comply with
      the
      Sarbanes-Oxley Act of 2002 and other rules and regulations applicable to public
      companies. Stock-based compensation expense included in general and
      administrative expenses increased to $258,000 in 2006 from $5,000 in 2005.
      As a
      percent of 2006 revenue, general and administrative expense fell to 12% from
      17%
      in 2005.





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Other
      Income (Expense),
      Net.  Other expense, net increased by nearly $9.9 million
      to $10.0 million in 2006 from $68,000 in 2005. The increase was primarily
      due to a $8.4 million warrant revaluation expense in 2006. Interest expense
      increased due to a higher average debt balance throughout 2006 that carried
      a
      higher average interest rate. The increase in the average debt balance was
      primarily attributable to a $6.0 million subordinated debt financing that
      closed in the first quarter of 2006, which was terminated in December 2006
      subsequent to the initial public offering. Included in interest expense for
      2006
      was a debt discount of $540,000 and an early termination fee of $180,000 related
      to this debt financing.





Liquidity
      and Capital Resources




As
      of
      December 30, 2007, our principal sources of liquidity consisted of cash,
      cash equivalents, and marketable securities of $85.9 million and net
      accounts receivable of $20.2 million. Our cash, cash equivalents, and
      marketable securities balances were substantially generated from our initial
      public offering in December 2006 in which we received net proceeds of
      approximately $105.7 million (after underwriters’ discounts of
      $8.1 million and additional offering related costs of approximately
      $2.4 million). Our primary sources of cash historically have been proceeds
      from the issuance of convertible preferred stock, customer payments for our
      products and services and proceeds from the issuance of notes payable. From
      the
      beginning of 2001 through December 31, 2006, we issued convertible
      preferred stock with aggregate net proceeds of $69.5 million and notes
      payable with aggregate proceeds of $70.4 million. The proceeds from the
      notes payable have been used to fund our losses from operations and capital
      expenditures. Although our credit facilities remain available, we anticipate
      that we will not have a need to fund operations through additional borrowings
      in
      the near term. In 2006, we repaid our remaining notes payable and we currently
      have no debt outstanding.




Our
      principal uses of cash historically have consisted of payroll and other
      operating expenses, repayments of borrowings and purchases of property and
      equipment primarily to support the development of new products.




Since
      the
      second quarter of 2005, we have expanded our operations internationally. Our
      sales contracts are typically denominated in United States dollars. However,
      our
      local operating expenses are derived in foreign currencies.  Thus, as
      the United States dollar decreases in value against the local currencies where
      we have operations, our cash flows from operations are negatively
      affected.  As we fund our international operations, our cash and cash
      equivalents could be affected by changes in exchange rates. To date, the foreign
      currency effect on our cash and cash equivalents has been
      immaterial.




The
      following table shows our working capital and cash, cash equivalents and
      marketable securities as of the stated dates:




As
                    ofDecember 30,
                
                
                December 31,
                
                
                January 1,2007
                
                
                2006
                
                
                2006Restated(1)(In
                    thousands)Working
                    capital
                
                $
                87,251
                
                
                $
                108,519
                
                
                $
                7,332Cash,
                    cash equivalents and marketable securities
                
                
                85,861
                
                
                
                99,899
                
                
                
                12,656







(1)
                See
                    Note 3,
                    "Restatement of Consolidated Financial Statements," of the Notes
                    to
                    Consolidated Financial
                    Statements.


The
      following table shows our cash flows from operating activities, investing
      activities and financing activities for the stated periods:




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(1)(In
                thousands)Net
                cash used in operating activities
            
            $
            (6,950
            )
            
            $
            (17,300
            )
            
            $
            (18,411
            )Net
                cash used in investing activities
            
            
            (53,870
            )
            
            
            (3,491
            )
            
            
            (5,536
            )Net
                cash (used in) provided by financing activities
            
            
            (82
            )
            
            
            109,833
            
            
            
            26,179




(1)
                See
                    Note 3,
                    "Restatement of Consolidated Financial Statements," of the Notes
                    to
                    Consolidated Financial
                    Statements.
  Cash
      Flows from Operating Activities




Our
      cash
      flows from operating activities are significantly influenced by our cash
      investments to support the growth of our business in areas such as research
      and
      development, sales and marketing and corporate administration. Our operating
      cash flows are also influenced by our working capital needs to support growth
      and fluctuations in inventory, accounts receivable, vendor accounts payable
      and
      other current assets and liabilities. Certain metrics such as inventory and
      accounts receivable turns historically have been impacted by our product mix
      and
      the timing of orders from our customer base. As we have continued to build
      our
      integrated relationship with our manufacturing partner, we have experienced
      a
      steady improvement in inventory turns due to outsourcing our inventory
      management. Accounts receivable levels at quarter-ends have historically been
      affected by the timing of orders from our customers during the
      quarter.





48
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Net
      cash
      used in operating activities was $7.0 million, $17.3 million, and
      $18.4 million in 2007, 2006, and 2005, respectively. Net cash used in
      operating activities in 2007 consisted primarily of our net loss of $26.9
      million offset by a $8.8 million increase in accounts payable and accrued
      liabilities, compensation payable and deferred rent, a $7.4 million increase
      in
      deferred revenue, $5.3 million of depreciation and amortization expense, and
      $4.0 million of stock compensation expense.  Net cash used in
      operating activities in 2006 consisted primarily of our net loss of
      $26.0 million and a $15.4 million increase in net accounts receivable
      offset by $8.4 million of non-cash charges related to the revaluation of
      our preferred stock warrants to their estimated fair value, an increase of
      $7.8 million in deferred revenue and customer deposits and
      $4.2 million of depreciation and amortization expense. Net cash used in
      operating activities in 2005 consisted of our net loss of $19.2 million and
      a use of $2.0 million related to net changes in our operating assets and
      liabilities, reduced by depreciation and amortization expense of
      $2.6 million.





Cash
      Flows from Investing Activities




Cash
      flows from investing activities primarily relate to capital expenditures to
      support our growth.





Net
      cash
      used in investing activities in 2007 was $53.9 million, comprised
      of  net purchases of marketable securities of $46.6 million related to
      investing our initial public offering proceeds received in December 2006 in
      short-term investments and $7.3 million of capital expenditures, primarily
      related to additional lease space expenditures and continued purchases of
      research and development lab equipment.





Net
      cash
      used in investing activities in 2006 was $3.5 million, comprised of
      $5.3 million of capital expenditures, primarily related to improvements for
      newly-leased space for our headquarters and increased research and development
      lab equipment, offset primarily by $1.8 million of net sales of marketable
      securities.





Net
      cash
      used in investing activities was $5.5 million in 2005, comprised of capital
      expenditures of $3.7 million and net purchases of marketable securities of
      $1.8 million.




Cash
      Flows from Financing Activities




Net
      cash
      used in financing activities was $82,000 in 2007 and net cash provided by
      financing activities was $109.8 million, and $26.2 million
      in  2006 and 2005, respectively. In 2007, we generated $1.1 million in
      net proceeds from issuance of common stock including through our Employee Stock
      Purchase Plan, which was offset by payments of offering costs of $1.1
      million.  In 2006, we generated $107.4 million in net proceeds
      from issuance of common stock in our initial public offering, sold our
      Series E convertible preferred stock for net proceeds of $9.9 million,
      borrowed and repaid $6.0 million under a subordinated loan agreement and
      made net repayments of $7.5 million under our line of credit facilities.
      Net cash provided by financing activities increased to $26.2 million in
      2005 from $17.8 million in 2004. In 2005, we sold our Series D
      convertible preferred stock for net proceeds of $19.9 million and made net
      borrowings of $6.1 million under our line of credit facilities. These
      borrowings were used to fund losses from operations and for capital
      expenditures.




We
      believe that our $85.9 million of cash, cash equivalents, and marketable
      securities as of December 30, 2007, together with any cash flows from
      our operations, will be sufficient to fund our projected operating requirements
      for at least twelve months. However, we may need to raise additional capital
      or
      incur additional indebtedness to continue to fund our operations in the future.
      Our future capital requirements will depend on many factors, including our
      rate
      of revenue growth, the expansion of our sales and marketing activities, the
      timing and extent of our expansion into new territories, the timing of
      introductions of new products and enhancements to existing products, and the
      continuing market acceptance of our products. Although we currently are not
      a
      party to any agreement or letter of intent with respect to potential material
      investments in, or acquisitions of, complementary businesses, services or
      technologies, we may enter into these types of arrangements in the future,
      which
      could also require us to seek additional equity or debt financing. Additional
      funds may not be available on terms favorable to us or at all.




Contractual
      Obligations




The
      following is a summary of our contractual obligations as of December 30,
      2007:




Payments
                Due by PeriodLess
                Than
            
            
            1
                - 3
            
            
            3
                - 5
            
            
            More
                ThanTotal
            
            
            1 Year
            
            
            Years
            
            
            Years
            
            
            5 Years(In
                thousands)Operating
                lease obligations
            
            $
            18,108
            
            
            $
            3,197
            
            
            $
            5,104
            
            
            $
            5,498
            
            
            $
            4,309Purchase
                obligations (1)
            
            
            10,436Total
            
            $
            28,544
            
            
            $
            3,197
            
            
            $
            5,104
            
            
            $
            5,498
            
            
            $
            4,309




(1)
            The
              Company maintains, with its contract manufacturer, a rolling 90-day
              firm
              order for products it manufactures for the Company, and these orders
              may
              only be rescheduled or cancelled by its contract manufacturer under
              certain limited conditions and, even then, with certain restrictions
              and
              penalties up to the full cost of the product. The remaining amount
              on the
              open purchase order with its contract manufacturer at December 30,
              2007,
              was $10.4 million.






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Guarantees




In
      the
      ordinary course of business, we have entered into agreements with, among others,
      customers, value-added resellers, system integrators and distributors that
      include guarantees or indemnity provisions. Based on historical experience
      and
      information known to us, as of December 30, 2007, we believe our exposure
      related to the above guarantees and indemnities at December 30, 2007 was
      not material. In the ordinary course of business, we also enter into
      indemnification agreements with our officers and directors and our certificate
      of incorporation and bylaws include similar indemnification obligations to
      our
      officers and directors. It is not possible to determine the amount of our
      liability related to these indemnification agreements and obligations to our
      officers and directors due to the limited history of prior indemnification
      claims and the unique facts and circumstances involved in each particular
      agreement.  Accordingly, we have no liabilities recorded for these
      agreements as of December 30, 2007 and December 31, 2006.





Off-Balance
      Sheet Arrangements




During
      the periods presented, we did not have any relationships with unconsolidated
      entities or financial partnerships, such as entities often referred to as
      structured finance or special purpose entities, which would have been
      established for the purpose of facilitating off-balance sheet arrangements
      or
      other contractually narrow or limited purposes.





Recent
      Accounting Pronouncements




In
      September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, or
      SFAS 157.  SFAS 157 defines fair value, establishes a framework
      for measuring fair value and expands disclosure of fair value measurements.
      SFAS 157 applies under other accounting pronouncements that require or
      permit fair value measurements and accordingly, does not require any new fair
      value measurements. SFAS 157 is effective for financial statements issued
      for fiscal years beginning after November 15, 2007. We do not expect its
      adoption will have a significant impact on our consolidated financial
      statements.





In
      February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
      Financial
      Assets and Financial Liabilities,or SFAS 159.
      SFAS 159
      permits companies to choose to measure many financial instruments and certain
      other items at fair value. SFAS 159 is effective for financial statements
      issued for fiscal years beginning after November 15, 2007. We do not expect
      the adoption of SFAS 159 will have a material impact on our consolidated
      financial statements.





In
      February 2008, the FASB issued FASB Staff Position (FSP) No. FAS 157-b, Fair Value Measurements, or
      FSP 157-b. FSP 157-b delays the effective date of SFAS 157 until
      January 1, 2009, for all nonfinancial assets and liabilities, except those
      recognized or disclosed at fair value in the financial statements on
      a recurring basis. Nonfinancial assets and liabilities include, among
      others: intangible assets acquired through business
      combinations; long-lived assets when assessing potential impairment; and
      liabilities associated with restructuring activities.





In
      December 2007, the FASB issued SFAS No. 141 (R), Business Combinations, or
      SFAS 141R and SFAS No. 160, Noncontrolling Interests
      in
      Consolidated Financial Statements,or SFAS
      160.  SFAS 141R requires an acquirer to measure the
      identifiable assets acquired, the liabilities assumed and any noncontrolling
      interest in the acquiree at their fair values on the acquisition date, with
      goodwill being the excess value over the net identifiable assets acquired.
      SFAS 160 clarifies that a noncontrolling interest in a subsidiary should be
      reported as equity in the consolidated financial statements. The calculation
      of
      earnings per share will continue to be based on income amounts attributable
      to
      the parent. SFAS 141R and SFAS 160 are effective for financial
      statements issued for fiscal years beginning after December 15, 2008. Early
      adoption is prohibited. We have not yet determined the effect on our
      consolidated financial statements, if any, of the adoption of SFAS
      141R or SFAS 160.




**I****TE****M 7A.** 
      ***Quantitative and Qualitative Disclosures About Market
      Risk***




Foreign
      Currency Risk




Our
      international sales and marketing operations incur expenses that are denominated
      in foreign currencies. These expenses could be materially affected by currency
      fluctuations. Our exposures are to fluctuations in exchange rates for the
      U.S. dollar versus the euro, the British pound, the Japanese yen and, to a
      lesser extent, the Canadian dollar and the Korean won. Changes in currency
      exchange rates could adversely affect our consolidated results of operations
      or
      financial position. Additionally, our international sales and marketing
      operations maintain cash balances denominated in foreign currencies. In order
      to
      decrease the inherent risk associated with translation of foreign cash balances
      into our reporting currency, we have not maintained excess cash balances in
      foreign currencies. As of December 30, 2007, we had $272,000 of cash in
      foreign accounts. To date, we have not hedged our exposure to changes in foreign
      currency exchange rates.





Interest
      Rate Risk




We
      had a
      cash and cash equivalents balance of $39.0 million and marketable
      securities of $46.8 million as of December 30, 2007, which were held
      for working capital purposes. We do not enter into investments for trading
      or
      speculative purposes. Investments in fixed rate, interest-earning instruments
      carry a degree of interest rate risk. Fixed rate securities may have their
      market value adversely impacted due to rising interest rates.  In a
      declining interest rate environment, as short term investments mature,
      reinvestment occurs at less favorable market rates. The fair value of our
      marketable securities fluctuates based on changes in market conditions and
      interest rates; however, given the short-term maturities, an increase in
      interest rates by 10% from our 2007 year end levels would not have a material
      effect upon our marketable securities balances, operating results or cash flows.





50
 Table
            of Contents





ITEM 8.Financial
      Statements and
      Supplementary Data




INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS




PageReport
                of Independent Registered Public Accounting Firm
            52Consolidated
                Balance Sheets
            53Consolidated
                Statements of Operations
            54Consolidated
                Statements of Changes in Mandatorily Redeemable Convertible Preferred
                Stock and Stockholders’ Equity (Deficit) and Comprehensive
                Loss
            55Consolidated
                Statements of Cash Flows
            56Notes
                to Consolidated Financial Statements
            57




51
 Table
            of Contents





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM







To
      The
      Board of Directors and Stockholders of Isilon Systems, Inc.:





In
      our
      opinion, the accompanying consolidated balance sheets and the related
      consolidated statements of operations, of changes in mandatorily redeemable
      convertible preferred stock and stockholders' equity (deficit) and comprehensive
      loss, and of cash flows present fairly, in all material respects, the financial
      position of Isilon Systems, Inc. at December 30, 2007 and December 31, 2006,
      and
      the results of its operations and its cash flows for each of the three years
      in
      the period ended December 30, 2007 in conformity with accounting principles
      generally accepted in the United States of America.  Also in our
      opinion, the Company maintained, in all material respects, effective internal
      control over financial reporting as of December 30, 2007, based on criteria
      established in Internal
      Control - Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (COSO).  The Company's
      management is responsible for these financial statements, for maintaining
      effective internal control over financial reporting and for its assessment
      of
      the effectiveness of internal control over financial reporting, included in
      Management's Annual Report on Internal Control over Financial Reportingappearing under
      Item 9A.  Our responsibility is to express opinions on these
      financial statements and on the Company's internal control over financial
      reporting based on our audits (which was an integrated audit in
      2007).  We conducted our audits in accordance with the standards of
      the Public Company Accounting Oversight Board (United States).  Those
      standards require that we plan and perform the audits to obtain reasonable
      assurance about whether the financial statements are free of material
      misstatement and whether effective internal control over financial reporting
      was
      maintained in all material respects.  Our audits of the financial
      statements included examining, on a test basis, evidence supporting the amounts
      and disclosures in the financial statements, assessing the accounting principles
      used and significant estimates made by management, and evaluating the overall
      financial statement presentation.  Our audit of internal control over
      financial reporting included obtaining an understanding of internal control
      over
      financial reporting, assessing the risk that a material weakness exists, and
      testing and evaluating the design and operating effectiveness of internal
      control based on the assessed risk.  Our audits also included
      performing such other procedures as we considered necessary in the
      circumstances. We believe that our audits provide a reasonable basis for our
      opinions.





As
      discussed in Note 1 to the consolidated financial statements, the Company
      adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment,
      effective January 2, 2006.





As
      discussed in Note 1 to the consolidated financial statements, the Company
      adopted Financial Accounting Standards Board Staff Position No. 150-5,Issuer's Accounting under
      FASB
      Statement No. 150 for Freestanding Warrants and Other Similar Instruments on
      Shares That Are Redeemable, during the fiscal year ended January 1,
      2006.





As
      discussed in Note 3 to the consolidated financial statements, the Company has
      restated its 2006 consolidated financial statements.




A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles.  A company’s internal
      control over financial reporting includes those policies and procedures that
      (i) pertain to the maintenance of records that, in reasonable detail,
      accurately and fairly reflect the transactions and dispositions of the assets
      of
      the company; (ii) provide reasonable assurance that transactions are
      recorded as necessary to permit preparation of financial statements in
      accordance with generally accepted accounting principles, and that receipts
      and
      expenditures of the company are being made only in accordance with
      authorizations of management and directors of the company; and
      (iii) provide reasonable assurance regarding prevention or timely detection
      of unauthorized acquisition, use, or disposition of the company’s assets that
      could have a material effect on the financial statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements.  Also, projections of any evaluation
      of effectiveness to future periods are subject to the risk that controls may
      become inadequate because of changes in conditions, or that the degree of
      compliance with the policies or procedures may deteriorate.








/s/
      PricewaterhouseCoopers LLP


Seattle,
      Washington


April
      2,
      2008





52
 Table
            of Contents





Isilon
      Systems, Inc.


Consolidated
      Balance Sheets





As
                ofDecember
                30,
              2007
            
            
            December
                31,
              2006
              Restated
                (1)(In
                thousands, except per share
                data)ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            38,999
            
            
            $
            99,899Marketable
                securities
            
            
            46,862
            
            
            
            —Trade
                receivables, net of allowances of $324 and $501,
                respectively
            
            
            20,152
            
            
            
            23,248Inventories
            
            
            9,430
            
            
            
            4,125Other
                current assets
            
            
            5,524
            
            
            
            2,304Total
                current assets
            
            
            120,967
            
            
            
            129,576Property
                and equipment, net
            
            
            10,571
            
            
            
            7,158Total
                assets
            
            $
            131,538
            
            
            $
            136,734LIABILITIES
                AND STOCKHOLDERS’ EQUITYCurrent
                liabilities:Accounts
                payable
            
            $
            10,962
            
            
            $
            6,777Accrued
                liabilities
            
            
            5,182
            
            
            
            3,249Accrued
                compensation and related benefits
            
            
            5,180
            
            
            
            3,463Deferred
                revenue
            
            
            12,392
            
            
            
            7,568Total
                current liabilities
            
            
            33,716
            
            
            
            21,057Deferred
                revenue, net of current portion
            
            
            5,819
            
            
            
            3,284Deferred
                rent, net of current portion
            
            
            3,414
            
            
            
            2,186Total
                liabilities
            
            
            42,949
            
            
            
            26,527Commitments
                and contingencies (Note 12)Stockholders'
                equity:Preferred
                stock, par value $0.00001: 10,000 shares authorized; no shares issued
                and
                outstanding
            
            
            —
            
            
            
            —Common
                stock, par value $0.00001: 250,000 shares authorized;62,918 and
                61,519 shares issued and outstanding
            
            
            1
            
            
            
            1Additional
                paid-in capital
            
            
            191,254
            
            
            
            185,947Accumulated
                other comprehensive loss
            
            
            (76
            )
            
            
            (83
            )Accumulated
                deficit
            
            
            (102,590
            )
            
            
            (75,658
            )Total
                stockholders' equity
            
            
            88,589
            
            
            
            110,207Total
                liabilities and stockholders' equity
            
            $
            131,538
            
            
            $
            136,734





(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.








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





53
 Table
            of Contents





Isilon
      Systems, Inc.


Consolidated
      Statements of Operations




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(2)(In
                thousands, except per share data)Revenue:Product
            
            $
            74,434
            
            
            $
            53,137
            
            
            $
            18,709Services
            
            
            14,564
            
            
            
            8,069
            
            
            
            2,374Total
                revenue
            
            
            88,998
            
            
            
            61,206
            
            
            
            21,083Cost
                of revenue:Product
            
            
            33,761
            
            
            
            25,186
            
            
            
            10,388Services(1)
            
            
            8,975
            
            
            
            3,622
            
            
            
            1,187Total
                cost of revenue
            
            
            42,736
            
            
            
            28,808
            
            
            
            11,575Gross
                profit
            
            
            46,262
            
            
            
            32,398
            
            
            
            9,508Operating
                expenses:Research
                and development(1)
            
            
            19,903
            
            
            
            16,524
            
            
            
            12,478Sales
                and marketing(1)
            
            
            42,595
            
            
            
            24,390
            
            
            
            12,377General
                and administrative(1)
            
            
            14,945
            
            
            
            7,411
            
            
            
            3,681Total
                operating expenses
            
            
            77,443
            
            
            
            48,325
            
            
            
            28,536Loss
                from operations
            
            
            (31,181
            )
            
            
            (15,927
            )
            
            
            (19,028
            )Other
                income (expense), netInterest
                income and other
            
            
            4,470
            
            
            
            230
            
            
            
            314Interest
                expense
            
            
            —
            
            
            
            (1,751
            )
            
            
            (330
            )Warrant
                revaluation expense
            
            
            —
            
            
            
            (8,431
            )
            
            
            (52
            )Total
                other income (expense), net
            
            
            4,470
            
            
            
            (9,952
            )
            
            
            (68
            )Loss
                before income tax expense and cumulative effect of change in accounting
                principle
            
            
            (26,711
            )
            
            
            (25,879
            )
            
            
            (19,096
            )Income
                tax expense
            
            
            (221
            )
            
            
            (109
            )
            
            
            —Loss
                before cumulative effect of change in accounting principle
            
            
            (26,932
            )
            
            
            (25,988
            )
            
            
            (19,096
            )Cumulative
                effect of change in accounting principle
            
            
            —
            
            
            
            —
            
            
            
            (89
            )Net
                loss
            
            $
            (26,932
            )
            
            $
            (25,988
            )
            
            $
            (19,185
            )Net
                loss per common share, basic and diluted
            
            $
            (0.44
            )
            
            $
            (3.09
            )
            
            $
            (3.95
            )Shares
                used in computing basic and diluted net loss per common
                share
            
            
            61,514
            
            
            
            8,423
            
            
            
            4,852(1) Includes
                stock-based compensation expense as follows:Cost
                of services revenue
            
            $
            149
            
            
            $
            24
            
            
            $
            —Research
                and development
            
            
            702
            
            
            
            160
            
            
            
            —Sales
                and marketing
            
            
            1,601
            
            
            
            198
            
            
            
            —General
                and administrative
            
            
            1,526
            
            
            
            258
            
            
            
            5




(2)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.








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





54
 Table
            of Contents





Isilon
      Systems, Inc.


Consolidated
      Statements of Changes in Mandatorily Reedemable Convertible


Preferred
      Stock and Stockholders’ Equity (Deficit) and Comprehensive Loss




MandatorilyRedeemable
              
              
              
              
              
              
              
              
              
              
              
              Accumulated
              
              
              
              
              
              TotalConvertible
              
              
              
              
              
              
              
              
              Additional
              
              
              Other
              
              
              
              
              
              Stockholders’Preferred
                  Stock
              
              
              Common
                  Stock
              
              
              Paid-in
              
              
              Comprehensive
              
              
              Accumulated
              
              
              EquityShares
              
              
              Amount
              
              
              Shares
              
              
              Amount
              
              
              Capital
              
              
              Income
                  (Loss)
              
              
              (Deficit)
              
              
              (Deficit)(In
                  thousands)Balances
                  as of January 2, 2005
              
              
              33,123
              
              
              **$**
              39,736
              ****
              ****
              ****
              6,174
              ****
              ****
              **$**
              —
              ****
              ****
              **$**
              158
              
              
              **$**
              —
              
              
              **$**
              (30,485
              )
              
              **$**
              (30,327
              )Common
                  stock issued in connection with early-exercises of stock
                  options
              
              
              —
              
              
              
              —
              
              
              
              462
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
                  stock issued in connection with all other exercises of stock
                  options
              
              
              —
              
              
              
              —
              
              
              
              270
              
              
              
              —
              
              
              
              42
              
              
              
              —
              
              
              
              —
              
              
              
              42Vesting
                  of early-exercised stock options
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              119
              
              
              
              —
              
              
              
              —
              
              
              
              119Issuance
                  and modification of warrants
              
              
              —
              
              
              
              112
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Issuance
                  of Series D convertible preferred stock, net of issuance costs of
                  $73
              
              
              8,666
              
              
              
              19,927
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Stock-based
                  compensation expense
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              5
              
              
              
              —
              
              
              
              —
              
              
              
              5Reclassification
                  of warrants to liabilities
              
              
              —
              
              
              
              (226
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Comprehensive
                  loss:Net
                  loss
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (19,185
              )Foreign
                  currency translation adjustment
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (29
              )
              
              
              —Total
                  comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (19,214
              )Balances
                  as of January 1, 2006
              
              
              41,789
              
              
              **$**
              59,549
              
              
              
              6,906
              
              
              **$**
              —
              
              
              **$**
              324
              
              
              **$**
              (29
              )
              
              **$**
              (49,670
              )
              
              
              (49,375
              )Common
                  stock issued in connection with early-exercises of stock
                  options
              
              
              —
              
              
              
              —
              
              
              
              333
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
                  stock issued in connection with all other exercises of stock
                  options
              
              
              —
              
              
              
              —
              
              
              
              1,655
              
              
              
              —
              
              
              
              324
              
              
              
              —
              
              
              
              —
              
              
              
              324Common
                  stock issued in connection with exercises of warrants
              
              
              —
              
              
              
              —
              
              
              
              245
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Vesting
                  of early-exercised stock options
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              143
              
              
              
              —
              
              
              
              —
              
              
              
              143Repurchase
                  of shares of unvested common stock
              
              
              —
              
              
              
              —
              
              
              
              (57
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Issuance
                  of Series E convertible preferred stock, net of issuance costs of
                  $55
              
              
              1,707
              
              
              
              9,945
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Conversion
                  of mandatorily redeemable convertible preferred stock to common
                  stock
              
              
              (43,496
              )
              
              
              (69,494
              )
              
              
              43,496
              
              
              
              1
              
              
              
              69,493
              
              
              
              —
              
              
              
              —
              
              
              
              69,494Sale
                  of common stock, net of offering expenses
              
              
              —
              
              
              
              —
              
              
              
              8,941
              
              
              
              —
              
              
              
              105,685
              
              
              
              —
              
              
              
              —
              
              
              
              105,685Conversion
                  of mandatorily redeemable convertible preferred stock warrants
                  to common
                  stock warrants
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              9,338
              
              
              
              —
              
              
              
              —
              
              
              
              9,338Stock-based
                  compensation expense
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              640
              
              
              
              —
              
              
              
              —
              
              
              
              640Comprehensive
                  loss:Net
                  loss, restated(1)
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (25,988
              )Unrealized
                  gain on marketable securities
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              14
              
              
              
              —Reclassification
                  of unrealized gain on marketable securities to income upon
                  sale
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (14
              )
              
              
              —Foreign
                  currency translation adjustment
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (54
              )
              
              
              —Total
                  comprehensive loss, restated(1)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (26,042
              )Balances
                  as of December 31, 2006, restated (1)
              
              
              **—**
              ****
              ****
              **$**
              **—**
              ****
              ****
              ****
              **61,519**
              ****
              ****
              **$**
              **1**
              ****
              ****
              **$**
              **185,947**
              ****
              ****
              **$**
              **(83**
              **)**
              ****
              **$**
              **(75,658**
              **)**
              ****
              **$**
              **110**,**207**Common
                  stock issued in connection with exercise of stock options
              
              
              —
              
              
              
              —
              
              
              
              1,534
              
              
              
              —
              
              
              
              782
              
              
              
              —
              
              
              
              —
              
              
              
              782Common
                  stock issued in connection with Employee Stock Purchase
                  Plan
              
              
              —
              
              
              
              —
              
              
              
              46
              
              
              
              —
              
              
              
              365
              
              
              
              —
              
              
              
              —
              
              
              
              365Initial
                  public offering expenses
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (41
              )
              
              
              —
              
              
              
              —
              
              
              
              (41
              )Vesting
                  of early-exercised stock options
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              223
              
              
              
              —
              
              
              
              —
              
              
              
              223Repurchase
                  of shares of unvested common stock
              
              
              —
              
              
              
              —
              
              
              
              (181
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              
              
              
              
              —Stock-based
                  compensation expense
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              3,978
              
              
              
              —
              
              
              
              —
              
              
              
              3,978Comprehensive
                  loss:Net
                  loss
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (26,932
              )Unrealized
                  gain on marketable securities
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              94
              
              
              
              —Foreign
                  currency translation adjustment
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (87
              )
              
              
              —Total
                  comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (26,925
              )Balances
                  as of December 30, 2007
              
              
              —
              
              
              **$**
              —
              
              
              
              62,918
              
              
              $
              1
              
              
              $
              191,254
              
              
              $
              (76
              )
              
              $
              (102,590
              )
              
              $
              88,589




(1)See
      Note 3,
      "Restatement of Consolidated Financial Statements," of the Notes to Consolidated
      Financial Statements.






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





55
 Table
            of Contents





Isilon
      Systems, Inc.


Consolidated
      Statements of Cash Flows




Year
                EndedDecember
                30,
              2007
            
            
            December
                31,
              2006
              Restated(1)
            
            
            January
                1,
              2006(in
                thousands)Cash
                flows from operating activitiesNet
                loss
            
            $
            (26,932
            )
            
            $
            (25,988
            )
            
            $
            (19,185
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            5,337
            
            
            
            4,169
            
            
            
            2,596Realized
                gain on sale of marketable securities
            
            
            —
            
            
            
            (14
            )
            
            
            —Non-cash
                interest expense
            
            
            —
            
            
            
            646
            
            
            
            69Amortization
                of discount on marketable securities
            
            
            (182
            )
            
            
            —
            
            
            
            —Stock-based
                compensation expense
            
            
            3,978
            
            
            
            640
            
            
            
            5Loss
                on disposal of property and equipment
            
            
            —
            
            
            
            76
            
            
            
            —Warrant
                revaluation expense
            
            
            —
            
            
            
            8,431
            
            
            
            141Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            3,056
            
            
            
            (15,386
            )
            
            
            (4,515
            )Inventories
            
            
            (5,305
            )
            
            
            (1,167
            )
            
            
            (807
            )Other
                current assets
            
            
            (3,032
            )
            
            
            (1,810
            )
            
            
            (172
            )Accounts
                payable
            
            
            4,914
            
            
            
            3,201
            
            
            
            1,113Accrued
                liabilities, compensation payable and deferred rent
            
            
            3,857
            
            
            
            2,134
            
            
            
            1,280Deferred
                revenue
            
            
            7,359
            
            
            
            7,768
            
            
            
            1,064Net
                cash used in operating activities
            
            
            (6,950
            )
            
            
            (17,300
            )
            
            
            (18,411
            )Cash
                flows from investing activitiesPurchases
                of property and equipment
            
            
            (7,284
            )
            
            
            (5,340
            )
            
            
            (3,733
            )Purchases
                of marketable securities
            
            
            (71,581
            )
            
            
            (691
            )
            
            
            (3,253
            )Proceeds
                from sales and maturities of marketable securities
            
            
            24,995
            
            
            
            2,508
            
            
            
            1,450Proceeds
                from sale of property and equipment
            
            
            —
            
            
            
            32
            
            
            
            —Net
                cash used in investing activities
            
            
            (53,870
            )
            
            
            (3,491
            )
            
            
            (5,536
            )Cash
                flows from financing activitiesProceeds
                from issuance of preferred stock
            
            
            —
            
            
            
            9,945
            
            
            
            19,927Proceeds
                from issuance of common stock
            
            
            782
            
            
            
            108,801
            
            
            
            183Proceeds
                from issuance of common stock, employee stock purchase
                plan
            
            
            365
            
            
            
            —
            
            
            
            —Proceeds
                from notes payable
            
            
            —
            
            
            
            54,524
            
            
            
            13,467Repurchases
                of unvested common stock
            
            
            (94
            )
            
            
            —
            
            
            
            —Payment
                of offering costs
            
            
            (1,135
            )
            
            
            (1,376
            )
            
            
            —Payments
                of notes payable and capital lease obligations
            
            
            —
            
            
            
            (62,061
            )
            
            
            (7,398
            )Net
                cash (used in) provided by financing activities
            
            
            (82
            )
            
            
            109,833
            
            
            
            26,179Effect
                of exchange rate changes on cash and cash equivalents
            
            
            2
            
            
            
            4
            
            
            
            3Net
                (decrease) increase in cash and cash equivalents
            
            
            (60,900
            )
            
            
            89,046
            
            
            
            2,235Cash
                and cash equivalents at beginning of year
            
            
            99,899
            
            
            
            10,853
            
            
            
            8,618Cash
                and cash equivalents at end of year
            
            $
            38,999
            
            
            $
            99,899
            
            
            $
            10,853Supplemental
                dislosure of cash flow information:Cash
                paid for interest
            
            $
            —
            
            
            $
            1,141
            
            
            
            243Cash
                paid for taxes
            
            
            69
            
            
            
            17
            
            
            
            —Non-cash
                investing and financing activities:Additions
                to property and equipment included in accounts payable
            
            
            449
            
            
            
            231
            
            
            
            722Vesting
                of early exercise-excised stock options
            
            
            223
            
            
            
            143
            
            
            
            119Additions
                to property and equipment provided by lessor
            
            
            1,209
            
            
            
            2,417
            
            
            
            —Issuance
                and modifications of warrants for deferred financings
                costs
            
            
            —
            
            
            
            —
            
            
            
            112Debt
                discount resulting from the issuance of warrants
            
            
            —
            
            
            
            540
            
            
            
            —Unrealized gain
                on marketable securities
            
            
            94
            
            
            
            14
            
            
            
            —Accrued
                initial public offering costs
            
            
            —
            
            
            
            1,033
            
            
            
            —Conversion
                of mandatorily redeemable convertible preferred stock warrants to
                common
                stock warrants
            
            
            —
            
            
            
            9,338
            
            
            
            —




(1)See
      Note 3,
      "Restatement of Consolidated Financial Statements," of the Notes to Consolidated
      Financial Statements.





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





56
 Table
            of Contents





Isilon
      Systems, Inc.




NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS




1.  Organization
      and Significant Accounting Policies




Organization




Isilon
      Systems, Inc. (the “Company”) was incorporated in the State of Delaware on
      January 24, 2001. The Company designs, develops and markets clustered
      storage systems for storing and managing digital content. The Company began
      selling its products and services in January 2003. The Company sells systems
      that generally include a software license, hardware, post-contract customer
      support and, in some cases, additional elements.





Significant
      Accounting Policies




Fiscal
      Year End




The
      Company operates on a 52/53-week fiscal year ending on the Sunday closest to
      December 31. Accordingly, the Company’s fiscal year 2007 ended December 30,
      2007, its fiscal year 2006 ended on December 31, 2006, and its fiscal year
      2005 ended on January 1, 2006.





Accounting
      Principles




The
      consolidated financial statements and accompanying notes were prepared in
      accordance with generally accepted accounting principles in the United States
      of
      America (“GAAP”).





Basis
      of Consolidation




The
      consolidated financial statements include the accounts of Isilon Systems, Inc.
      and its wholly owned subsidiaries. All intercompany transactions and
      balances have been eliminated in consolidation.





Use
      of Estimates




The
      preparation of financial statements in conformity with GAAP requires management
      to make estimates and assumptions that affect the reported amounts of assets
      and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of revenue and expenses during
      the reporting period. Significant estimates are inherent in the preparation
      of
      the consolidated financial statements and include accounting for revenue
      recognition, the allowance for doubtful accounts, obsolete and excess inventory,
      the valuation allowance on deferred tax assets and the valuation of preferred
      stock warrants and stock-based compensation expense. Actual results could differ
      from those estimates.





Cash
      and Cash Equivalents




The
      Company considers all highly liquid investments purchased with remaining
      maturities of 90 days or less at the time of purchase to be cash equivalents.
      Cash and cash equivalents are recorded at cost, which approximates market value,
      and consisted of the following:




As
                ofDecember 30,
            
            
            December 31,2007
            
            
            2006(In
                thousands)Bank
                deposits
            
            $
            4,971
            
            
            $
            6,891Money
                market funds
            
            
            21,347
            
            
            
            93,008U.S. government
                securities
            
            
            12,681
            
            
            
            —$
            38,999
            
            
            $
            99,899




Marketable
      Securities




At
      their
      date of acquisition, the Company’s marketable securities are classified into
      categories in accordance with the provisions of Statement of Financial
      Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments
      in Debt and Equity Securities. During the periods presented, the Company had
      securities classified as available-for-sale, which were reported at fair value
      with the related unrealized gains and losses included as a separate component
      in
      stockholders’ equity (deficit). Realized gains and losses and declines in value
      of securities judged to be other than temporary are included in other income
      (expense), net. The fair value of marketable securities is based on quoted
      market prices. Realized and unrealized gains and losses are based on the
      specific identification method. The Company’s investments in marketable
      securities are diversified among high-credit quality securities in accordance
      with the Company’s investment policy.





The
      fair
      value of the Company’s marketable securities fluctuates based on changes in
      market conditions and interest rates; however, given the short-term maturities,
      management believes that these instruments are not subject to significant market
      or interest rate risk.  Investments in fixed rate, interest-earning
      instruments carry a degree of interest rate risk. Fixed rate securities may
      have
      their market value adversely impacted due to rising interest rates. In a
      declining interest rate environment, as short term investments mature,
      reinvestment occurs at less favorable market rates. Given the short term nature
      of certain investments, anticipated declining interest rates will negatively
      impact the Company’s investment income.





57
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            of Contents


Isilon
        Systems, Inc.
 NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Marketable
      securities consisted of the following:




Gross
            
            
            GrossAmortized
            
            
            Unrealized
            
            
            Unrealized
            
            
            FairCost
            
            
            Gains
            
            
            Losses
            
            
            Value(In
                thousands)As
                of December 30, 2007Commercial
                paper
            
            $
            5,512
            
            
            $
            —
            
            
            $
            —
            
            
            $
            5,512Corporate
                bonds and notes
            
            
            3,581
            
            
            
            —
            
            
            
            (1
            )
            
            
            3,580U.S. government
                securities
            
            
            37,676
            
            
            
            97
            
            
            
            (3
            )
            
            
            37,770$
            46,769
            
            
            $
            97
            
            
            $
            (4
            )
            
            $
            46,862




The
      Company did not hold any marketable securities as of December 31,
      2006.





The
      unrealized losses on these investments were caused by interest rate increases
      and not credit quality. The Company determined the unrealized losses to be
      temporary since the duration of the decline in value of the investments was
      short, the extent of the decline, in both dollars and as a percentage of cost,
      was not significant, and the Company has the ability and intent to hold the
      investments until it recovered at least substantially all of the cost of the
      investments.





Allowance
      for Doubtful Accounts




The
      Company reviews its allowance for doubtful accounts quarterly by assessing
      individual accounts receivable over a specific age and amount, and all other
      balances on a pooled basis based on historical collection experience and
      economic risk assessment. The Company’s allowance for doubtful accounts was
      $324,000 and $501,000 as of December 30, 2007 and December 31, 2006,
      respectively.





Inventories




Inventories
      are stated at the lower of cost or market value. Cost is determined using the
      average cost method, which approximates FIFO, and market value represents the
      lower of replacement cost or estimated net realizable value. Reserves for excess
      and obsolete inventory are established based on management’s analysis of
      inventory levels and future sales forecasts. Once established, the original
      cost
      of the Company’s inventory less the related inventory valuation reserve
      represents the new cost basis of these products. Inventories consist of
      components, finished goods and evaluation units.





Property
      and Equipment




Property
      and equipment are recorded at cost. Disposals are removed at cost less
      accumulated depreciation, and any gain or loss from disposition is reflected
      in
      the statement of operations in the period of disposition. Depreciation and
      amortization are provided over the estimated useful lives of the depreciable
      assets, using the straight-line method, as follows:




EstimatedUseful
                LivesSoftware
                and computer equipment
            
            1
                to 3 yearsFurniture,
                office equipment and other
            
            2
                to 3 yearsLeasehold
                improvements
            
            1
                to 7 years




Leasehold
      improvements are amortized over the shorter of the lease term or the estimated
      useful lives of the improvements. Additions and improvements that increase
      the
      value or extend the life of an asset are capitalized. Maintenance and repairs
      are expensed as incurred.




Software
      Development Costs




Software
      development costs incurred in conjunction with product development are charged
      to research and development expense until technological feasibility is
      established. Thereafter, until the product is released for sale, software
      development costs are capitalized and reported at the lower of unamortized
      cost
      or net realizable value of the related product. The establishment of
      technological feasibility and the ongoing assessment of recoverability of costs
      require considerable judgment by the Company with respect to certain internal
      and external factors, including, but not limited to, anticipated future gross
      product revenue, estimated economic life and changes in hardware and software
      technology. Since inception, the Company has not capitalized any software
      development costs because the costs incurred between the time technological
      feasibility was established and the time the product was released for sale
      were
      not significant.





58
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Impairment
      of Long-Lived Assets




The
      Company reviews long-lived assets, including property and equipment, for
      impairment whenever events or changes in business circumstances indicate that
      the carrying amount of the assets may not be fully recoverable. An impairment
      loss would be recognized when estimated undiscounted future cash flows expected
      to result from the use of the asset and its eventual disposition are less than
      its carrying amount. While the Company’s current operating and cash flow losses
      are indicators of impairment, the Company believes that the future cash flows
      to
      be received from its long-lived assets will exceed their carrying value and,
      accordingly, has not recognized any impairment losses during the periods
      presented.




Fair
      Value of Financial Instruments




The
      Company carries its marketable securities classified as available-for-sale
      at
      fair value. The carrying amounts of certain of the Company’s financial
      instruments, including cash and cash equivalents, accounts receivable, other
      receivables and assets, accounts payable, accrued liabilities, other payables
      and liabilities, approximate their fair values due to their short-term nature.
      Based on borrowing rates available to the Company as of the balance sheet dates
      presented for loans with similar terms and similar circumstances, the carrying
      amounts of the Company’s debt obligations approximate their respective fair
      values.




Concentration
      of Risks




The
      Company’s cash and cash equivalents are invested with financial institutions in
      deposits that, at times, may exceed federally insured limits. The Company has
      not experienced any losses on its deposits of cash and cash equivalents.
      Management believes that the institutions are financially sound and,
      accordingly, that minimal credit risk exists.




The
      Company does not require collateral to support credit sales. Allowances are
      maintained for potential credit losses. Customer concentrations of greater
      than
      10% were as follows:


Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 2,2007
            
            
            2006
            
            
            2005Restated(1)%
                of Total RevenueEastman
                Kodak Company
            
            
            10
            %
            
            
            10
            %
            
            
            20
            %Comcast
                Corporation(2)
            
            
            —
            
            
            
            15
            
            
            
            3All
                other customers
            
            
            90
            
            
            
            75
            
            
            
            77Total
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %





As
                    ofDecember 31,
                
                December 31,2007
                
                2006Restated(1)%
                    of Gross Accounts ReceivableComcast
                    Corporation(2)
                
                Less
                    than 10 %
                
                14%





(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.




(2)
            Comcast
                Corporation purchases through one of the Company’s resellers, Computer
                Design and Integration LLC.




The
      Company is dependent on a single contract manufacturer, and some of the key
      components in the Company’s products come from single or limited sources of
      supply.




Revenue
      Recognition




The
      Company derives its revenue from sales of its products and services. Product
      revenue consists of revenue from sales of systems and software. Shipping charges
      billed to customers are included in product revenue and the related shipping
      costs are included in cost of product revenue.




The
      Company’s software is integrated with industry standard hardware and is
      essential to the functionality of the integrated system product. The Company
      provides unspecified software updates and enhancements related to its products
      through service contracts. As a result, the Company accounts for revenue in
      accordance with AICPA Statement of Position No. 97-2,Software Revenue
      Recognition, or SOP 97-2, as amended by Statement of Position
      No. 98-9,Modification of SOP 97-2, Software Revenue Recognition,
      With Respect to
      Certain Transactions, or SOP 98-9, for all transactions involving
      the sale of software. The Company recognizes product revenue when it has entered
      into an arrangement with a customer, delivery has occurred, the fee is deemed
      fixed or determinable and free of contingencies and significant uncertainties,
      and collection is reasonably assured













59
 Table
            of Contents





Isilon
      Systems, Inc.




NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS — (Continued)




On
      sales to channel partners, the Company evaluates whether fees are
      considered fixed or determinable by considering a number of factors, including
      the Company’s ability to estimate returns, the geography in which a sales
      transaction originates, payment terms and the Company’s relationship and past
      history with the particular channel partner.  If fees are not considered
      fixed or determinable at the time of sale to a channel partner, revenue
      recognition is deferred until there is persuasive evidence indicating product
      has sold-through to an end-user.  Persuasive evidence of sell-through may
      include reports from channel partners documenting sell-through activity, copies
      of end-user purchase orders, data indicating an order has shipped to an
      end-user, cash payments or letters of credit guaranteeing cash payments or
      other
      similar information.


At
        the
        time of shipment, the Company records revenue reserves for estimated sales
        returns and stock rotation arrangements.  Sales returns and stock rotation
        reserves are estimated based on historical activity and expectations of future
        experience.  The Company monitors and analyzes actual experience and
        adjusts these reserves on a quarterly basis.
  Substantially
        all of the Company’s products are sold in combination with services, which
        primarily consist of hardware and software support. Software support provides
        customers with rights to unspecified software updates and to maintenance
        releases and patches released during the term of the support period. Hardware
        support includes Internet access to technical content through Isilon Insight,
        the Company’s knowledge database, repair or replacement of hardware in the event
        of breakage or failure, and telephone and Internet access to technical support
        personnel during the term of the support period. Installation services, when
        provided, are also included in services revenue.
  Sales
        generally consist solely of hardware and software products and support services.
        The Company has established vendor specific objective evidence, or VSOE,
        for the
        fair value of its support services as measured by the renewal prices offered
        to
        and paid by its customers. The Company uses the residual method, as allowed
        by
        SOP 98-9, to determine the amount of product revenue to be recognized.
        Under the residual method, the fair value of the undelivered element, support
        services, is deferred and the remaining portion of the sales amount is
        recognized as product revenue. This product revenue is recognized upon shipment,
        based on freight terms, assuming all other criteria for recognition discussed
        above have been met. The fair value of the support services is recognized
        as
        services revenue on a straight-line method over the term of the related
        support period, which is typically one to three years.




Guarantees




In
      the
      ordinary course of business, the Company has entered into agreements with,
      among
      others, customers, value-added resellers, system integrators and distributors
      that include guarantees or indemnity provisions. Based on historical
      experience and information known to the Company, it believes its exposure
      related to the above guarantees and indemnities was immaterial for each of
      the
      periods presented. In the ordinary course of business, the Company also
      enters into indemnification agreements with its officers and directors and
      the
      Company’s certificate of incorporation and bylaws include similar
      indemnification obligations to its officers and directors. It is not possible
      to
      determine the amount of the Company’s liability related to these indemnification
      agreements and obligations to its officers and directors due to the limited
      history of prior indemnification claims and the unique facts and circumstances
      involved in each particular agreement.  Accordingly, the Company has
      no liabilities recorded for these agreements as of December 30, 2007 and
      December 31, 2006.





Research
      and Development




Research
      and development costs are expensed as incurred and primarily include personnel
      costs, prototype expenses, facilities costs and depreciation of equipment used
      in research and development.





Advertising




Advertising
      costs are expensed as incurred. The Company incurred $539,000, $734,000 and
      $168,000 in advertising costs during the years ended December 30, 2007,
      December 31, 2006, and January 1, 2006, respectively.





Operating
      Leases




The
      Company recognizes rent expense on the straight-line method over the term of
      the
      lease. The difference between rent expense (which includes the impact of
      escalation provisions and lease incentives, such as tenant improvements provided
      by lessors) and rent paid is recorded as deferred rent in the Company’s
      consolidated balance sheets.





60
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Income
      Taxes




The
      Company provides for deferred income taxes under the asset and liability method.
      Under this method, deferred tax assets, including those related to tax loss
      carryforwards and credits, and liabilities are determined based on the
      differences between the financial statement and tax bases of assets and
      liabilities using enacted tax rates in effect for the year in which the
      differences are expected to reverse. A valuation allowance is recorded to reduce
      deferred tax assets when it is more likely than not that the net deferred tax
      asset will not be realized.




Foreign
      Currency Translation and Transactions




The
      Company considers the functional currency of each of its foreign subsidiaries
      to
      be the local currency of the country in which the subsidiary operates. Assets
      and liabilities of foreign operations are translated into U.S. dollars
      using rates of exchange in effect at the end of the reporting period. Income
      and
      expense accounts are translated into U.S. dollars using average rates of
      exchange for the reporting period. The net gain or loss resulting from
      translation is shown as a foreign currency translation adjustment and included
      as a component of accumulated other comprehensive loss in stockholders’ equity
      (deficit).





Accounting
      for Stock-Based Compensation




Prior
      to
      January 2, 2006, the Company accounted for employee stock options using the
      intrinsic value method in accordance with Accounting Principles Board Opinion
      No. 25,Accounting for Stock
      Issued to Employees, or APB 25, and Financial Accounting Standards
      Board (“FASB”) Interpretation No. 44,Accounting for Certain
      Transactions Involving Stock Compensation, an Interpretation of APB
      No. 25, and had adopted the disclosure-only provisions using the minimum
      value method of SFAS No. 123,Accounting for
      Stock-Based Compensation, or SFAS 123, and
      SFAS No. 148,Accounting for
      Stock-Based Compensation — Transition and Disclosure. In accordance
      with APB 25, the Company recognized no compensation cost for options
      granted with an exercise price equal to or greater than the fair value of the
      underlying common stock on the date of grant.




On
      January 2, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment, or
      SFAS 123(R), using the prospective transition method. Under this method,
      the Company’s stock-based compensation costs recognized during 2006 were
      comprised of compensation costs for all share-based payment awards granted
      subsequent to January 1, 2006, based on their grant-date fair value
      estimated using the Black-Scholes model, in accordance with the provisions
      of
      SFAS 123(R). Accordingly, stock-based compensation expense recognized in
      the statement of operations for the years ended December 30, 2007 and
      December 31, 2006, is based on options ultimately expected to vest and thus
      includes an estimate for forfeitures.




The
      Company chose the straight-line method of allocating compensation cost over
      the
      requisite service period of the related award under SFAS 123(R). The
      Company calculated the expected term based on the provisions outlined in
      SFAS 123(R), which, for options granted in the years ended
      December 30, 2007 and December 31, 2006, resulted in an expected term of
      approximately four years. The Company based its estimate of expected volatility
      on the estimated volatility of similar entities whose share prices are publicly
      available.





For
      the
      years ended December 30, 2007 and December 31, 2006, the Company recorded
      non-cash stock-based compensation expense under SFAS 123(R) of $4.0 million
      and $640,000, respectively. In future periods, stock-based compensation expense
      is expected to increase as the Company amortizes expense related to previously
      issued stock-based compensation awards and issues additional equity-based awards
      to continue to attract and retain key employees. As of December 30, 2007,
      the Company’s total unrecognized compensation cost related to stock-based awards
      granted since January 2, 2006 to employees and non-employee directors was
      $19.9 million, which will be recognized over the weighted-average remaining
      requisite service period of 3.1 years. The Company recorded no tax benefit
      related to these options during the year ended December 30, 2007, since the
      Company currently maintains a full valuation allowance.




The
      Company accounts for stock-based compensation arrangements with non-employees
      in
      accordance with FASB Emerging Issues Task Force No. 96-18,Accounting for Equity Instruments
      That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
      Selling,Goods or
      Services, or EITF No. 96-18, using a fair value approach. For stock
      options granted to non-employees, the fair value of the stock options was
      estimated using the Black-Scholes option valuation model. This model utilizes
      the estimated fair value of the Company’s underlying common stock at the date of
      grant, the contractual term of the option, the expected volatility of the price
      of the Company’s common stock, risk-free interest rates and expected dividend
      yields of the Company’s common stock.





Other
      Comprehensive Income (Loss)




Other
      comprehensive income (loss) (“OCI”) includes charges or credits to equity that
      are not the result of transactions with stockholders. For the Company, this
      includes unrealized gains and losses on marketable securities and foreign
      currency translation adjustments. Amounts are reclassified from OCI into results
      of operations to the extent unrealized gains and losses become realized. During
      the years ended December 30, 2007 and December 31, 2006, realized gains of
      $0 and $14,000, respectively, were reclassified into earnings from OCI as
      marketable securities were sold prior to maturity with a fair value greater
      than
      their original cost. The Company
      has included components of comprehensive income (loss) within the consolidated
      statements of changes in mandatorily redeemable convertible preferred stock
      and
      stockholders’ equity (deficit) and comprehensive loss.





61
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            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Cumulative
      Effect of Change in Accounting Principle




On
      June 29, 2005, the FASB issued Staff Position No. 150-5,Issuer’s Accounting under FASB
      Statement No. 150 for Freestanding Warrants and Other Similar Instruments
      on Shares that are Redeemable, or FSP 150-5. FSP 150-5 affirms that
      warrants to purchase shares of the Company’s mandatorily redeemable convertible
      preferred stock are subject to the requirements in FSP 150-5 and requires the
      Company to classify these warrants as liabilities and revalue them to fair
      value
      at the end of each reporting period. The Company adopted FSP 150-5 and accounted
      for the cumulative effect of the change in accounting principle as of the
      beginning of the third quarter of 2005. The impact consisted of an $89,000
      cumulative charge as of July 4, 2005, when the Company adopted FSP 150-5,
      to increase the recorded value of the warrants to their fair value as of the
      date of adoption, and $52,000 of expense that was recorded in other income
      (expense), net to reflect the increase in fair value between July 4, 2005
      and January 1, 2006. For the year
      ended December 31, 2006, the Company recorded an $8.4 million charge
      reflecting the increase in fair value between January 2, 2006, and
      December 20, 2006, the date of the closing of the Company’s initial public
      offering and conversion of preferred stock to common stock.




The
      impact of the cumulative effect of change in accounting principle on net loss
      per common share was as follows:




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(1)(In
                thousands, except per share data)Net
                loss per common share, basic and diluted:Loss
                before cumulative effect of change in accounting principle
            
            $
            (0.44
            )
            
            $
            (3.09
            )
            
            $
            (3.93
            )Cumulative
                effect of change in accounting principle
            
            
            —
            
            
            
            —
            
            
            
            (0.02
            )Net
                loss per common share, basic and diluted
            
            $
            (0.44
            )
            
            $
            (3.09
            )
            
            $
            (3.95
            )Denominator
                for basic and diluted net loss per common share
            
            
            61,514
            
            
            
            8,423
            
            
            
            4,852




(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.




Recent
      Accounting Pronouncements




In
      September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, or
      SFAS 157. SFAS 157 defines fair value, establishes a framework for
      measuring fair value and expands disclosure of fair value measurements.
      SFAS 157 applies under other accounting pronouncements that require or
      permit fair value measurements and accordingly, does not require any new fair
      value measurements. SFAS 157 is effective for financial statements issued
      for fiscal years beginning after November 15, 2007. We do not expect its
      adoption will have a significant impact on our consolidated financial
      statements.





In
      February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
      Financial
      Assets and Financial Liabilities,or SFAS 159.
      SFAS 159
      permits companies to choose to measure many financial instruments and certain
      other items at fair value. SFAS 159 is effective for financial statements
      issued for fiscal years beginning after November 15, 2007. We do not expect
      the adoption of SFAS 159 will have a material impact on our consolidated
      financial statements.





In
      February 2008, the FASB issued FASB Staff Position (FSP) No. FAS 157-b, Fair Value Measurements, or
      FSP 157-b. FSP 157-b delays the effective date of SFAS 157 until
      January 1, 2009, for all nonfinancial assets and liabilities, except those
      recognized or disclosed at fair value in the financial statements on
      a recurring basis. Nonfinancial assets and liabilities include, among
      others: intangible assets acquired through business
      combinations; long-lived assets when assessing potential impairment; and
      liabilities associated with restructuring activities.





In
      December 2007, the FASB issued SFAS No. 141 (R), Business Combinations, or
      SFAS 141R and SFAS No. 160, Noncontrolling Interests
      in
      Consolidated Financial Statements,or SFAS
      160.  SFAS 141R requires an acquirer to measure the
      identifiable assets acquired, the liabilities assumed and any noncontrolling
      interest in the acquiree at their fair values on the acquisition date, with
      goodwill being the excess value over the net identifiable assets acquired.
      SFAS 160 clarifies that a noncontrolling interest in a subsidiary should be
      reported as equity in the consolidated financial statements. The calculation
      of
      earnings per share will continue to be based on income amounts attributable
      to
      the parent. SFAS 141R and SFAS 160 are effective for financial
      statements issued for fiscal years beginning after December 15, 2008. Early
      adoption is prohibited. We have not yet determined the effect on our
      consolidated financial statements, if any, of the adoption of SFAS
      141R or SFAS 160.





62
 Table
            of Contents





Isilon
      Systems, Inc.





NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS — (Continued)




2.  Initial
      Public Offering




On
      December 14, 2006, the Company’s registration statement on Form S-1
      was declared effective for its initial public offering, pursuant to which the
      Company sold 8,940,717 shares of common stock, including the underwriters’
over-allotment, at $13.00 per share. The offering closed on
      December 20, 2006, and, as a result, the Company received net proceeds of
      approximately $105.7 million (after underwriters’ discounts of
      $8.1 million and additional offering-related costs of approximately
      $2.4 million).




Simultaneous
      with its initial public offering, the Company’s shares of mandatorily redeemable
      convertible preferred stock were automatically converted into 43.5 million
      shares of common stock and 409,478 warrants to purchase mandatorily redeemable
      convertible preferred stock were converted into warrants to purchase common
      stock.




3.  Restatement
      of Consolidated Financial Statements




On
      February 29, 2008, the Company announced that its Board of Directors,
      based upon the recommendation of the Audit Committee, determined that the
      Company should restate its financial statements for the fiscal year ended
      December 31, 2006, and for the first and second quarters of fiscal 2007, ended
      April 1, 2007 and July 1, 2007, respectively, as a result of errors in those
      financial statements.  As announced on November 8, 2007, the
      Company's Audit Committee, assisted by independent forensic accountants and
      legal advisors, has been conducting an independent investigation of certain
      of the Company's sales to resellers and other customers to determine
      whether commitments were made that have an impact on the timing and treatment
      of
      revenue recognition, and whether the Company's internal controls
      relating to revenue recognition are sufficient.




Background
      of the Restatement




In
      late
      October 2007, as part of the Company's finance department’s efforts to monitor
      its outstanding accounts receivable, its recently appointed Chief Financial
      Officer identified concerns regarding the recognition of revenue for certain
      sales to resellers and other customers.  These concerns were promptly
      communicated to the Chairman of the Audit Committee.  After receiving
      additional information from its Chief Financial Officer, on November 4, 2007,
      the Audit Committee decided to conduct an independent investigation of the
      issues identified by management and the Board of Directors concurred in that
      decision.  The Audit Committee subsequently retained independent legal
      counsel, Heller Ehrman LLP,  and independent forensic accounting
      experts, Huron Consulting Group, to assist in the investigation.




The
          investigation focused on revenue recorded in fiscal 2006 and the first
          three
          quarters of fiscal 2007.  During the course of the investigation, the
          Audit Committee and its advisors collected and reviewed more
          than 80,000 pages of hard copy documents from individual custodians,
          department files and central files, and also collected and searched more
          than
          166 gigabytes of electronically stored information.  The Audit
          Committee and its advisors conducted more than 40 interviews of current
          and
          former employees and customers.  The information obtained through this
          investigation was analyzed in conjunction with accounts receivable aging
          reports, credit memos, return materials authorizations, evaluation agreements,
          sales return reserves, bad debt write-offs, and reserves for bad debts. 
From this and other information, specific transactions were identified
          and
          tested for compliance with the Company's revenue recognition
          policies.  Testing procedures included review of customer contracts,
          customer correspondence and emails, sales quotes, customer purchase orders,
          shipping documentation, invoices, and cash receipts.


63
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Audit
      Committee Findings and Recommendations




The
      Company's Audit Committee determined that in fiscal year 2006, specifically,
      in
      the fourth quarter, revenue was recognized prematurely on a certain
      transaction.  There was a single
      transaction with a reseller was identified for $1.1 million where a contingency
      related to the qualification of the product performing to certain specifications
      in the identified end user network existed at the time of sale. This
      qualification was not communicated to legal and finance personnel or the
      Company's independent registerd public accounting firm in order to
      facilitate a proper evaluation of the transaction for revenue recognition
      purposes. The reseller paid for only a portion of the original transaction
      and
      the Company has since negotiated a return for the remaining
      product.




Summary
      of the Restatement
      Adjustments





The
      following tables summarize the impact of the restatement on the Company’s
      financial statements for the year ended December 31, 2006. Selected information
      about the impact of the restatement on the Company’s unaudited quarterly
      periods is provided in Note 13 to our consolidated financial
      statements.







64
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
  The
          following tables set forth summary financial data as originally reported
          and as restated:


Year
                    EndedDecember
                    31, 2006As
                    previously
                  reported
                
                
                Adjustments
                
                
                As
                    restatedStatement
                    of Operations
                
                (in
                    thousands, except per share data)Total
                    revenue
                
                $
                62,279
                
                
                $
                (1,073
                )
                
                $
                61,206Total
                    cost of revenue
                
                
                29,331
                
                
                
                (523
                )
                
                
                28,808Total
                    operating expenses
                
                
                48,325
                
                
                
                —
                
                
                
                48,325Loss
                    from operations
                
                
                (15,377
                )
                
                
                (550
                )
                
                
                (15,927
                )Net
                    loss
                
                
                (25,438
                )
                
                
                (550
                )
                
                
                (25,988
                )Net
                    loss per common share, basic and diluted
                
                $
                (3.02
                )
                
                $
                (0.07
                )
                
                $
                (3.09
                )As
                    of December 31, 2006Balance
                    Sheet
                
                As
                    previously
                  reported
                
                
                Adjustments
                
                
                As
                    restatedTrade
                    receivables
                
                $
                24,388
                
                
                $
                (1,140
                )
                
                $
                23,248Inventories
                    (1)
                
                
                3,587
                
                
                
                538
                
                
                
                4,125Other
                    current assets
                
                
                1,939
                
                
                
                365
                
                
                
                2,304Total
                    assets
                
                
                136,971
                
                
                
                (237
                )
                
                
                136,734Accrued
                    liabilities
                
                
                2,869
                
                
                
                380
                
                
                
                3,249Deferred
                    revenue
                
                
                7,611
                
                
                
                (43
                )
                
                
                7,568Total
                    current liabilities
                
                
                20,720
                
                
                
                337
                
                
                
                21,057Deferred
                    revenue, net of current portion
                
                
                3,308
                
                
                
                (24
                )
                
                
                3,284Total
                    liabilities
                
                
                26,214
                
                
                
                313
                
                
                
                26,527Accumulated
                    deficit
                
                
                (75,108
                )
                
                
                (550
                )
                
                
                (75,658
                )Total
                    liabilities and stockholders' equity
                
                $
                136,971
                
                
                $
                (237
                )
                
                $
                136,734Year
                    EndedDecember
                    31, 2006Statement
                    of Cash Flows
                
                As
                    previously
                  reported
                
                
                Adjustments
                
                
                As
                    restatedNet
                    loss
                
                $
                (25,438
                )
                
                $
                (550
                )
                
                $
                (25,988
                )Accounts
                    receivable, net
                
                
                (16,526
                )
                
                
                1,140
                
                
                $
                (15,386
                )Inventories
                
                
                (1,022
                )
                
                
                (145
                )
                
                
                (1,167
                )Other
                    current assets
                
                
                (1,444
                )
                
                
                (365
                )
                
                
                (1,810
                )Accrued
                    liabilities, compensationpayable
                    and deferred rent
                
                
                1,754
                
                
                
                380
                
                
                
                2,134Deferred
                    revenue and customer deposits
                
                
                7,835
                
                
                
                (67
                )
                
                
                7,768Net
                    cash used in operating activities
                
                $
                (17,300
                )
                
                $
                —
                
                
                $
                (17,300
                )




(1)
            Adjustments
              to inventory include amounts for previously identified errors, primarily
              related to inventory-in-transit amounts, that management previously
              concluded were not material, but nonetheless have been corrected in
              the restated consolidated financial
              statements.





The
      Company's Audit Committee determined that no senior executives currently
      employed by the Company engaged in any improper practices or are otherwise
      responsible for improper revenue recognition.  The Audit Committee
      determined that no sales personnel currently employed by the Company directly
      participated in negotiating oral side arrangements or reciprocal sales
      transactions, though several sales personnel appear to have been aware of such
      transactions.  The Audit Committee found evidence that the Company's
      former Chief Executive Officer, former Chief Financial Officer and former Vice
      President of North America Sales participated directly in certain of the
      transactions for which adjustments are being recorded, but the Audit Committee
      concluded that the evidence about their roles, knowledge and intent is
      conflicting, disputed, and ultimately inconclusive.







65
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


4.  Net
      Loss Per Common Share





The
      Company applies the provisions of EITF Issue No. 03-6,Participating Securities
      and the
      Two — Class Method under FASB Statement 128, or EITF
      No. 03-6, which established standards regarding the computation of earnings
      per share by companies with participating securities or multiple classes of
      common stock. The Company’s Series A through E mandatorily redeemable
      convertible preferred stock were participating securities due to their
      participation rights related to cash dividends declared by the Company as
      described in Note 7.





EITF
      No. 03-6 requires net loss attributable to common stockholders for the
      period to be allocated to common stock and participating securities to the
      extent that the securities are required to share in the losses. The Company’s
      Series A through E mandatorily redeemable convertible preferred stock did
      not have a contractual obligation to share in losses of the Company. As a
      result, basic net loss per share is calculated by dividing net loss by the
      weighted average shares of common stock outstanding during the period that
      are
      not subject to vesting provisions.





Basic
      and
      diluted net loss per common share was the same for all periods presented as
      the
      impact of all potentially dilutive securities outstanding was anti-dilutive.
      The
      following table presents the potentially dilutive securities outstanding that
      were excluded from the computation of diluted net loss per common share for
      the
      periods presented because their inclusion would have had an anti-dilutive
      effect:




As
                ofDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Options
                to purchase common stock
            
            
            8,366,297
            
            
            
            6,753,969
            
            
            
            4,766,233Common
                stock subject to vesting provisions
            
            
            187,952
            
            
            
            921,292
            
            
            
            1,480,710Mandatorily
                redeemable convertible preferred stock
            
            
            —
            
            
            
            —
            
            
            
            41,788,922Warrants
                to purchase mandatorily redeemable convertible preferred
                stock
            
            
            —
            
            
            
            —
            
            
            
            214,492Warrants
                to purchase common stock
            
            
            129,992
            
            
            
            129,992
            
            
            
            —8,684,241
            
            
            
            7,805,253
            
            
            
            48,250,357




5.  Inventories





The
      Company outsources the manufacturing of its products to a contract manufacturer
      that assembles each product to the Company’s specifications. As protection
      against component shortages and to provide replacement parts for its service
      teams, the Company also stocks limited supplies of certain key product
      components. The Company reduces inventory to its estimated net realizable value
      by reserving for excess and obsolete inventories determined primarily based
      on
      historical usage, forecasted demand and evaluation unit conversion rate and
      age.
      Inventories have been reduced by $934,000 and $1.1 million as of
      December 30, 2007, December 31, 2006, respectively.






66
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
  Inventories
          consisted of the following:


As
                ofDecember 30,
            
            
            December 31,2007
            
            
            2006Restated(1)(In
                thousands)Components
            
            $
            154
            
            
            $
            —Finished
                goods
            
            
            5,989
            
            
            
            2,595Evaluation
                units
            
            
            3,287
            
            
            
            1,530$
            9,430
            
            
            $
            4,125




(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.








6.  Property
      and Equipment




Property
      and equipment, net, consisted of the following:




As
                  ofDecember 30,
              
              
              December 31,2007
              
              
              2006(In
                  thousands)Software
                  and computer equipment
              
              $
              12,820
              
              
              $
              8,569Furniture,
                  office equipment and other
              
              
              6,356
              
              
              
              3,581Leasehold
                  improvements
              
              
              5,040
              
              
              
              3,30824,216
              
              
              
              15,458Less:
                  accumulated depreciation and amortization
              
              
              (13,645
              )
              
              
              (8,300
              )$
              10,571
              
              
              $
              7,158




Depreciation
      and amortization expense was $5.3 million, $4.2 million, and
      $2.6 million for the years ended December 30, 2007, December 31, 2006,
      and January 1, 2006, respectively.




7.  Notes Payable





In
      June
      2006, the Company and Silicon Valley Bank agreed to increase the maximum
      borrowing capacity under its revolving line of credit to $8.5 million
      through July 9, 2006. In July 2006, concurrent with the issuance of the
      Series E convertible preferred stock issued in July 2006, the Company
      repaid its outstanding borrowings of $1.7 million under the equipment line
      of credit with Silicon Valley Bank. In connection with repayment of these
      borrowings, the Company wrote off as interest expense the remaining $49,000
      of
      related deferred financing costs.





Additionally,
      in July 2006, the Company entered into an amended and restated loan and security
      agreement with Silicon Valley Bank, which increased the borrowing capacity
      on
      the revolving working capital line of credit to $11.0 million. The
      amendment increased the limit of eligible accounts receivable from 80% to 85%
      and provided to the Company the ability to extend the maturity date of the
      revolving line of credit from January 2007 to January 2008 at its sole
      discretion upon the payment of a $41,000 fee. In December 2006, concurrent
      with
      the Company’s initial public offering, the Company repaid its outstanding
      borrowings of $6.3 million under the revolving working capital line of
      credit with Silicon Valley Bank. In connection with the repayment of these
      borrowings, the Company wrote off as interest expense the remaining $11,000
      of
      related deferred financing costs.





As
      of
      both December 30, 2007 and December 31, 2006, there was $0 outstanding
      under the revolving line of credit and the equipment line of
      credit.




In
      March
      2006, the Company entered into a loan and security agreement with Horizon
      Technology Funding Company LLC to provide $6.0 million of subordinated debt
      financing, collateralized by all assets of the Company. The loan had a stated
      interest rate of 11.78%. This loan was subordinate to the Company’s existing
      working capital and equipment loan facilities. Interest only payments on the
      loan were due monthly, in arrears, until December 31, 2006, followed by
      thirty equal payments of principal and interest due monthly, in arrears. As
      discussed in Note 8, the Company issued warrants to purchase
      194,986 shares of its Series D convertible preferred stock to the
      lender in connection with the financing. In December 2006, subsequent to the
      initial public offering, the Company repaid the loan in full. In connection
      with
      the repayment of this loan, the Company wrote off the remaining $369,000 of
      the
      related debt discount described in Note 8 and paid an early termination fee
      of $180,000, which are included in interest expense.







67
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


8.  Mandatorily
      Redeemable Convertible Preferred Stock and Stockholders’ Equity




A
      1-for-2.4 reverse stock split of the Company’s common stock occurred on
      December 12, 2006. All references to shares in the consolidated financial
      statements and the accompanying notes, including but not limited to the number
      of shares and per share amounts, unless otherwise noted, have been adjusted
      to
      reflect the reverse stock split retroactively. Previously awarded options and
      warrants to purchase shares of the Company’s common stock and convertible
      preferred stock have been also retroactively adjusted to reflect the reverse
      stock split.





Mandatorily
      Redeemable Convertible Preferred Stock




As
      of
      December 30, 2007 and December 31, 2006, the Company was authorized to
      issue 10,000,000 shares of preferred stock and had no shares
      outstanding.





Upon
      the closing of the Company’s
      initial public offering on December 20, 2006, all previously issued and
      outstanding shares of convertible preferred stock automatically converted into
      one share of the Company’s common stock.





Warrants




The
      Company’s common stock warrants consisted of the following:




Number
                of SharesSubject
                to WarrantsExercise
            
            Expiration
            
            December 30,
            
            
            December 31,Issue
                Date
            
            Price
            
            Date
            
            2007
            
            
            2006Warrants
                to purchase common stock
            March
                2006
            
            
            2.3078
            
            March 2016
            
            
            129,992
            
            
            
            129,992129,992
            
            
            
            129,992




In
      March
      2006, in connection with the subordinated debt agreement discussed in
      Note 7, the Company issued to the lender warrants to purchase
      194,986 shares of the Company’s Series D convertible preferred stock.
      These warrants had an exercise price of $2.30784 per share, expire in March
      2016 and had an estimated fair value of $593,000 as determined using the
      Black-Scholes option pricing model at the date of issuance. The Company
      allocated $540,000 of the proceeds received from the issuance of the
      subordinated debt to these warrants based on the relative fair values of the
      debt and the warrants. This amount was recorded as a discount on the carrying
      value of the subordinated debt and was a component of the Company’s preferred
      stock warrant liability. During 2006, this debt discount was fully amortized
      to
      interest expense upon repayment of the related debt.





The
      warrants to purchase previously outstanding convertible preferred stock
      converted into warrants to purchase anaggregate of
      409,478 shares of common stock upon the closing of the Company’s initial
      public offering on December 20, 2006. Of the total warrants to purchase
      common stock, 279,486 were exercised on December 20, 2006 in conjunction
      with the closing of the initial public offering.





Stock
      Options and Unvested Common Stock




The
      Company adopted the 2006 Equity Incentive Plan (the “2006 Plan”) in the fourth
      quarter of 2006, which provides for the grant of various equity awards. In
      conjunction with the Company’s initial public offering in December 2006, the
      shares that were available for grant under the Amended and Restated 2001 Stock
      Plan (the “2001 Plan”) became available for grant under the 2006 Plan. As of
      December 30, 2007, the Company’s 2006 Plan has a total of
      6,138,475 shares of the Company’s common stock available for issuance to
      employees, officers, consultants and advisors of the Company. Generally, awards
      granted under the Plan vest four years from the date of grant and expire ten
      years from the date of grant.




The
      Company adopted an Employee Stock Purchase Plan (the “2006 ESPP Plan”) in the
      fourth quarter of 2006. A total of 750,000 shares of the Company’s common
      stock have been reserved for sale under the 2006 ESPP Plan, of which 703,962
      shares remain for issuance as of December 30, 2007. Under the 2006 ESPP Plan,
      employees may purchase shares of common stock through payroll deductions at
      a
      price per share that is 85% of the fair market value of the Company’s common
      stock on the applicable purchase date. During 2007, the Company issued 46,038
      shares under the 2006 ESPP Plan and recorded $64,000 of related stock-based
      compensation expense.




The
      Company accounts for cash received in consideration for the purchase of unvested
      shares of common stock or the early-exercise of unvested stock options as a
      current liability, included as a component of accrued liabilities in the
      Company’s consolidated balance sheets. As of December 30, 2007 and
      December 31, 2006, there were 187,952 and 921,292 unvested shares,
      respectively, of the Company’s common stock outstanding and $189,000 and
      $506,000, respectively, of related recorded liability.





68
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Detail
      related to activity of unvested shares of common stock is as
      follows:




Number
                of
            
            
            Weighted-AverageUnvested
                Shares
            
            
            Exercise/PurchaseOutstanding
            
            
            PriceBalance
                as of January 2, 2005
            
            
            1,830,848
            
            
            $
            0.14Issued
            
            
            462,498
            
            
            $
            0.31Vested
            
            
            (812,636
            )
            
            $
            0.15Balance
                as of January 1, 2006
            
            
            1,480,710
            
            
            $
            0.19Issued
            
            
            333,332
            
            
            $
            1.16Vested
            
            
            (836,105
            )
            
            $
            0.18Forfeited
            
            
            (56,645
            )
            
            $
            0.22Balance
                as of December 31, 2006
            
            
            921,292
            
            
            $
            0.55Issued
            
            
            —
            
            
            $
            —Vested
            
            
            (552,345
            )
            
            $
            0.43Forfeited
            
            
            (180,995
            )
            
            $
            0.56Balance
                as of December 30, 2007
            
            
            187,952
            
            
            $
            1.00




Detail
      related to stock option activity is as follows:




Weighted-Number
                of
            
            
            AverageShares
            
            
            ExerciseOutstanding
            
            
            PriceBalance
                as of January 2, 2005
            
            
            3,549,919
            
            
            $
            0.20Options
                granted
            
            
            2,172,444
            
            
            $
            0.31Options
                exercised
            
            
            (732,394
            )
            
            $
            0.25Options
                forfeited
            
            
            (223,736
            )
            
            $
            0.23Balance
                as of January 1, 2006
            
            
            4,766,233
            
            
            $
            0.24Options
                granted
            
            
            4,370,390
            
            
            $
            2.73Options
                exercised
            
            
            (1,987,730
            )
            
            $
            0.36Options
                forfeited
            
            
            (394,924
            )
            
            $
            1.05Balance
                as of December 31, 2006
            
            
            6,753,969
            
            
            $
            1.77Options
                granted
            
            
            5,030,876
            
            
            $
            10.65Options
                exercised
            
            
            (1,534,272
            )
            
            $
            0.51Options
                forfeited
            
            
            (1,884,276
            )
            
            $
            6.65Balance
                as of December 30, 2007
            
            
            8,366,297
            
            
            $
            6.24




The
      total
      intrinsic value for options exercised in the years ended December 30, 2007
      and December 31, 2006, was $13.6 million and $6.8 million, respectively,
      representing the difference between the estimated fair values of the Company’s
      common stock underlying these options at the dates of exercise and the exercise
      prices paid. During the years ended December 30, 2007 and December 31,
      2006, the total fair value of options vested was $1.8 million and $23,000,
      respectively.




The
      following table summarizes information about all stock options
      outstanding:




As
                of December 30, 2007Weighted-Shares
            
            
            Average
            
            
            Weighted-Subject
            
            
            Remaining
            
            
            Average
            
            
            TotalExercise
            
            to
                Options
            
            
            Contractual
            
            
            Exercise
            
            
            IntrinsicPrices
            
            Outstanding
            
            
            Life
                (in Years)
            
            
            Price
            
            
            Value(1)(Dollars
                in thousands, except per share data)$ 0.12 - 0.46
            
            
            1,531,197
            
            
            
            7.0
            
            
            $
            0.250.82 - 3.70
            
            
            1,814,076
            
            
            
            8.3
            
            
            
            1.135.18 - 5.75
            
            
            1,710,577
            
            
            
            9.9
            
            
            
            5.276.12 - 12.21
            
            
            1,869,929
            
            
            
            9.2
            
            
            
            10.2013.00
                - 25.79
            
            
            1,440,518
            
            
            
            9.3
            
            
            
            15.08$ 0.12 - 25.79
            
            
            8,366,297
            
            
            
            8.8
            
            
            
            6.24
            
            
            $
            (10,411
            )Exercisable
            
            
            1,916,838
            
            
            
            6.5
            
            
            
            1.55
            
            
            $
            6,612Vested
                and expected to vest
            
            
            8,038,292
            
            
            
            8.7
            
            
            
            6.03
            
            
            $
            (8,298
            )




(1)
            The
                total intrinsic value represents the difference between the aggregate
                estimated fair value of the Company’s common stock issuable and the
                aggregate exercise price payable.




69
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


The
      fair
      value of each employee option grant for the years ended December 30, 2007
      and December 31, 2006 under SFAS 123(R) was estimated on the date of grant
      using the Black-Scholes option pricing model with the following
      assumptions:





Year
                EndedDecember
                30,
              2007
            December
                31,
              2006Risk-free
                interest rate
            3.4%
                - 5.1%
            4.5%
                - 5.1%Expected
                life
            4 years
            4 yearsDividend
                yield
            None
            NoneVolatility
            39
                - 44%
            47
                - 59%




The
      Company determined that it is not practicable to calculate the volatility of
      its
      share price since the Company’s securities have been publicly traded for a
      limited period of time; it has limited information on its own past volatility;
      and the Company is a high-growth technology company whose future operating
      results are not comparable to its prior operating results. Therefore, the
      Company estimates its expected volatility based on reported market value data
      for a group of publicly traded companies, which it selected from certain market
      indices that the Company believes would be indicators of its future stock price
      volatility, after consideration of their size, stage of lifecycle,
      profitability, growth, and risk and return on investment. The Company uses
      the
      average expected volatility rates reported by the comparable group for an
      expected term that approximated the expected term estimated by the
      Company.





The
      estimated weighted-average grant date fair value, based on the minimum value
      method, of options granted during the year ended January 1, 2006, all of
      which were granted with exercise prices equal to the estimated per share fair
      value of the Company’s common stock at the date of grant, was $0.03. The
      estimated weighted-average grant date fair value of options granted during
      the
      year ended December 31, 2006, with exercise prices less than the estimated
      per share fair value of the Company’s common stock at the date of grant, was
      $1.19. The estimated weighted-average grant date fair value of options granted
      during the year ended December 31, 2006, with exercise prices that equaled
      the estimated per share fair value of the Company’s common stock at the date of
      grant, was $5.66.  The estimated weighted-average grant date fair
      value of options granted during the year ended December 30, 2007, with
      exercise prices that equaled the estimated per share fair value of the Company’s
      common stock at the date of grant, was $4.07.




9.  Income
      Taxes




The
      domestic and foreign components of income (loss) before income tax expense
      and
      cumulative effect of change in accounting principle were as
      follows:






(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.




Year
                  EndedDecember 30,
              
              
              December 31,
              
              
              January 1,2007
              
              
              2006
              
              
              2006Restated(1)(In
                  thousands)Domestic
              
              $
              (27,029
              )
              
              $
              (26,127
              )
              
              $
              (19,096
              )Foreign
              
              
              318
              
              
              
              248
              
              
              
              —$
              (26,711
              )
              
              $
              (25,879
              )
              
              $
              (19,096
              )


Income
      tax expense consists of the following:




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(1)(In
                thousands)Domestic —
                current and deferred
            
            $
            —
            
            
            $
            —
            
            
            $
            —Foreign —
                current and deferred
            
            
            221
            
            
            
            109
            
            
            
            —Total
                income tax expense
            
            $
            221
            
            
            $
            109
            
            
            $
            —




70
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


The
      Company’s effective tax rate differs from the U.S. federal statutory rate
      as follows:




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(1)Income
                tax at statutory rate
            
            
            34.0
            %
            
            
            34.0
            %
            
            
            34.0
            %State
                taxes, net of federal benefit
            
            
            3.5
            
            
            
            2.1
            
            
            
            2.4Warrant
                revaluation expense
            
            
            —
            
            
            
            (11.1
            )
            
            
            —Permanent
              difference
            
            
            (0.2
            )
            
            
            —
            
            
            
            —Other
            
            
            (0.7
            )
            
            
            —
            
            
            
            (0.1
            )Change
                in valuation allowance
            
            
            (37.4
            )
            
            
            (25.4
            )
            
            
            (36.3
            )Total
            
            
            (0.8
            )%
            
            
            (0.4
            )%
            
            
            —
            %




The
      tax
      effects of the temporary differences that give rise to deferred tax assets
      and
      liabilities are as follows:




As
                ofDecember 30,
            
            December 31,2007
            
            2006Restated(1)(In
                thousands)Deferred
                tax assets, current:Inventories
            
            $
            520
            
            $
            350Accrued
                vacation
            
            
            416
            
            
            —Deferred
                revenue
            
            
            991
            
            
            211Deferred
                rent
            
            
            —
            
            
            127Other
            
            
            658
            
            
            655Total
                gross deferred taxes, current
            
            
            2,585
            
            
            1,343Deferred
                tax assets, non-current:Net
                operating loss carryforwards
            
            
            21,366
            
            
            12,773Capitalized
                research and development
            
            
            6,012
            
            
            6,823Deferred
                revenue
            
            
            1,204
            
            
            1,268Stock-based
                compensation
            
            
            1,130
            
            
            —Deferred
                rent
            
            
            88
            
            
            790Property
                and equipment
            
            
            1,481
            
            
            936Total
                gross deferred taxes, non-current
            
            
            31,281
            
            
            22,590Gross
                deferred tax assets
            
            
            33,866
            
            
            23,933Less:
                valuation allowance
            
            
            (33,866
            )
            
            (23,933
            )Net
                deferred tax assets
            
            $
            —
            
            $
            —




As
      of
      December 30, 2007, the Company had total net operation loss carryforwards for
      federal and state income tax purposes of $73.7 million.  Realization
      of deferred tax assets is dependent upon future earnings, if any, the timing
      and
      amount of which are uncertain. Accordingly, the Company’s gross deferred tax
      assets have been fully offset by a valuation allowance. If not utilized, these
      net operating loss carryforwards will expire for federal purposes between 2021
      and 2026. Utilization of these net operating loss carryforwards is subject
      to an
      annual limitation due to provisions of the Internal Revenue Code of 1986, as
      amended. Events that cause limitations in the amount of net operating losses
      that the Company may utilize in any one year include, but are not limited to,
      a
      cumulative ownership change of more than 50%, as defined, over a three-year
      period.





The
      Company adopted the provisions of FASB Interpretation No. 48, Accounting for
      Uncertainty in Income Taxes, on January 1, 2007.  The Company did not have
      any unrecognized tax benefits which would require an adjustment to the January
      1, 2007 beginning balance of accumulated deficit.  The Company did not have
      any unrecognized tax benefits at January 1, 2007 or at December 30,
      2007.




The
      Company elected to include interest on tax positions as a component of interest
      expense and
      penalties as a component ofincome
      tax
      expense.During the years ended December 30, 2007 and December
      31, 2006 the Company recognized no interest and penalties.





71
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


The
      Company files income tax returns in the U.S. federal jurisdiction and various
      states.  The tax years 2004-2006 remain open to examination by major taxing
      jurisdictions to which the Company is subject.




10.  401(k)
      Savings Plan




The
      Company has established a defined contribution savings plan under
      Section 401(k) of the Internal Revenue Code. This plan covers substantially
      all domestic employees who meet minimum age and service requirements and allows
      participants to defer a portion of their annual compensation on a pre-tax basis.
      Company contributions to the plan may be made at the discretion of the board
      of
      directors. Through December 30, 2007, the Company had not made
      contributions to the plan.




11.  Segment
      Information




SFAS No. 131,Disclosures About Segments of an
      Enterprise and Related Information, establishes standards for reporting
      information about operating segments. Operating segments are defined as
      components of an enterprise for which separate financial information is
      available and evaluated regularly by the chief operating decision-maker, or
      decision-making group, in deciding how to allocate resources and in assessing
      performance. The Company is organized as, and operates in, one reportable
      segment: the development and sale of cluster storage solutions to data-intensive
      industries such as media and entertainment, Internet, cable and
      telecommunications, oil and gas, life sciences, manufacturing and to the
      federal government. The Company’s chief operating decision- maker
      is
      its Chief Executive Officer. The Company’s Chief Executive Officer reviews
      financial information presented on a consolidated basis, accompanied by
      information about revenue by geographic region, for purposes of evaluating
      financial performance and allocating resources. The Company and its Chief
      Executive Officer evaluate performance based primarily on revenue in the
      geographic locations in which the Company operates. Revenue is attributed by
      geographic location based on the location of the end customer. The Company’s
      assets are primarily located in the United States of America and not allocated
      to any specific region. Therefore, geographic information is presented only
      for
      total revenue.





The
      following presents total revenue by geographic region:




Year
                EndedDecember 30,
            
            
            December 31,
            
            
            January 1,2007
            
            
            2006
            
            
            2006Restated(1)(In
                thousands)United
                States of America
            
            $
            64,936
            
            
            $
            46,465
            
            
            $
            17,559Asia
            
            
            12,493
            
            
            
            8,137
            
            
            
            2,507EMEA
            
            
            10,682
            
            
            
            4,172
            
            
            
            408Other
            
            
            887
            
            
            
            2,432
            
            
            
            609Total
            
            $
            88,998
            
            
            $
            61,206
            
            
            $
            21,083




(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.




12.  Commitments
      and Contingencies




Leases




The
      Company leases its facilities under non-cancelable operating leases, which
      contain renewal options and escalation clauses and expire through June
      2014.




Minimum
      commitments under non-cancelable operating lease agreements as of
      December 30, 2007 were as follows (in thousands):




Fiscal
                2008
            
            $
            3,197Fiscal
                2009
            
            
            2,544Fiscal
                2010
            
            
            2,560Fiscal
                2011
            
            
            2,678Fiscal
                2012
            
            
            2,820Thereafter
            
            
            4,309$
            18,108




Rent
      expense incurred under operating leases was $2.9 million, $1.7 million, and
      $673,000 during the years ended December 30, 2007, December 31, 2006, and
      January 1, 2006, respectively.







72
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
  Purchase
        Commitments
  The
        Company maintains, with its contract manufacturer, a rolling 90-day firm
        order for products it manufactures for the Company, and these orders may
        only be
        rescheduled or cancelled by its contract manufacturer under certain limited
        conditions and, even then, with certain restrictions and penalties up to
        the
        full cost of the product. The remaining amount on the open purchase order
        with
        its contract manufacturer at December 30, 2007, was
        $10.4 million.
  Legal
  On
        November 1, 2007, a putative class action complaint was filed in the U.S.
        District Court for the Western District of Washington against the Company
        and
        certain of its current and former directors and officers. The complaint asserts
        claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934,
        as
        amended, and Rule 10b-5 promulgated there under, as well as under Sections
        11
        and 15 of the Securities Act of 1933. Substantially similar complaints were
        filed in the same court on December 12, 2007 and December 17, 2007. These
        cases,
        which were subsequently consolidated, purport to be brought on behalf of
        a class
        of purchasers and acquirers of the Company's stock during the period December
        16, 2006 to October 3, 2007. Plaintiffs allege that the defendants violated
        the
        federal securities laws during this period of time by, among other things,
        issuing a false and misleading registration statement and prospectus in
        connection with the Company's December 16, 2006 initial public offering,
        and by
        thereafter publicly misrepresenting the Company's current and prospective
        business and financial results. Plaintiffs claim that, as a result of these
        alleged wrongs, the Company's stock price was artificially inflated during
        the
        purported class period. Plaintiffs are seeking unspecified compensatory damages,
        interest, an award of attorneys' fees and costs, and injunctive
        relief.  Plaintiffs have until April 18, 2008 to file a consolidated
        amended complaint.


In
        addition, on March 18, 2008, a shareholder derivative action was filed in
        the
        Superior Court of the State of Washington (King County), allegedly on behalf
        of
        and for the benefit of the Company, against certain of the Company’s current and
        former directors and officers.  The Company was named as a nominal
        defendant.  The derivative complaint alleges that the individual defendants
        breached fiduciary duties owed to the Company by publicly misrepresenting
        Isilon’s business prospects, and by failing to properly account for certain
        revenues earned in the Company’s fiscal year ended December 31, 2006, and first
        and second quarters in fiscal 2007.  A substantially similar complaint was
        filed in the same court on March 24, 2008.  The revenues referenced in the
        complaints were the subject of the Company’s February 29, 2008 announcement that
        it would restate its financial statements for those periods.  The complaint
        seeks unspecified damages and equitable relief, disgorgement of compensation,
        attorneys’ fees, costs, and expenses.  Because the complaints are
        derivative in nature they do not seek monetary damages from the Company. 
However, the Company may be required throughout the course of the action
        to
        advance the legal fees and costs incurred by the individual
        defendants.
  We
        are
        unable to predict the outcome of these cases. A court determination against
        us
        could result in significant liability and could have a material adverse effect
        on our consolidated financial position, results of operations or cash
        flows.
  The
        Company has also provided information on a voluntary
        basis to the Enforcement Division of the Securities and Exchange Commission
        concerning the Audit Committee's independent review and the Company's financial
        restatement.




73
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


13.  Quarterly
      Results of Operations (unaudited)




Following
      is a summary of unaudited quarterly financial information for fiscal years
      2007
      and 2006.  This selected quarterly information has been restated for
      the fourth quarter of 2006 from previously reported information included in
      the  Form 10-K for the year ended December 31, 2006 and for the
      first and second quarters of 2007 from previously reported information filed
      on
      Form 10-Q.  The adjustments for the fourth quarter of 2006 are as a
      result of the restatement of our financial results discussed in Note 3 to the
      consolidated financial statements. The Audit Committee investigation described
      in Note 3 also indentified the following errors related to the first and second
      quarters of 2007:




·
              In
                  the first quarter of 2007, the Company recognized revenue in a
                  transaction with a customer that included a commitment from the
                  Company to
                  acquire software from the customer. Based upon facts discovered
                  during the
                  investigation, the Company has now concluded that the end user
                  did not
                  have the ability or intent to pay and revenue recognition was
                  inconsistent with the accounting rules applicable to reciprocal sales
                  transactions.
  ·
              In
                  the first and second quarters of fiscal 2007, transactions with
                  resellers were identified where the timing of revenue recognition
                  was
                  improper. In certain instances, revenue was recognized when persuasive
                  evidence of an end-user did not exist, when oral arrangements existed
                  that
                  would have precluded revenue recognition, or when resellers did
                  not have
                  the ability or intent to pay independent of payment by the end-user
                  customer. Revenue from these transactions was adjusted and will
                  only be
                  recognized upon sell-through of the product to end-users and when
                  collection is reasonably assured and all other criteria for the
                  recognition of revenue are met.
  ·
              The
                  Company originally recognized revenue in the second quarter of 2007
                  on a sale directly to an end-user customer for which the terms
                  and
                  conditions were not fixed or determinable. This revenue has now
                  been
                  recognized in the fourth quarter of 2007 when the terms became
                  fixed or
                  determinable and all other criteria for the recognition of revenue
                  were
                  met.


Condensed
                Consolidated Statement of OperationsQ1
            
            
            Q2
            
            
            Q3
            
            
            Q4Restated
            
            
            Restated(In
                thousands, except per share data)Year
                ended December 30, 2007Total
                revenue
            
            $
            17,846
            
            
            $
            22,911
            
            
            $
            21,643
            
            
            $
            26,598Gross
                profit
            
            
            8,578
            
            
            
            11,603
            
            
            
            12,060
            
            
            
            14,021Total
                operating expenses
            
            
            16,559
            
            
            
            17,756
            
            
            
            20,343
            
            
            
            22,785Loss
                from operations
            
            
            (7,981
            )
            
            
            (6,153
            )
            
            
            (8,283
            )
            
            
            (8,764
            )Net
                loss
            
            
            (6,856
            )
            
            
            (5,022
            )
            
            
            (7,183
            )
            
            
            (7,871
            )Net
                loss per common share, basic and diluted
            
            $
            (0.11
            )
            
            $
            (0.08
            )
            
            $
            (0.12
            )
            
            $
            (0.13
            )Shares
                used in computing basic and diluted net loss per common
                share
            
            
            60,733
            
            
            
            61,148
            
            
            
            61,771
            
            
            
            62,404Q1
            
            
            Q2
            
            
            Q3
            
            
            Q4RestatedYear
                ended December 31, 2006Total
                revenue
            
            $
            10,423
            
            
            $
            13,414
            
            
            $
            17,786
            
            
            $
            19,583Gross
                profit
            
            
            5,397
            
            
            
            7,019
            
            
            
            9,344
            
            
            
            10,638Total
                operating expenses
            
            
            9,669
            
            
            
            11,356
            
            
            
            13,224
            
            
            
            14,076Loss
                from operations
            
            
            (4,272
            )
            
            
            (4,337
            )
            
            
            (3,880
            )
            
            
            (3,438
            )Net
                loss
            
            
            (4,518
            )
            
            
            (5,497
            )
            
            
            (5,014
            )
            
            
            (10,959
            )Net
                loss per common share, basic and diluted
            
            $
            (0.79
            )
            
            $
            (0.89
            )
            
            $
            (0.70
            )
            
            $
            (0.75
            )Shares
                used in computing basic and diluted net loss per common
                share
            
            
            5,709
            
            
            
            6,177
            
            
            
            7,172
            
            
            
            14,550




74
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)


Condensed
                Consolidated Balance Sheets2007Q1
            
            
            Q2
            
            
            Q3
            
            
            Q4Restated
            
            
            Restated(In
                thousands, except per share data)Cash,
                cash equivalents(1) and marketable
                securities
            
            $
            99,438
            
            
            $
            94,507
            
            
            $
            92,087
            
            
            $
            85,861Trade
                receivables, net
            
            
            19,911
            
            
            
            22,705
            
            
            
            18,604
            
            
            
            20,152Total
                current assets
            
            
            128,318
            
            
            
            128,082
            
            
            
            123,871
            
            
            
            120,967Total
                assets
            
            
            137,614
            
            
            
            138,340
            
            
            
            134,399
            
            
            
            131,538Accounts
                payable, and accrued liabilities,compensation
                and related benefits
            
            
            18,751
            
            
            
            21,183
            
            
            
            19,865
            
            
            
            21,324Deferred
                revenue
            
            
            7,840
            
            
            
            8,661
            
            
            
            11,124
            
            
            
            12,392Total
                current liabilities
            
            
            26,591
            
            
            
            29,844
            
            
            
            30,989
            
            
            
            33,716Deferred
                revenue, net of current portion
            
            
            3,864
            
            
            
            4,986
            
            
            
            5,213
            
            
            
            5,819Total
                liabilities
            
            
            33,786
            
            
            
            38,323
            
            
            
            39,656
            
            
            
            42,949Additional
                paid-in capital
            
            
            186,419
            
            
            
            187,689
            
            
            
            189,590
            
            
            
            191,254Accumulated
                deficit
            
            
            (82,514
            )
            
            
            (87,536
            )
            
            
            (94,719
            )
            
            
            (102,590
            )Total
                stockholders' equity
            
            
            103,828
            
            
            
            100,017
            
            
            
            94,743
            
            
            
            88,589Total
                liabilities and stockholders' equity
            
            
            137,614
            
            
            
            138,340
            
            
            
            134,399
            
            
            
            131,538




(1)
              The
                adjustments for the first and second quarters of fiscal 2007 did
                not have
                a significant impact on the classification of cash flows from operating
                activities for the three months ended April 1, 2007, and six months
                ended,
                July 1, 2007.


The
      following tables set for summary restated financial data as originally reported
      and as restated:




Three Months EndedDecember 31, 2006As previously
                reported
              
              
              Adjustments
              
              
              As restatedStatement
                  of Operations
              
              (in
                  thousands, except per share data)Total
                  revenue
              
              $
              20,656
              
              
              $
              (1,073
              )
              
              $
              19,583Total
                  cost of revenue
              
              
              9,468
              
              
              
              (523
              )
              
              
              8,945Total
                  operating expenses
              
              
              14,076
              
              
              
              —
              
              
              
              14,076Loss
                  from operations
              
              
              (2,888
              )
              
              
              (550
              )
              
              
              (3,438
              )Net
                  loss
              
              
              (10,409
              )
              
              
              (550
              )
              
              
              (10,959
              )Net
                  loss per common share, basic and diluted
              
              $
              (0.72
              )
              
              $
              (0.03
              )
              
              $
              (0.75
              )




75
 Table
            of Contents


Isilon
        Systems, Inc.
  NOTES TO
        CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
  Three Months Ended
                
                
                Three Months EndedApril 1, 2007
                
                
                July 1, 2007As previously
                  reported
                
                
                Adjustments
                
                
                As restated
                
                
                As previously
                  reported
                
                
                Adjustments
                
                
                As restatedStatement
                    of Operations
                
                (in
                    thousands, except per share data)
                
                
                (in
                  thousands, except per share data)Total
                    revenue
                
                $
                21,607
                
                
                $
                (3,761
                )
                
                $
                17,846
                
                
                $
                25,116
                
                
                $
                (2,205
                )
                
                $
                22,911Total
                    cost of revenue
                
                
                9,837
                
                
                
                (569
                )
                
                
                9,268
                
                
                
                11,999
                
                
                
                (691
                )
                
                
                11,308Total
                    operating expenses
                
                
                16,645
                
                
                
                (86
                )
                
                
                16,559
                
                
                
                17,869
                
                
                
                (113
                )
                
                
                17,756Loss
                    from operations
                
                
                (4,875
                )
                
                
                (3,106
                )
                
                
                (7,981
                )
                
                
                (4,752
                )
                
                
                (1,401
                )
                
                
                (6,153
                )Net
                    loss
                
                
                (3,750
                )
                
                
                (3,106
                )
                
                
                (6,856
                )
                
                
                (3,621
                )
                
                
                (1,401
                )
                
                
                (5,022
                )Net
                    loss per common share, basic and diluted
                
                $
                (0.06
                )
                
                $
                (0.05
                )
                
                $
                (0.11
                )
                
                $
                (0.06
                )
                
                $
                (0.02
                )
                
                $
                (0.08
                )
  
 As
                    of April 1, 2007
                
                
                As
                    of July 1, 2007As
                    previously
                  reported
                
                
                Adjustments
                
                
                As
                    restated
                
                
                As
                    previously
                  reported
                
                
                Adjustments
                
                
                As
                    restatedBalance
                  Sheet
                
                (in
                    thousands, except per share data)
                
                
                (in
                    thousands, except per share data)Trade
                    receivables
                
                $
                25,207
                
                
                $
                (5,296
                )
                
                $
                19,911
                
                
                $
                29,261
                
                
                $
                (6,556
                )
                
                $
                22,705Inventories
                    (1)
                
                
                4,628
                
                
                
                158
                
                
                
                4,786
                
                
                
                5,744
                
                
                
                34
                
                
                
                5,778Other
                    current assets
                
                
                3,247
                
                
                
                936
                
                
                
                4,183
                
                
                
                4,405
                
                
                
                687
                
                
                
                5,092Total
                    assets
                
                
                141,816
                
                
                
                (4,202
                )
                
                
                137,614
                
                
                
                144,175
                
                
                
                (5,835
                )
                
                
                138,340Accrued
                    liabilities
                
                
                2,721
                
                
                
                (170
                )
                
                
                2,551
                
                
                
                2,697
                
                
                
                (152
                )
                
                
                2,545Deferred
                    revenue
                
                
                8,167
                
                
                
                (327
                )
                
                
                7,840
                
                
                
                9,050
                
                
                
                (389
                )
                
                
                8,661Total
                    current liabilities
                
                
                27,088
                
                
                
                (497
                )
                
                
                26,591
                
                
                
                30,385
                
                
                
                (541
                )
                
                
                29,844Deferred
                    revenue, net of current portion
                
                
                3,913
                
                
                
                (49
                )
                
                
                3,864
                
                
                
                5,223
                
                
                
                (237
                )
                
                
                4,986Total
                    liabilities
                
                
                34,332
                
                
                
                (546
                )
                
                
                33,786
                
                
                
                39,101
                
                
                
                (778
                )
                
                
                38,323Accumulated
                    deficit
                
                
                (78,858
                )
                
                
                (3,656
                )
                
                
                (82,514
                )
                
                
                (82,479
                )
                
                
                (5,057
                )
                
                
                (87,536
                )Total
                    liabilities and stockholders' equity
                
                $
                141,816
                
                
                $
                (4,202
                )
                
                $
                137,614
                
                
                $
                144,175
                
                
                $
                (5,835
                )
                
                $
                138,340




(1)
              Adjustments
                to inventory include amounts for previously identified errors, primarily
                related to inventory-in-transit amounts, that management previously
                concluded were not material, but nonetheless have been corrected in
                the restated consolidated financial
                statements.


76
 Table
          of Contents




ITEM 9.Changes
      in and
      Disagreements with Accountants on Accounting and Financial
      Disclosure




None.




ITEM 9A.Controls
      and
      Procedures





EVALUATION
      OF DISCLOSURE
      CONTROLS AND PROCEDURES





We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in the reports that we file or submit
      under
      the Exchange Act is recorded, processed, summarized and reported within the
      time
      periods specified in the SEC’s rules and forms, and that such information is
      accumulated and communicated to our management, including our Chief Executive
      Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow
      timely decisions regarding required disclosure. In connection with the
      preparation of this Annual Report on Form 10-K, our management carried out
      an
      evaluation, under the supervision and with the participation of our CEO and
      CFO,
      as of December 30, 2007, of the effectiveness of the design and operation of
      our
      disclosure controls and procedures, as such term is defined under Rule 13a-15(e)
      and 15d-15(e) under the Exchange Act.  Based upon this evaluation, our
      CEO and CFO concluded that our disclosure controls and procedures were effective
      as of December 30, 2007.





MANAGEMENT’S
      ANNUAL REPORT
      ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Management
      is responsible for establishing and maintaining adequate internal control over
      financial reporting for the Company, as such term is defined in Rules 13a-15(f)
      and 15d-15(f) under the Exchange Act.  Our internal control over
      financial reporting is a process designed to provide reasonable assurance
      regarding the reliability of financial reporting and the preparation of
      financial statements for external purposes in accordance with generally accepted
      accounting principles. Internal control over financial reporting includes those
      policies and procedures that: pertain to the maintenance of records that, in
      reasonable detail, accurately and fairly reflect the transactions and
      dispositions of our assets; provide reasonable assurance that transactions
      are
      recorded as necessary to permit preparation of financial statements in
      accordance with generally accepted accounting principles, and that our receipts
      and expenditures are being made only in accordance with authorizations of our
      management and directors; and provide reasonable assurance regarding prevention
      or timely detection of unauthorized acquisition, use or disposition of our
      assets that could have a material effect on our financial statements. Because
      of
      its inherent limitations, internal control over financial reporting may not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





Management
      has conducted an assessment of the effectiveness of our internal control over
      financial reporting as of December 30, 2007. In making its assessment of
      internal control over financial reporting, management used the criteria in
Internal Control — Integrated
      Framework issued by the Committee of Sponsoring Organizations of the
      Treadway Commission (“COSO”).  Based on this assessment, the Company’s
      management has concluded that, as of December 30, 2007, the Company’s internal
      control over financial reporting was effective.





The
      effectiveness of our internal control over financial reporting as of December
      30, 2007 has been audited by PricewaterhouseCoopers LLP, an independent
      registered public accounting firm, as stated in their report which appears
      in
      this Annual Report on Form 10-K.





MANAGEMENT’S
      REMEDIATION
      INITIATIVES





In
      our
      Quarterly Report on Form 10-Q for the quarter ended September 30, 2007,
      management identified the following deficiencies in the Company’s internal
      control over financial reporting which aggregated to a material
      weakness:





The
        Company did not maintain effective internal communication and risk assessment
        processes to keep pace with the Company's growth and transition to a public
        company in 2007. Specifically, the Company did not maintain effective lines
        of
        communication regarding certain sales transactions involving unique or
        non-standard terms and conditions among sales, finance, accounting, legal,
        and senior management personnel for evaluation of revenue recognition. When
        persuasive evidence of an end-user did not exist, when oral or side arrangements
        existed, when contingencies existed with respect to the acceptance of the
        product by the end-user, or when resellers did not have the ability or intent
        to
        pay independent of payment by the end-user customer, this information was
        not
        properly communicated among sales, finance, accounting, legal and senior
        management personnel for such evaluation. In addition, the Company's risk
        assessment process did not evolve during 2007 to provide an adequate
        consideration to the risks resulting from the increase in the number of sales
        representatives, channel partners, complexity of sales arrangements and the
        use
        of unique and non standard terms and conditions by sales, finance,
        accounting, legal, and senior management personnel.





A
      material weakness is a deficiency, or a combination of deficiencies, in internal
      control over financial reporting, such that there is a reasonable possibility
      that a material misstatement of the annual or interim financial statements
      will
      not be prevented or detected on a timely basis.





In
      response to this material weakness, we took a number of substantial actions
      during the year and quarter ended December 30, 2007, as outlined
      below.





77
 Table
            of Contents





·
            We
                enhanced our existing revenue recognition training for sales personnel
                and
                instituted new hire and recurring revenue recognition training for
                sales
                personnel during the third and fourth quarter of fiscal
                2007;





·
            We
                implemented additional controls regarding our sales to channel
                distributors designed to ensure appropriate revenue
                recognition;





·
            We
                documented and communicated these enhanced revenue recognition controls
                to
                our sales force; and





·
            We
                operated and tested controls at each quarter end, expanding the scope
                of
                testing each quarter and at
                year-end.





·
            We
                continue to emphasize the importance of effective
                communication among sales, finance, accounting, legal and senior
                management.





We
      have
      determined as of December 30, 2007 that the remediated controls discussed above
      were effectively designed and demonstrated effective operation for a sufficient
      period of time to enable us to conclude that the material weakness has been
      remediated.





The
      effectiveness of any controls and procedures is subject to certain limitations,
      and, as a result, there can be no assurance that our controls and procedures
      will detect all errors or fraud.  A control, no matter how well
      conceived and operated, can provide only reasonable, not absolute, assurance
      that the objectives of the control system will be attained.





We
      will
      continue to develop new policies and procedures as well as educate and train
      our
      employees on our existing policies and procedures in a continual effort to
      improve our internal control over financial reporting, and we will be taking
      further actions as appropriate.  We view this as an ongoing effort to
      which we will be devoting significant resources and which will need to be
      maintained and updated over time.





CHANGES
      IN INTERNAL CONTROL
      OVER FINANCIAL REPORTING





As
      described above, there have been changes in our internal control over financial
      reporting during the quarter ended December 30, 2007 that have materially
      affected, or are reasonably likely to materially affect, our internal control
      over financial reporting.




ITEM 9B.Other
      Information




None.





78
 Table
            of Contents





PART III




We
      have
      omitted certain information from this report that is required by Part III.
      We intend to file a definitive proxy statement pursuant to Regulation 14A
      with the Securities and Exchange Commission relating to our annual meeting
      of
      stockholders not later than 120 days after the end of the fiscal year
      covered by this report, and such information is incorporated by reference
      herein.









ITEM 10.Directors
      and Executive
      Officers of the Registrant




Certain
      information regarding our executive officers and directors is included in
      Part I of this report under the caption “Executive Officers and Directors”
and is incorporated by reference into this Item.




Other
      information required by this Item will be included in our proxy statement and
      is
      incorporated by reference herein.









ITEM 11.Executive
      Compensation




The
      information required by this Item will be included in our proxy statement and
      is
      incorporated by reference herein.









ITEM 12.Security
      Ownership of
      Certain Beneficial Owners and Management and Related Stockholder
      Matters




The
      information required by this Item will be included in our proxy statement and
      is
      incorporated by reference herein.









ITEM 13.Certain
      Relationships
      and Related Transactions




The
      information required by this Item will be included in our proxy statement and
      is
      incorporated by reference herein.









ITEM 14.Principal
      Accounting
      Fees and Services




The
      information required by this Item will be included in our proxy statement and
      is
      incorporated by reference herein.







PART IV






ITEM 15.Exhibits,
      Financial
      Statement Schedules




(a)






1.
            Consolidated
                Financial
                Statements.




See
      Index
      to Consolidated Financial Statements at Item 8 on page 51of this
      report.







2.
            Financial
                Statement
                Schedules.




79
 Table
            of Contents





Schedule II —
      Valuation and Qualifying Accounts and Reserves








Description
            
            Balanceat
              Beginning
              of
                Period
            
            
            Charges
                to
              Cost
                and
              Expenses
            
            
            Deductions
            
            
            Balanceat
              End
                of
              Period(in
                thousands)Year
                ended December 30, 2007Allowance
                for doubtful accounts
            
            $
            501
            
            
            $
            150
            
            
            $
            (327
            )
            
            $
            324Income
                tax valuation allowance
            
            
            23,933
            
            
            
            9,933
            
            
            
            —
            
            
            
            33,866Year
                ended December 31, 2006Allowance
                for doubtful accounts
            
            $
            239
            
            
            $
            279
            
            
            $
            (17
            )
            
            $
            501Income
                tax valuation allowance, restated (1)
            
            
            18,208
            
            
            
            5,725
            
            
            
            —
            
            
            
            23,933Year
                ended January 1, 2006Allowance
                for doubtful accounts
            
            $
            116
            
            
            $
            141
            
            
            $
            (18
            )
            
            $
            239Income
                tax valuation allowance
            
            
            10,299
            
            
            
            7,909
            
            
            
            —
            
            
            
            18,208







(1)
            See
                Note 3, "Restatement of Consolidated Financial Statements," of the
                Notes to Consolidated Financial
                Statements.




All
      other
      schedules are omitted because they are inapplicable or the requested information
      is shown in the consolidated financial statements or related notes
      thereto.







3.
            Exhibits.




The
      following exhibits are incorporated by reference or filed herewith.





Exhibit




**Incorporation
                by Reference
                Herein**Number
            
            Description
            Form
            Date3.1*
            
            Amended
                and Restated Certificate of Incorporation of the
                registrant.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              20063.2*
            
            Amended
                and Restated Bylaws of the registrant.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              20064.1*
            
            Form
                of registrant’s common stock certificate.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            November
              24, 20064.2*
            
            Fourth
                Amended and Restated Investors’ Rights Agreement between the registrant
                and certain of its security holders dated July 19,
                2006.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.1*
            
            Form
                of Indemnification Agreement.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.2*
            
            Amended
                and Restated 2001 Stock Plan.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.3*
            
            Form
                of Stock Option Agreement under the Amended and Restated 2001 Stock
                Plan.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.4*
            
            2006
                Equity Incentive Plan.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            November 24,
                200610.5*
            
            Form
                of Stock Option Agreement under the 2006 Equity Incentive
                Plan.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            November 24,
                200610.6*
            
            2006
                Employee Stock Purchase Plan.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            November 24,
                200610.7*
            
            Form
                of Subscription Agreement under the 2006 Employee Stock Purchase
                Plan.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            November 24,
                200610.8*
            
            Offer
                Letter with Steven Goldman dated July 17, 2003.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.9*
            
            Offer
                Letter with Eric J. Scollard dated October 4, 2002.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.10*
            
            Offer
                Letter with Mark L. Schrandt dated October 3, 2003.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.11*
            
            Offer
                Letter with Brett G. Goodwin dated March 10, 2002.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.12*
            
            Offer
                Letter with John W. Briant dated September 29, 2004.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.13*
            
            Offer
                Letter with Stuart W. Fuhlendorf dated March 29,
                2004.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.14*
            
            Offer
                Letter with Thomas P. Pettigrew dated December 22,
                2003.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.15*†
            
            Manufacturing
                Services Agreement between the registrant and Sanmina-SCI Corporation
                dated February 17, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            December 14,
                200610.16*
            
            Office
                Lease between the registrant and Selig Holdings Company dated
                November 11, 2005.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.17*
            
            First
                Amendment to Office Lease between the registrant and Selig Holdings
                Company dated December 2, 2005.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.18*
            
            Second
                Amendment to Office Lease between the registrant and Selig Holdings
                Company dated August 4, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                2006




80
 Table
          of Contents




**Exhibit******
            ****
            **Incorporation
                by Reference Herein****Number**
            ****
            **Description**
            **Form**
            **Date**10.19*
            
            Venture
                Loan and Security Agreement between the registrant and Horizon Technology
                Funding Company LLC dated March 22, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.20*
            
            Amendment
                to Venture Loan and Security Agreement between the registrant and
                Horizon
                Technology Funding Company LLC dated July 18, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.21*
            
            Loan
                and Security Agreement between the registrant and Silicon Valley
                Bank
                dated June 24, 2004.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.22*
            
            Amendment
                to Loan and Security Agreement between the registrant and Silicon
                Valley
                Bank dated March 10, 2005.
            Registration
                  Statement on Form S-1, as amended (File No.
                  333-137078)
            September 1,
              200610.23*
            
            Amendment
                to Loan and Security Agreement between the registrant and Silicon
                Valley
                Bank dated March 21, 2005.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.24*
            
            Amendment
                to Loan and Security Agreement between the registrant and Silicon
                Valley
                Bank dated June 29, 2005.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.25*
            
            Amendment
                to Loan Documents between the registrant and Silicon Valley Bank
                dated
                March 22, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
                200610.26*
            
            Amendment
                to Loan Documents between the registrant and Silicon Valley Bank
                dated
                July 18, 2006.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            September 1,
              200610.27*
            
            Warrant
                to Purchase Stock issued by registrant to Horizon Technology Funding
                Company III LLC, dated March 22, 2006.
            Registration
              Statement on Form S-1, as amended (File No. 333-137078)
            October 10,
                200610.28*
            
            Warrant
                to Purchase Stock issued by registrant to Horizon Technology Funding
                Company III LLC, dated March 22, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            October
              10, 200610.29*
            
            Offer
                Letter with Gwen Weld dated June 5, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            November 9,
                    200610.30*
            
            Offer
                Letter with James Richardson dated October 2, 2006.
            Registration
                Statement on Form S-1, as amended (File No. 333-137078)
            November 9,
                200610.31*†
            
            Offer
                Letter with Steven D. Fitz dated April 11, 2007.
            Quarterly
              Report on Form 10-Q for the quarter ended July 1, 2007 (File
              001-33196)
            August
              9, 200723.1
            
            Consent
                of PricewaterhouseCoopers LLP, independent registered public accounting
                firm.24.1
            
            Power
                of Attorney (contained on signature page).31.1
            
            Rule 13a-14(a)/15d-14(a)
                Certification of Principal Executive Officer.31.2
            
            Rule 13a-14(a)/15d-14(a)
                Certification of Principal Financial Officer.32.1
            
            Section 1350
                Certification of Chief Executive Officer.32.2
            
            Section 1350
                Certification of Chief Financial
                Officer.




*     Previously
      filed.





† Registrant
        has omitted portions of the referenced exhibit and filed such exhibit separately
        with the Securities and Exchange Commission pursuant to a grant of confidential
        treatment under Rule 406 promulgated under the Securities Act of
        1933.







SIGNATURES




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act
      of 1934, as amended, the registrant has duly caused this report to be signed
      on
      its behalf by the undersigned, thereunto duly authorized.




ISILON
                SYSTEMS, INC.By:
            /s/  Sujal
                PatelSujal
                PatelPresident,
                Chief Executive Officer and
                Director




81
 Table
            of Contents





POWER
      OF ATTORNEY




KNOW
      ALL
      PERSONS BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Keenan Conder, Bill Richter and each of them, with
      full power of substitution and resubstitution and full power to act without
      the
      other, as his or her true and lawful attorney-in-fact and agent to act in his
      or
      her name, place and stead and to execute in the name and on behalf of each
      person, individually and in each capacity stated below, and to file, any and
      all
      documents in connection therewith, with the Securities and Exchange Commission,
      granting unto said attorneys-in-fact and agents, and each of them, full power
      and authority to do and perform each and every act and thing, ratifying and
      confirming all that said attorneys-in-fact and agents or any of them or their
      and his or her substitute or substitutes, may lawfully do or cause to be done
      by
      virtue thereof.




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities indicated and on the dates indicated.







Signature
            
            Title
            
            Date/s/  Sujal
                Patel
              
              Sujal
                  Patel
            
            President,
                Chief Executive Officer
              and
                Director
              (Principal
                Executive Officer)
            
            April
                2, 2008/s/  William
                Richter
              
              William
                  Richter
            
            Interim
                Chief Financial Officer
              (Principal
                Accounting and
              Financial
                Officer)
            
            April
                  2, 2008/s/  Elliott
                H. Jurgensen, Jr.
              
              Elliott
                  H. Jurgensen, Jr.
            
            Director
            
            April
                  2, 2008/s/  William
                D. Ruckelshaus
              
              William
                  D. Ruckelshaus
            
            Chairman
                of Board of Directors
              and
                Director
            
            April
                  2, 2008/s/  Barry
                J. Fidelman
              
              Barry
                  J. Fidelman
            
            Director
            
            April
                  2, 2008/s/  Gregory
                L. McAdoo
              
              Gregory
                  L. McAdoo
            
            Director
            
            April
                  2, 2008/s/  Matthew
                S. Mcllwain
              
              Matthew
                  S. Mcllwain
            
            Director
            
            April
                  2, 2008/s/  James
                G. Richardson
              
              James
                  G. Richardson
            
            Director
            
            April
                  2, 2008/s/ Peter
                H. van Oppen
              
              Peter
                H. van Oppen
            
            Director
            
            April
                  2, 2008




82
 Table
            of Contents








INDEX
      TO EXHIBITS






Exhibit




**Incorporation
                  by Reference
                  Herein**Number
              
              Description
              Form
              Date3.1*
              
              Amended
                  and Restated Certificate of Incorporation of the
                  registrant.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                20063.2*
              
              Amended
                  and Restated Bylaws of the registrant.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                20064.1*
              
              Form
                  of registrant’s common stock certificate.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              November
                24, 20064.2*
              
              Fourth
                  Amended and Restated Investors’ Rights Agreement between the registrant
                  and certain of its security holders dated July 19,
                  2006.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.1*
              
              Form
                  of Indemnification Agreement.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.2*
              
              Amended
                  and Restated 2001 Stock Plan.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.3*
              
              Form
                  of Stock Option Agreement under the Amended and Restated 2001 Stock
                  Plan.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.4*
              
              2006
                  Equity Incentive Plan.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              November 24,
                  200610.5*
              
              Form
                  of Stock Option Agreement under the 2006 Equity Incentive
                  Plan.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              November 24,
                  200610.6*
              
              2006
                  Employee Stock Purchase Plan.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              November 24,
                  200610.7*
              
              Form
                  of Subscription Agreement under the 2006 Employee Stock Purchase
                  Plan.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              November 24,
                  200610.8*
              
              Offer
                  Letter with Steven Goldman dated July 17, 2003.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.9*
              
              Offer
                  Letter with Eric J. Scollard dated October 4, 2002.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.10*
              
              Offer
                  Letter with Mark L. Schrandt dated October 3, 2003.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.11*
              
              Offer
                  Letter with Brett G. Goodwin dated March 10, 2002.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.12*
              
              Offer
                  Letter with John W. Briant dated September 29, 2004.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.13*
              
              Offer
                  Letter with Stuart W. Fuhlendorf dated March 29,
                  2004.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.14*
              
              Offer
                  Letter with Thomas P. Pettigrew dated December 22,
                  2003.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.15*†
              
              Manufacturing
                  Services Agreement between the registrant and Sanmina-SCI Corporation
                  dated February 17, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              December 14,
                  200610.16*
              
              Office
                  Lease between the registrant and Selig Holdings Company dated
                  November 11, 2005.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.17*
              
              First
                  Amendment to Office Lease between the registrant and Selig Holdings
                  Company dated December 2, 2005.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.18*
              
              Second
                  Amendment to Office Lease between the registrant and Selig Holdings
                  Company dated August 4, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  2006




83
 Table
          of Contents


**Exhibit****Incorporation
                  by Reference
                  Herein****Number**
              
              Description
              **Form**
              **Date**10.19*
              
              Venture
                  Loan and Security Agreement between the registrant and Horizon
                  Technology
                  Funding Company LLC dated March 22, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.20*
              
              Amendment
                  to Venture Loan and Security Agreement between the registrant and
                  Horizon
                  Technology Funding Company LLC dated July 18, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.21*
              
              Loan
                  and Security Agreement between the registrant and Silicon Valley
                  Bank
                  dated June 24, 2004.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.22*
              
              Amendment
                  to Loan and Security Agreement between the registrant and Silicon
                  Valley
                  Bank dated March 10, 2005.
              Registration
                    Statement on Form S-1, as amended (File No.
                    333-137078)
              September 1,
                200610.23*
              
              Amendment
                  to Loan and Security Agreement between the registrant and Silicon
                  Valley
                  Bank dated March 21, 2005.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.24*
              
              Amendment
                  to Loan and Security Agreement between the registrant and Silicon
                  Valley
                  Bank dated June 29, 2005.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.25*
              
              Amendment
                  to Loan Documents between the registrant and Silicon Valley Bank
                  dated
                  March 22, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                  200610.26*
              
              Amendment
                  to Loan Documents between the registrant and Silicon Valley Bank
                  dated
                  July 18, 2006.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              September 1,
                200610.27*
              
              Warrant
                  to Purchase Stock issued by registrant to Horizon Technology Funding
                  Company III LLC, dated March 22, 2006.
              Registration
                Statement on Form S-1, as amended (File No. 333-137078)
              October 10,
                  200610.28*
              
              Warrant
                  to Purchase Stock issued by registrant to Horizon Technology Funding
                  Company III LLC, dated March 22, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              October
                10, 200610.29*
              
              Offer
                  Letter with Gwen Weld dated June 5, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              November 9,
                      200610.30*
              
              Offer
                  Letter with James Richardson dated October 2, 2006.
              Registration
                  Statement on Form S-1, as amended (File No. 333-137078)
              November 9,
                  200610.31*†
              
              Offer
                  Letter with Steven D. Fitz dated April 11, 2007.
              Quarterly
                Report on Form 10-Q for the quarter ended July 1, 2007 (File
                001-33196)
              August
                9, 200723.1
              
              Consent
                  of PricewaterhouseCoopers LLP, independent registered public accounting
                  firm.24.1
              
              Power
                  of Attorney (contained on signature page).31.1
              
              Rule 13a-14(a)/15d-14(a)
                  Certification of Principal Executive Officer.31.2
              
              Rule 13a-14(a)/15d-14(a)
                  Certification of Principal Financial Officer.32.1
              
              Section 1350
                  Certification of Chief Executive Officer.32.2
              
              Section 1350
                  Certification of Chief Financial
                  Officer.


*          Previously
      filed.





†           Registrant
      has omitted portions of the referenced exhibit and filed such exhibit separately
      with the Securities and Exchange Commission pursuant to a grant of confidential
      treatment under Rule 406 promulgated under the Securities Act of
      1933.






84