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 31,
      2008ORo
            
            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.  þ




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
      filero
            Smaller
      reporting companyo





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 $94,909,888. 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
February 6, 2009, 63,890,137 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 April 20,
2009.







1




TABLE OF CONTENTS




Part IItem 1.
                  Business
                  3Item 1A.
                  Risk
      Factors
                  19Item 1B.
                  Unresolved Staff
      Comments
                  36Item 2.
                  Properties
                  36Item 3.
                  Legal
      Proceedings
                  36Item 4.
                  Submission of Matters to a
      Vote of Security Holders
                  36Part IIItem 5.
                  Market for
      Registrant’s Common Equity, Related Stockholder Matters and
      Issuer Purchases of EquitySecurities
                  37Item 6.
                  Selected Financial
      Data
                  40Item 7.
                  Management’s Discussion
      and Analysis of Financial Condition and Results of
      Operations
                  42Item 7A.
                  Quantitative and Qualitative
      Disclosures About Market Risk
                  58Item 8.
                  Financial Statements and
      Supplementary Data
                  59Item 9.
                  Changes in and Disagreements
      with Accountants on Accounting and Financial
      Disclosure
                  87Item 9A.
                  Controls and
      Procedures
                  87Item 9B.
                  Other
      Information
                  87Part IIIItem 10.
                  Directors and Executive
      Officers of the Registrant
                  88Item 11.
                  Executive
      Compensation
                  88Item 12.
                  Security Ownership of Certain
      Beneficial Owners and Management andRelated Stockholder Matters
                  88Item 13.
                  Certain Relationships and
      Related Transactions
                  88Item 14.
                  Principal Accounting Fees and
      Services
                  88Part IVItem 15.
                  Exhibits and Financial Statement
      Schedules
                  88Signatures
                  
                  91EXHIBIT
      23.1EXHIBIT
      31.1EXHIBIT
      31.2EXHIBIT
      32.1EXHIBIT
      32.2




2
 Table of Contents





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; general economic and
industry conditions and macroeconomic factors affecting the U.S. and global
economies; the anticipated growth of file-based data; 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 further grow into
enterprise accounts; our ability to add value-added resellers and distributors
and improve our channel performance in the U.S. and internationally; our ability
to improve and enhance demand generation; our ability to improve and ehance
customer support and service; 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 Systems, Inc., and its consolidated subsidiaries, unless the context
otherwise dictates.





ITEM 1.Business




Overview




We
provide scale-out NAS storage systems – combining our proprietary OneFS®
operating system software and unique clustered architecture – for file-based
data, including video, audio, digital images, computer models, PDF files,
scanned images, reference information, test and simulation data, and other
file-based information. We designed and developed our scale-out NAS solutions
specifically to address the needs of storing and managing file-based data. 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 OneFS operating system software, which unifies a
cluster of nodes into a single shared resource. Through the end of fiscal 2008,
we have sold our scale-out NAS storage systems to more than 900 customers across
a wide range of industries. We sell our products directly through our field
sales force and indirectly through a channel partner program that includes more
than 180 value-added resellers and distributors.





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.




3
 Table of Contents




Industry
Background




Proliferation
of File-Based Data




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
file-based 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 file-based data. As more business and consumer activities create and utilize
file-based data and applications, the need for ways to store, manage and access
this information is growing rapidly. The worldwide market for external disk
storage systems is expected to grow to approximately $24.1 billion in 2011.
The external disk storage systems market has traditionally been served by
storage solutions based on Storage Area Network, or SAN, Network Attached
Storage, or NAS, and Direct Attached Storage, or DAS, architectures. While the
worldwide market for external disk storage systems is expected to grow at a
steady rate through 2011, the market for storage solutions dedicated to
file-based data and applications 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, 2008
represented an inflection point where more disk capacity was shipped to store
file-level data than block-level data. In 2012, more than 78 percent of disk
storage systems capacity will be shipped to support some sort of file-level
data.








Widespread
and Increasing Use of File-Based Data




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





·
                Media and
      Entertainment.Digitization of production and delivery
      of file-based 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, digital video
      standards like Sony Blu-Ray, streaming media formats for online delivery
      of content and 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, file-based data storage requirements will continue to grow. In
      movie production, for example, ten seconds of high-resolution digital
      footage can require more than 12 gigabytes of storage, and in the
      publishing industry, sophisticated digital cameras can take more than
      eight photos per second, each of which can create an image file of more
      than 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 file-based data, and
      provide aggregate data throughput of multiple gigabytes per
      second.




·
            Life
      Sciences.  Research
      and development in the life sciences, specifically bioinformatics, 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 greater than 18 megapixels and three-dimensional display
      capability. As a result, life sciences professionals are storing,
      retrieving and analyzing increasingly large amounts of file-based data.
      Specifically, the data growth and performance needs of DNA sequencing have
      changed rapidly and unexpectedly, driven by a recent flurry of
      next-generation technologies. With major bioinformatics organizations
      creating upwards of 15-20 terabytes of data per day, cost-effective
      scaling of performance and capacity is absolutely critical to deriving
      maximum value from this mission-critical
      information.




·
            Manufacturing.New
      testing and digital simulation technologies used to enhance manufacturing
      processes are creating significant amounts of file-based data and require
      next-generation, high-performance scale-out NAS 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, automation technology and other
      file-based applications into their workflows, they are creating a large
      amount of file-based data.




4
 Table of Contents


·
            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.




·
              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 File-Based Data




Traditional
storage system architectures were primarily designed for block-based, 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 file-based
data and applications, 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 information. We believe the distinctive
characteristics and rapid growth of file-based data 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 file-based data. 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
      file-based data 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 file-based data, 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.




·
            Cost
      Efficiency.  Traditional
      storage systems are becoming increasingly complex and expensive to install
      and configure, increasing the upfront cost of enterprise storage.
      Especially in a challenging macro-economic environment, enterprises want
      storage systems that offer the capital expenditure benefits of modular,
      “pay-as-you-grow” capabilities and we believe purchasing practices are
      shifting 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.




·
            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 file-based
      information as well as ensure that customers and business units have
      uninterrupted access to those assets. As file-based data 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 file-based data
      must be fault tolerant and be able to analyze systems for potential
      hardware or software failures to ensure uninterrupted user
      access.





5
 Table of Contents




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 file-based data, 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 occurring 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.




·
            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 file-based data and
the unique challenges associated with storing and managing this information, we
believe there is a significant market opportunity for a scale-out NAS solution
based upon a clustered architecture and optimized for storing and managing
file-based data.







Our
Scale-Out NAS Storage Solutions




We
believe we are the leading provider of scale-out NAS storage solutions for
storing and managing file-based data, based on customer adoption, breadth of
product offerings, independent analyst data 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 scale-out NAS solutions enable data-intensive
enterprises to manage file-based data more efficiently and cost effectively than
traditional storage systems.




Our
Isilon IQ X-Series combines 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
      2,300 terabytes, or 2.3 petabytes, of storage capacity in a single
      cluster – more than 100x traditional NAS and SAN – and can deliver total
      data throughput of twenty gigabytes per second from a single file system
      and single pool of storage – more than 20x traditional systems, providing
      linear scalability in both storage capacity and performance. Our systems
      support both Gigabit Ethernet and 10 Gigabit Ethernet front-side
      connectivity and high-performance InfiniBand interconnect for low-latency,
      high-bandwidth, intra-cluster
communication.




6
 Table of Contents




·
            Reduced Storage
      Cost.  Our scale-out NAS storage systems deliver
      significant value for storing and managing the growth of file-based data.
      According to a recent Isilon-commissioned study conducted by Forrester
      Consulting, interviewed Isilon customers achieved a risk-adjusted ROI of
      125 percent and a payback period within five months, on average. These
      same customers experienced an average reduction in storage management
      resource of 97%, as well as a 22% increase in storage utilization
      resulting in a 37% decrease in storage capacity required. Isilon’s
      modular, “pay as you grow” scale-out NAS storage systems significantly
      reduce both capital acquisition costs as well as operating and management
      expenditures over the life of the
system.




·
            Reliability.  Our scale-out NAS 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.




·
                Increased IT Operating
      Efficiency.  Our scale-out NAS storage systems enable
      customers to manage their growing amounts of file-based data 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.


·
            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 file-based data,
      capitalize on new products and service models for delivering this content
      and unlock new revenue opportunities. For example, NBC used Isilon IQ
      solutions to help store, access and edit more than 3,600 broadcast
      hours during the 2008 Summer Olympics, providing immediate access to all
      programming and tripling the number of broadcast hours compared with
      previous Summer 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 file-based data while maintaining
      their existing storage systems for block-based, 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.






7
 Table of Contents




Our
Strategy




Our
strategic focus is to enhance our position as the market leader in scale-out NAS
storage solutions for file-based data. 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 file-based
      data are critical to the success of many enterprises. To date, our
      solutions have been deployed by customers in industries such as media and
      entertainment, life sciences, Internet, manufacturing, cable and
      telecommunications, oil and gas, 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
      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 scale-out
      NAS systems’ clustered architecture, 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 54% of our
      total revenue in 2008 through indirect channels. We have established a
      distribution channel program that, as of December 31, 2008, had more than
      180 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.






Technology
and Architecture




We have
designed a scale-out NAS storage solution based upon a clustered architecture
consisting of independent nodes that are all integrated with our OneFS operating
system software to form a single shared resource. Our scale-out NAS 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 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 architecture with industry standard hardware, to
take advantage of significant advances in performance or capacity. In addition
to our core scale-out NAS storage systems, we provide standalone software
applications designed to operate with our OneFS operating system software and
leverage our clustered architecture.




8
 Table of Contents




Our OneFS
operating system software is the core technology of Isilon IQ 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 file-based data.





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 file-based data, 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.






9
 Table of Contents




Products




Our
product family consists of scale-out NAS storage systems and related software
applications. Our storage systems combine our fifth-generation OneFS operating
system software with our clustered 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-x and the
Isilon EX 6000, EX 9000 and EX 12000. We also offer four related software
applications that extend the capabilities and functionality of our systems:
SyncIQ replication software, SmartConnectTM load-balancing software, SnapshotIQTM
protection software, and SmartQuotasTM management and provisioning
software.





Isilon IQ Platform
Nodes.  Our Isilon IQ platform nodes combine a storage server
and, depending on the system, 1.92, 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 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
for intra-cluster communication and provide front-side communication via
standard Gigabit Ethernet and 10 Gigabit Ethernet.





Isilon IQ
Accelerator-x.  Our Isilon IQ Accelerator-x 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-x 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 twenty gigabytes per second with no system downtime.
Additionally, the Accelerator-x enables 10 Gigabit Ethernet front-end
communication for high-performance file-based applications.




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 2,300 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 Data Management
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.





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Customers




Through
the end of fiscal 2008, we have sold our products worldwide to more than 900 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 2008, no single customer accounted for 10% or more of our total
revenue. During 2007, Eastman Kodak Company accounted for 10% of our total
revenue. During 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 Comcast Corporation and Eastman Kodak Company buy our
products on a purchase order basis and do not have a long-term contract or
minimum purchase commitment. In 2008, 2007 and 2006, we derived 35%, 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.








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 file-based
data:




·
              Field Sales
      Force.  Our field sales force is responsible for managing
      all direct and indirect sales within our geographic territories, including
      North America, Europe and
Asia.




·
            Value-Added Resellers and
      Distributors.  We currently contract with more than 180
      channel partners to 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.





·
            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, demand generation
programs, 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 party maintenance providers
that provide onsite hardware support, hardware replacement, spares inventory and
other field services in the U.S. and international regions in which we sell our
products. We recently transitioned to a new primary third party maintenance
provider. 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.




11
 Table of Contents




Manufacturing





We
outsource the manufacturing of all our systems and currently rely on a single
contract manufacturer.  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.  We are
continuing to negotiate a master services agreement with Flextronics and
currently utilize 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.  See Note 12, “Commitments and
Contingencies” of the Notes to Consolidated Financial Statements.








Research
and Development




Our
research and development organization is responsible for the design,
development, testing and certification of our scale-out NAS 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. Through the end of 2007,
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 incurred
substantial expenditures related to 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 $24.0 million in 2008, $19.9 million
in 2007, and $16.5 million in 2006.







12
 Table of Contents




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, NetApp, 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 smaller, 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;




·
            cost
      efficiency in acquisition, deployment and ongoing support;
    and




·
            reliability
      to ensure uninterrupted user access in
  acquisition.




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





13
 Table of Contents




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.





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 31, 2008, we had 394 employees worldwide, including 157 in sales
and marketing, 137 in research and development, 52 in support and services, and
48 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.




14
 Table of Contents




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 31,
            
            
            December 30,
            
            
            December 31,2008
            
            
            2007
            
            
            2006Restated(1)(Dollars
      in thousands)Revenue
      by geography:Domestic
            
            $
            74,612
            
            
            $
            64,936
            
            
            $
            46,465International
            
            
            39,810
            
            
            
            24,062
            
            
            
            14,741Total
      revenue
            
            $
            114,422
            
            
            $
            88,998
            
            
            $
            61,206%
      revenue by geography:Domestic
            
            
            65
            %
            
            
            73
            %
            
            
            76
            %International
            
            
            35
            
            
            
            27
            
            
            
            24Total
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %




(1)
            See
      Note 2, "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.







15
 Table of Contents




Executive
Officers and Directors





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





Name
            
            Age
            
            Position(s)Executive
      Officers:Sujal
      M. Patel
            
            34
            
            President,
      Chief Executive Officer and DirectorWilliam
      D. Richter
            
            34
            
            Vice
      President of Finance, Interim Chief Financial OfficerKeenan
      M. Conder
            
            45
            
            Vice
      President, General Counsel and Corporate SecretarySteven
      D. Fitz
            
            44
            
            Senior
      Vice President of Worldwide Field OperationsPaul
      G. Rutherford
            
            52
            
            Chief
      Technology OfficerBrett
      L. Helsel
            
            49
            
            Senior
      Vice President of EngineeringRam
      Appalaraju
            
            48
            
            Vice
      President of MarketingMary
      Godwin
            
            50
            
            Vice
      President of OperationsGwen
      E. Weld
            
            51
            
            Vice
      President of Human Resources and Organizational
  DevelopmentDirectors:Barry
      J. Fidelman
            
            68
            
            DirectorElliott
      H. Jurgensen, Jr.
            
            64
            
            DirectorGregory
      L. McAdoo
            
            44
            
            DirectorMatthew
      S. McIlwain
            
            44
            
            DirectorJames
      G. Richardson
            
            51
            
            DirectorWilliam
      D. Ruckelshaus
            
            76
            
            Chairman
      of the Board of Directors and DirectorPeter
      H. van Oppen
            
            56
            
            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 Vice President of Finance since April 2008.  Mr. Richter also
served as our Senior Director of Finance and Corporate Controller from December
2006 to October 2007. 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. Conder has 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 and technology company. From May 2002 to
February 2004, Mr. Conder served as Senior Vice President and General
Counsel of Travelocity.com LP, 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.





16
 Table of Contents




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. Rutherford has 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.





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.





Ram V. Appalaraju has served
as Isilon’s Vice President of Marketing since November 2008.  Prior to
joining us, from November 2006 to November 2008, Mr. Appalaraju served as Vice
President, Technology and Product Marketing at Azul Systems, Inc., a global
provider of enterprise server appliances.  Prior to Azul, Mr. Appalaraju
served in various positions from 1995 to 2006 at Hewlett Packard Company, most
recently as Vice President HP Enterprise Business Portfolio Marketing. 
From 1987 to 1995, Mr. Appalaraju was a product marketing manager with Digital
Equipment Corporation and from 1983 to 1987 a product marketing manager with
General Electric Company.  Mr. Appalaraju received a Bachelor of
Science in Electrical Engineering from the University of Madras, India, and a
Master of Science in Electrical Engineering from Northeastern
University.





Mary E. Godwinhas served as
Isilon’s Vice President of Operations since July 2008.  Prior to joining
us, from October 2005 to December 2007, Ms. Godwin served as Vice President,
Account Executive at Solectron Corporation (subsequently acquired by Flextronics
International Ltd.), an electronics manufacturing services provider.  Prior
to Solectron, Ms. Godwin served in various executive positions from 2001 to
October 2005 at Lucent Technologies (subsequently merged with Alcatel), a global
communications solutions provider, most recently as Vice President, Product and
Supply Chain Management.  Prior to Lucent, Ms. Godwin also served in
executive positions with Set Engineering, Philips Electronics, ET Communications
and Radius, Inc.  Ms. Godwin received a Bachelor of Science degree in
plastics engineering from University of Massachusetts, Lowell and a Master of
Business Administration degree from Santa Clara University.




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.




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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. In January 2008, Mr. Richardson
retired from the executive management team at Cisco Systems, Inc.  Mr.
Richardson had been with Cisco since 1990, where he began his career as the
founder of Cisco’s Canadian operations. Mr. Richardson served as Cisco’s
Senior Vice President, Commercial Business from January 2006 to January 2008 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.





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 Oppen has 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, Mr. van Oppen served
as President and Chief Executive Officer of Interpoint, a predecessor
company to ADIC, from 1989 until its acquisition by Crane Co. in October 1996,
and has also been a consultant at Price Waterhouse LLP and Bain &
Company. Mr. van Oppen currently serves as Vice Chairman of the Board of
Trustees and Chair of the Investment Committee at Whitman College. 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 financial  restatement and prior
weaknesses in our internal controls, including adverse publicity and potential
concerns from our customers and prospective customers, and regulatory and
litigation matters, could have a material adverse effect on our business,
revenues, operating results, or financial condition.





As more
fully described in Footnote 2, “Restatement of Consolidated Financial
Statements,” of the Notes to the Consolidated Financial Statements, 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 were
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 our Annual
Report on Form 10-K for the year ended December 30, 2007, 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 in Part 1 of our Annual Report on Form 10-K
for 2007.





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, derivative
litigation, and an SEC investigation, and could result in other litigation or
regulatory proceedings, 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.





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Impact
on our Business





We
believe that our competitors have sought and will continue to seek to leverage
the restatement and investigation and related litigation and regulatory matters
to try and raise concerns about us in the minds of our customers and customer
prospects.  Our restatement and related litigation and regulatory
matters and other adverse publicity has affected and could continue to
affect our relationships with customers and customer prospects and has and
could continue to have a material adverse effect on our business, revenues,
operating results, and financial condition and cash flows.





Litigation
and Regulatory Matters





As
further described in Part I, Item 3, Legal Proceedings of this Form 10-K, we and
certain of our executive officers, directors, underwriters and venture capital
firms were named as defendants in a consolidated federal securities class
action.  The amended consolidated complaint filed April 18, 2008,
asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of
1934, as amended, and Rule 10b-5 promulgated thereunder, as well as under
Section 11, 12 and 15 of the Securities Act of 1933.  On September 30,
2008, the Company and the other defendants moved to dismiss the consolidated
amended complaint.  In a decision issued on December 29, 2008, the
Court granted in part and denied in part the motions to dismiss.  All
claims against defendants Sequoia Capital (and related entities), Atlas Venture
(and related entities) and Madrona Venture Group LLC were
dismissed.  The Section 12 claims were dismissed as against the
Company, its former CEO Steven Goldman, and its former CFO Stuart Fuhlendorf, as
were the Section 10(b) claims against Isilon directors William Ruckelshaus and
Matthew McIlwain.  The Court denied the remainder of the defendants’
motions.  All remaining defendants filed answers to the complaint on
January 30, 2009.





In
addition, on March 18 and 24, 2008, shareholder derivative actions were 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.  The derivative complaints arise out of many of the
factual allegations at issue in the class action, and generally 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 recognized in our fiscal year ended December 31, 2006, and
first and second quarters in fiscal 2007.  On August 27, 2008, at the
request of the parties, the court stayed the consolidated derivative action
pending resolution of the motions to dismiss in the securities class
action.  As noted above, as the motions to dismiss in the securities
case were resolved on December 29, 2008, the parties to the derivative action,
on January 12, 2009, stipulated and asked the Court to order that plaintiff
amend his complaint, and also that the Court schedule defendants’ motion(s) to
dismiss such amended derivative complaint.  The Court has not yet
signed the proposed order associated with this stipulation.





We have
been cooperating on a voluntary basis with an investigation being conducted by
the SEC concerning our prior financial restatement.  Also, as
previously disclosed, the SEC has issued a formal order of nonpublic
investigation and has issued subpoenas to certain of our former officers. The
SEC’s investigation is a nonpublic, fact-finding inquiry to determine if there
have been violations of the federal securities laws. We are continuing to
cooperate voluntarily with the SEC.




These
matters are in preliminary stages and 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 or regulatory proceedings or actions arising out of our
Audit Committee’s investigation and the related restatement of our historic
financial statements.   Litigation and regulatory 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 regulatory action or proceeding could have a material adverse effect
on our business, results of operations, financial condition, and cash
flows.




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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.




Our
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 a ccordance
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.




We are
required to comply with Section 404 of the Sarbanes-Oxley Act of
2002.  We have expended significant resources in developing and
maintaining 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 continue 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





Changes
in economic conditions in the United States and globally could adversely affect
our business.





Since at
least mid-2007, global credit, financial and other markets in the U.S. and
globally have suffered substantial stress, volatility, illiquidity and
disruption. This global economic uncertainty has continued, resulting in, among
other things, the bankruptcy or acquisition of, or government assistance to,
many major domestic and international financial institutions.  This
ongoing macroeconomic uncertainty poses a continuing risk to the overall economy
as businesses and consumers may defer, delay or forgo purchases in response to
continuing negative financial or economic news and events which could effect
demand for our products and services.  There could be a number of
negative follow-on effects from the ongoing economic uncertainty on our
business, including insolvency of key suppliers resulting in product delays
and inability of customers to obtain credit to finance purchases of our products
and/or customer insolvencies.





Moreover,
as noted above, the current uncertainty in global economic conditions poses a
risk to the overall economy as consumers and businesses may defer purchases in
response to negative financial or economic news and events, which could
negatively affect product demand and other related
matters.  Consequently, demand could be different from our current
expectations due to factors including negative changes in general business and
economic conditions and/or further tightening or deterioration in global credit
markets, either of which could affect consumer confidence, customer acceptance
of our and our competitors’ products and changes in customer order patterns
including order cancellations.







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 $25.1 million in 2008 and $26.9 million in 2007.  As of
December 31, 2008, our accumulated deficit was $127.7 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, margins 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, NetApp, 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.




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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 NetApp, 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 and potentially accelerate as companies
attempt to strengthen or maintain their market positions in this evolving
industry and in the midst of a difficult and challenging macroeconomic
environment.  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:




·
            changes
      and uncertainty in the U.S. and global economies and macroeconomic
      conditions, and specific economic conditions in the computer and storage
      industries;




·
            general
      or sustained decrease in global corporate spending on information
      technology and storage related products leading to a decline in demand for
      our products;





·
            continued
      and increased customer uncertainty due to uncertainty and weakness in the
      U.S. and global economies;




·
            reductions
      in customers’ budgets for information technology and storage related
      purchases, delays in their purchasing cycles or deferments of their
      product purchases based on market and economic uncertainty or in
      anticipation of new products or updates from us or our
      competitors;





·
            the
      ability of our customers, channel partners, and suppliers to obtain
      financing or to fund capital expenditures and their ability to continue as
      a going concern;





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





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 Table of Contents




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





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





·
            our
      ability to improve our marketing and demand generation and attract new
      customers;




·
              our
      ability to continually improve and provide high quality customer service
      and experience;




·
            our
      ability to effectively manage our relationships with our third party
      maintenance providers that provide onsite support, hardware replacement,
      manage and disburse our spares product inventory and provide other field
      services in the U.S. and international regions in which we sell our
      products;




·
            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;





·
            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.




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 Table of Contents




Our
future financial performance depends on growth in the storage of file-based
data. If growth in the storage of file-based data  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 file-based data. 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 file-based data 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 file-based data 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. While our customer base has grown and
diversified, the potential for concentrated purchases by certain new and
existing customers remains and our largest customers may continue to vary from
quarter to quarter. As a consequence of historical patterns and the potential
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 life sciences, government, manufacturing and oil and gas,
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 substantial
portion of our total revenue is currently sold 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. We have not to date been
involved in any litigation related to intellectual property.  In
the past, on July 31, 2006, we received a letter from counsel to SeaChange
International, Inc. suggesting that our products may be infringing certain
SeaChange patents.  We exchanged 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 received no further
correspondence in the matter.  If this matter or other matters arise,
and we are unable to reach an amicable resolution, it is possible that
litigation could 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.




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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.





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 may 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, which may be
further impacted by current macroeconomic concerns and conditions. 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 or terabyte 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 scale-out NAS 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.




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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. 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:




·
            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.




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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.




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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.






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 third-party maintenance providers or
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 further into larger enterprise
accounts, and expandour
operations internationally, our customer services organization will face
additional challenges, including those associated with providing more
mission-critical services in enterprise accounts, as well asdelivering
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 35% and 27% of our total revenue from customers outside
the United States in 2008 and 2007, 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;




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·
            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, including a global
  recession.




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.




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.




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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.







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.




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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, although not yet currently required, we could
be required to adopt International Financial Reporting Standards (IFRS) which is
different than accounting principles generally accepted in the United States of
America for our accounting and reporting standards.






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. Due to the recent
tightening if the credit and private equity markets, such financing may not be
available, or we may not be able to secure timely additional financing on
favorable terms. 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.




33
 Table of Contents


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








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 February 6, 2009, our stock
price has fluctuated from a high of $28.50 to a low of $2.31.  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;





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





·
            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;





·
            inquiries
      or investigations by the SEC, NASDAQ, law enforcement or other regulatory
      bodies;





·
            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;
      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. For example, current macroeconomic conditions
have caused substantial and continuing volatility in the U.S. stock markets.
Although such conditions have not been specific to our company, our stock has
experienced similar volatility. 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.




34
 Table of Contents




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 September 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.





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




As of
December 31, 2008, our directors and executive officers and their affiliates
beneficially own, in the aggregate, approximately 61% 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.





35
 Table of Contents





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 thereunder, as well as under Sections 11, 12
and 15 of the Securities Act of 1933.  Substantially similar
complaints were filed later in the same court and all of these
cases were subsequently consolidated.  On April 18,
2008, lead plaintiffs filed a consolidated amended complaint against
the Company, certain of its current and former directors and officers,
underwriters, and venture capital firms.  The consolidated
complaint purports to be brought on behalf of a class of persons who purchased
or otherwise acquired the Company’s stock during the period December 16, 2006 to
October 3, 2007.  Plaintiffs allege that defendants violated the
federal securities laws by issuing a false and misleading registration statement
and prospectus in connection with the Company’s December 16, 2006 initial public
offering and by thereafter misrepresenting the Company’s current and prospective
business and financial results, thereby causing the Company’s stock price to be
artificially inflated during the purported class period.  Plaintiffs
seek unspecified compensatory damages, interest, attorneys’ fees and costs, and
injunctive relief.





On
September 30, 2008, the Company and the other defendants moved to dismiss the
consolidated amended complaint.  Oral argument on the defendants’
motions was heard on December 16, 2008, and a decision was issued on December 29
granting in part and denying in part the motions.  All claims against
defendants Sequoia Capital (and related entities), Atlas Venture (and related
entities) and Madrona Venture Group LLC were dismissed.  The
Section 12 claims were dismissed as against defendants Isilon, its former
CEO Steven Goldman, and its former CFO Stuart Fuhlendorf, as were the Section
10(b) claims against Isilon directors William Ruckelshaus and Matthew
McIlwain.  The Court denied the remainder of the defendants’
motions.  All remaining defendants filed answers to the complaint on
January 30, 2009.





On March
18 and 24, 2008, shareholder derivative actions were 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.  On April 17, 2008, the court consolidated these actions and
appointed lead counsel.  The derivative complaints arise out of many
of the factual allegations at issue in the securities class action, and
generally 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 recognized in the Company’s
fiscal year ended December 31, 2006, and first and second quarters in fiscal
2007.  The complaints seek 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 to advance
the legal fees and costs incurred by the individual defendants.  On August
27, 2008, at the request of the parties, the court stayed the consolidated
derivative action pending resolution of the motions to dismiss in the securities
class action.





As noted
above, the motions in the securities case were resolved on December 29,
2008.  Thereafter, on January 12, 2009, the parties to the derivative
action stipulated, and asked the Court to order, that plaintiff amend his
complaint.  The parties also agreed, and asked the Court to order,
that the schedule for defendants’ motion(s) to dismiss the amended complaint
shall be decided and submitted for approval after receipt of any amended
derivative complaint.  The Court has not yet signed the proposed order
associated with this stipulation.




We are
unable to predict the outcome of these cases.  A court determination
against us in the class action, and our indemnity obligations in the derivative
actions, 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 been cooperating on a voluntary basis with an investigation being
conducted by the SEC concerning the Company’s prior financial
restatement.  The SEC has issued a formal order of nonpublic
investigation and has issued subpoenas to certain of the Company’s former
officers.  The SEC’s investigation is a nonpublic, fact-finding
inquiry to determine if there have been violations of the federal securities
laws.






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 2008.




36
 Table of Contents




PART II




ITETEM 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 as reported by The Nasdaq Global
Market.




High
              
              
              LowYear
      ended December 30, 2007:First
      quarter
              
              $
              27.87
              
              
              $
              16.14Second
      quarter
              
              
              18.94
              
              
              
              11.48Third
      quarter
              
              
              16.98
              
              
              
              7.56Fourth
      quarter
              
              
              7.95
              
              
              
              4.55Year
      ended December 31, 2008:First
      quarter
              
              $
              6.10
              
              
              $
              4.51Second
      quarter
              
              
              5.49
              
              
              
              4.43Third
      quarter
              
              
              5.15
              
              
              
              3.70Fourth
      quarter
              
              
              4.44
              
              
              
              2.31




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 February 6, 2009, there were approximately 128 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.





37
 Table of Contents




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 31, 2008, the last trading day of our
2008 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 2 Year Cumulative Total Return


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









12/15/06
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  12/29/06
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  3/30/07
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  6/29/07
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  9/28/07
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  12/28/07
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  3/31/08
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  6/30/08
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  9/30/08
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  12/31/08Isilon
      Systems, Inc.
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  100.00
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  118.48
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  70.00
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  66.75
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  33.33
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  21.65
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  21.13
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  19.22
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  19.09
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  14.24NASDAQ
      Composite
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  100.00
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  98.29
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  98.55
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  105.94
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  109.94
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  108.84
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  92.75
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  93.32
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  85.13
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  64.18NASDAQ
      Computer
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  100.00
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  97.66
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  97.07
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  106.91
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  112.61
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  120.26
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  95.02
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  99.67
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  84.19
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  63.44





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.





38
 Table of Contents




Recent
Sales of Unregistered Securities




During
the fiscal year ended December 31, 2008, 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 31, 2008.





39
 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 31,
                                              
                                              
                                              December 30,
                                              
                                              
                                              December 31,
                                              
                                              
                                              January 1,
                                              
                                              
                                              January 2,2008
                                              
                                              
                                              2007
                                              
                                              
                                              2006
                                              
                                              
                                              2006
                                              
                                              
                                              2005Restated(3)(In
      thousands, except per share data)Consolidated
      Statements of Operations Data:Total
      revenue
                                              
                                              $
                                              114,422
                                              
                                              
                                              $
                                              88,998
                                              
                                              
                                              $
                                              61,206
                                              
                                              
                                              $
                                              21,083
                                              
                                              
                                              $
                                              7,653Total
      cost of revenue(1)
                                              
                                              
                                              49,988
                                              
                                              
                                              
                                              42,736
                                              
                                              
                                              
                                              28,808
                                              
                                              
                                              
                                              11,575
                                              
                                              
                                              
                                              4,163Gross
      profit
                                              
                                              
                                              64,434
                                              
                                              
                                              
                                              46,262
                                              
                                              
                                              
                                              32,398
                                              
                                              
                                              
                                              9,508
                                              
                                              
                                              
                                              3,490Operating
      expenses:Research
      and development(1)
                                              
                                              
                                              24,049
                                              
                                              
                                              
                                              19,903
                                              
                                              
                                              
                                              16,524
                                              
                                              
                                              
                                              12,478
                                              
                                              
                                              
                                              7,446Sales
      and marketing(1)
                                              
                                              
                                              47,363
                                              
                                              
                                              
                                              42,595
                                              
                                              
                                              
                                              24,390
                                              
                                              
                                              
                                              12,377
                                              
                                              
                                              
                                              6,305General
      and administrative(1)
                                              
                                              
                                              19,700
                                              
                                              
                                              
                                              14,945
                                              
                                              
                                              
                                              7,411
                                              
                                              
                                              
                                              3,681
                                              
                                              
                                              
                                              2,300Total
      operating expenses
                                              
                                              
                                              91,112
                                              
                                              
                                              
                                              77,443
                                              
                                              
                                              
                                              48,325
                                              
                                              
                                              
                                              28,536
                                              
                                              
                                              
                                              16,051Loss
      from operations
                                              
                                              
                                              (26,678
                                              )
                                              
                                              
                                              (31,181
                                              )
                                              
                                              
                                              (15,927
                                              )
                                              
                                              
                                              (19,028
                                              )
                                              
                                              
                                              (12,561
                                              )Total
      other income (expense), net(2)
                                              
                                              
                                              2,069
                                              
                                              
                                              
                                              4,470
                                              
                                              
                                              
                                              (9,952
                                              )
                                              
                                              
                                              (68)
                                              
                                              
                                              
                                              18Loss
      before income tax expense and cumulative effect of change in accounting
      principle
                                              
                                              
                                              (24,609
                                              )
                                              
                                              
                                              (26,711
                                              )
                                              
                                              
                                              (25,879
                                              )
                                              
                                              
                                              (19,096
                                              )
                                              
                                              
                                              (12,543
                                              )Income
      tax expense
                                              
                                              
                                              (469
                                              )
                                              
                                              
                                              (221
                                              )
                                              
                                              
                                              (109)
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Loss
      before cumulative effect of change in accounting principle
                                              
                                              
                                              (25,078
                                              )
                                              
                                              
                                              (26,932
                                              )
                                              
                                              
                                              (25,988
                                              )
                                              
                                              
                                              (19,096
                                              )
                                              
                                              
                                              (12,543
                                              )Cumulative
      effect of change in accounting principle(2)
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              (89)
                                              
                                              
                                              
                                              —Net
      loss
                                              
                                              $
                                              (25,078
                                              )
                                              
                                              $
                                              (26,932
                                              )
                                              
                                              $
                                              (25,988
                                              )
                                              
                                              $
                                              (19,185
                                              )
                                              
                                              $
                                              (12,543
                                              )Net
      loss per common share, basic and diluted
                                              
                                              $
                                              (0.40
                                              )
                                              
                                              $
                                              (0.44
                                              )
                                              
                                              $
                                              (3.09
                                              )
                                              
                                              $
                                              (3.95
                                              )
                                              
                                              $
                                              (3.61
                                              )Shares
      used in computing basic and diluted net loss per common
    share
                                              
                                              
                                              63,318
                                              
                                              
                                              
                                              61,514
                                              
                                              
                                              
                                              8,423
                                              
                                              
                                              
                                              4,852
                                              
                                              
                                              
                                              3,474____________(1)
      Includes stock-based compensation expense* as follows:Cost
      of revenue
                                              
                                              $
                                              124
                                              
                                              
                                              $
                                              149
                                              
                                              
                                              $
                                              24
                                              
                                              
                                              $
                                              —
                                              
                                              
                                              $
                                              —Research
      and development
                                              
                                              
                                              1,165
                                              
                                              
                                              
                                              702
                                              
                                              
                                              
                                              160
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Sales
      and marketing
                                              
                                              
                                              2,257
                                              
                                              
                                              
                                              1,601
                                              
                                              
                                              
                                              198
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —General
      and administrative
                                              
                                              
                                              2,359
                                              
                                              
                                              
                                              1,526
                                              
                                              
                                              
                                              258
                                              
                                              
                                              
                                              5
                                              
                                              
                                              
                                              4




*
            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 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.




40
 Table of Contents


As
      ofDecember 31,
                                      
                                      
                                      December 30,
                                      
                                      
                                      December
      31,
                                      
                                      
                                      January 1,
                                      
                                      
                                      January
      2,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006
                                      
                                      
                                      2006
                                      
                                      
                                      2005Restated(1)(In
      thousands)Consolidated
      Balance Sheet Data:Cash,
      cash equivalents and marketable securities
                                      
                                      $
                                      77,783
                                      
                                      
                                      $
                                      85,861
                                      
                                      
                                      $
                                      99,899
                                      
                                      
                                      $
                                      12,656
                                      
                                      
                                      $
                                      8,618Working
      capital
                                      
                                      
                                      70,840
                                      
                                      
                                      
                                      87,251
                                      
                                      
                                      
                                      108,519
                                      
                                      
                                      
                                      7,332
                                      
                                      
                                      
                                      7,204Total
      assets
                                      
                                      
                                      120,190
                                      
                                      
                                      
                                      131,538
                                      
                                      
                                      
                                      136,734
                                      
                                      
                                      
                                      28,241
                                      
                                      
                                      
                                      17,550Preferred
      stock warrant liability
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      367
                                      
                                      
                                      
                                      —Current
      and long-term notes payable and capital lease obligations
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      7,543
                                      
                                      
                                      
                                      1,474Convertible
      preferred stock
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      59,549
                                      
                                      
                                      
                                      39,736Common
      stock and additional paid-in capital
                                      
                                      
                                      197,685
                                      
                                      
                                      
                                      191,255
                                      
                                      
                                      
                                      185,948
                                      
                                      
                                      
                                      324
                                      
                                      
                                      
                                      158Total
      stockholders’ equity (deficit)
                                      
                                      
                                      70,023
                                      
                                      
                                      
                                      88,589
                                      
                                      
                                      
                                      110,207
                                      
                                      
                                      
                                      (49,375
                                      )
                                      
                                      
                                      (30,327


`




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.  41
 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.Beginning in fiscal 2008, we
reported financial results based on a calendar year end with fiscal year 2008
ending on December 31, 2008.  Prior to 2008, we reported 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 and 2006 refers to the fiscal
year ended December 31, 2006.





Restatement
of Previously Issued Consolidated Financial Statements




As
announced on November 8, 2007, our Audit Committee, assisted by independent
forensic accountants and legal advisors, initiated an independent investigation
of certain of our sales to resellers and other customers to determine whether
commitments were made that had an impact on the timing and treatment of revenue
recognition, and whether our internal controls relating to revenue recognition
were sufficient. 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.




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 2 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 file-based data.
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.




42
 Table of Contents




We sell
scale-out NAS 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 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 file-based data. 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.




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, 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.




43
 Table of Contents




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;




·
            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.




44
 Table of Contents




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 we have 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 our support services as measured by the renewal prices offered to and
paid by our 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 our
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.




45
 Table of Contents




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 $250,000  and $324,000 as of
December 31, 2008 and December 30, 2007, respectively.






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.





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 2008,
we recorded non-cash stock-based compensation expense of $5.9 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 31, 2008, our total
unrecognized compensation expense related to stock-based awards granted in
accordance with SFAS 123(R) since January 2, 2006 was
$18.0 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.  Stock-based compensation expense during 2008 relating to
awards to non-employees was $124,000. As of December 31, 2008, there was no
unrecognized compensation expense related to stock-based awards granted in
accordance with EITF 96-18.





46
 Table of Contents




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.





Inventory
Valuation




Inventories
are primarily comprised of finished systems, service spares and evaluation units
and are accounted for using first-in, first-out (“FIFO”) method using a lower of
cost or market valuation. Spares inventory consists of components and finished
goods used to support our field services organization. Evaluation units are
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. In order to fulfill our obligations
related to the hardware support services that we sell, we also hold component
parts and finished systems in our inventory that are used to repair and replace
broken hardware. 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 $2.1 million and $934,000
as of December 31, 2008 and December 30, 2007,
respectively.






Accounting
for Income Taxes




At
December 31, 2008, we had $117.6 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 2028.
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 31, 2008, we had gross deferred tax assets of $42.3
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 $42.3
million of gross deferred tax assets as of December 31, 2008. 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.




47
 Table of Contents




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.




Year
      EndedDecember 31,
                    
                    
                    December 30,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006Restated(1)(Dollars
      in thousands)Revenue
      by type:Product
                    
                    $
                    91,946
                    
                    
                    $
                    74,434
                    
                    
                    $
                    53,137Services
                    
                    
                    22,476
                    
                    
                    
                    14,564
                    
                    
                    
                    8,069Total
      revenue
                    
                    $
                    114,422
                    
                    
                    $
                    88,998
                    
                    
                    $
                    61,206%
      revenue by type:Product
                    
                    
                    80
                    %
                    
                    
                    84
                    %
                    
                    
                    87
                    %Services
                    
                    
                    20
                    
                    
                    
                    16
                    
                    
                    
                    13Total
                    
                    
                    100
                    %
                    
                    
                    100
                    %
                    
                    
                    100
                    %Revenue
      by geography:Domestic
                    
                    $
                    74,612
                    
                    
                    $
                    64,936
                    
                    
                    $
                    46,465International
                    
                    
                    39,810
                    
                    
                    
                    24,062
                    
                    
                    
                    14,741Total
      revenue
                    
                    $
                    114,422
                    
                    
                    $
                    88,998
                    
                    
                    $
                    61,206%
      revenue by geography:Domestic
                    
                    
                    65
                    %
                    
                    
                    73
                    %
                    
                    
                    76
                    %International
                    
                    
                    35
                    
                    
                    
                    27
                    
                    
                    
                    24Total
                    
                    
                    100
                    %
                    
                    
                    100
                    %
                    
                    
                    100
                    %Revenue
      by sales channel:Direct
                    
                    $
                    53,171
                    
                    
                    $
                    40,464
                    
                    
                    $
                    34,431Indirect
                    
                    
                    61,251
                    
                    
                    
                    48,534
                    
                    
                    
                    26,775Total
      revenue
                    
                    $
                    114,422
                    
                    
                    $
                    88,998
                    
                    
                    $
                    61,206%
      revenue by sales channel:Direct
                    
                    
                    46
                    %
                    
                    
                    45
                    %
                    
                    
                    56
                    %Indirect
                    
                    
                    54
                    
                    
                    
                    55
                    
                    
                    
                    44Total
                    
                    
                    100
                    %
                    
                    
                    100
                    %
                    
                    
                    100
                    %




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.





48
 Table of Contents




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.






Year
      EndedDecember 31,
                    
                    
                    December 30,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006Restated(1)(Dollars
      in thousands)Revenue:Product
                    
                    $
                    91,946
                    
                    
                    $
                    74,434
                    
                    
                    $
                    53,137Services
                    
                    
                    22,476
                    
                    
                    
                    14,564
                    
                    
                    
                    8,069Total
      revenue
                    
                    $
                    114,422
                    
                    
                    $
                    88,998
                    
                    
                    $
                    61,206Cost
      of revenue:Product
                    
                    $
                    36,775
                    
                    
                    $
                    33,761
                    
                    
                    $
                    25,186Services
                    
                    
                    13,213
                    
                    
                    
                    8,975
                    
                    
                    
                    3,622Total
      cost of revenue
                    
                    $
                    49,988
                    
                    
                    $
                    42,736
                    
                    
                    $
                    28,808Gross
      margin:Product
                    
                    
                    60
                    %
                    
                    
                    55
                    %
                    
                    
                    53
                    %Services
                    
                    
                    41
                    %
                    
                    
                    38
                    %
                    
                    
                    55
                    %Total
      gross margin
                    
                    
                    56
                    %
                    
                    
                    52
                    %
                    
                    
                    53
                    %




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.




49
 Table of Contents




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, through the end of fiscal 2007 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 31,
                    
                    
                    December 30,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006(Dollars
      in thousands)Research
      and development expenses
                    
                    $
                    24,049
                    
                    
                    $
                    19,903
                    
                    
                    $
                    16,524Percent
      of total revenue
                    
                    
                    21
                    %
                    
                    
                    22
                    %
                    
                    
                    27
                    %




Sales and Marketing
Expenses.  Sales and marketing expenses primarily include
personnel costs, sales commissions, professional services fees, trade shows,
marketing programs, facilities and depreciation 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 and 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 fully productive. Accordingly, the timing of
sales personnel hiring and the rate at which they become productive will affect
our future performance.




Year
      EndedDecember 31,
                        
                        
                        December 30,
                        
                        
                        December 31,2008
                        
                        
                        2007
                        
                        
                        2006(Dollars
      in thousands)Sales
      and marketing expenses
                        
                        $
                        47,363
                        
                        
                        $
                        42,595
                        
                        
                        $
                        24,390Percent
      of total revenue
                        
                        
                        41
                        %
                        
                        
                        48
                        %
                        
                        
                        40
                        %





General and Administrative
Expenses.  General and administrative expenses primarily
include personnel costs, facilities expenses related to our executive, finance,
human resources, information technology and legal organizations, bad debt
expense, public company related expenses, and fees for professional services
such as legal, accounting, compliance and information systems. Also included in
general and administrative expenses are attorneys’ fees and costs for the legal
proceedings described in more detail in Part II, Note 12, Notes to Consolidated
Financial Statements, as well as costs associated with our completed 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.




Year
      EndedDecember 31,
                      
                      
                      December 30,
                      
                      December 31,2008
                      
                      
                      2007
                      
                      2006(Dollars
      in thousands)General
      and administrative expenses
                      
                      $
                      19,700
                      
                      
                      $
                      14,945
                      
                      
                      $
                      7,411Percent
      of total revenue
                      
                      
                      17
                      %
                      
                      
                      17
                      %
                      
                      
                      12
                      %




50
 Table of Contents




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 other income (expense), net,
included an adjustment to record our preferred stock warrants at fair value in
accordance with FSP 150-5.




Year
      EndedDecember 31,
                        
                        
                        December 30,
                        
                        
                        December 31,2008
                        
                        
                        2007
                        
                        
                        2006(In
      thousands)Interest
      income and other
                        
                        $
                        2,069
                        
                        
                        $
                        4,470
                        
                        
                        $
                        230Interest
      expense
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        (1,751
                        )Warrant
      revaluation expense
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        (8,431
                        )Other
      income (expense), net
                        
                        $
                        2,069
                        
                        
                        $
                        4,470
                        
                        
                        $
                        (9,952
                        )







Fiscal
2008 Compared With Fiscal 2007




Revenue.  Total
revenue was $114.4 million in 2008 compared to $89.0 million in 2007,
an increase of 29%. This growth has been driven primarily by an increase in our
customer base, reorders from our existing customer base, expanded product
offerings and revenue from our recently established international markets,
particularly in Asia.





Our
customer base increased 35% from December 30, 2007 to December 31, 2008 and the
number of new customers added in 2008 was 239, representing a 25% decrease
compared to 320 new customers added in 2007. We believe this decrease is due, in
part, to difficulties in our ability to obtain new customers during 2008 due to
the uncertainty created by our internal investigation and related matters,
including our delayed SEC filings and the status of our NASDAQ listing. A
majority of our customers that buy our storage systems later add to their
storage cluster.  In 2008, reorders from existing customers
represented approximately 79% of total revenue, compared to 58% in
2007.  The average initial order size decreased 10% from 2007 to 2008,
while the average reorder size increased 2% in the same comparative
period.  The overall average order size remained consistent
year-over-year. In 2008, no single customer accounted for more than 10% of our
total revenue, compared to 2007 when Eastman Kodak Company accounted for 10% of
total 2007 revenue.




The
growth in our revenue has also been driven by new product introductions. In 2008
we introduced the X-series product line as well as our OneFS® 5.0 operating
system. These new products offer new features and functionality that allow us to
market to a broader array of customers.




We
generated 35% of our total revenue in 2008 from international locations,
compared to 27% in 2007.  We plan to continue to expand into
international locations and introduce our products in new markets directly and
indirectly through channel partners.  In 2008, we derived 54% of our
total revenue from indirect channels compared to 55% in 2007.





Service
revenue increased $7.9 million, or 54%, to $22.5 million in 2008 from $14.6
million in 2007.  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 many of our customers continue to renew their service contracts,
we expect services revenues to continue to grow.





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 Table of Contents




Gross
Margin.  Gross margin increased four percentage points to 56%
in 2008 from 52% in 2007. Gross margin for product revenue increased five
percentage points to 60% in 2008 from 55% in 2007. The increase in product
revenue gross margin was primarily due to increased customer adoption of our new
generation of software applications and lower product discounting together with
a reduction in component costs. Additionally, after restating our first quarter
2007 results, gross margin for 2007 included costs of product revenue for
transactions for which no revenue was recorded, reducing gross margins by
approximately 1%.





All of
our software applications carry a higher gross margin than our overall product
margin. During 2008, approximately 57% of our customers purchased one or more of
our four software applications compared to approximately 51% in
2007.   Additionally, 64% of our new customers purchased one or
more of our software applications compared to 50% in 2007.





We have
experienced and expect to continue to experience pricing pressures within our
industry as the price per terabyte of storage decreases year over year. This
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-third of the product cost.
Historically, disk drives have decreased in price approximately 30% from year to
year.  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 unit
basis.  This added to the overall increase in product gross margin
year over year.




Gross
margin for services revenue increased three percentage points to 41% in 2008
from 38% in 2007. Services revenue includes support services for both our
software and our hardware products and professional services fees. 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 2008, we continued to
incur expenditures related to our customer service and support structure,
including hiring new personnel, transitioning from one primary third party
maintenance provider to our current service provider, expanding our service
organization geographically to enhance the reliability and responsiveness for
our customers. These costs were offset by an increase in customer renewal rates
for our support services as well as a decrease in stock-based compensation
expense related to services costs of revenue.





As our
customer base continues to grow, it will be necessary for us to continue to
incur significant upfront expenditures on our customer service and support
structure to support this growth.  The rate at which we add new
customers as well as the added complexity of managing spares inventory located
in various geographic regions will affect the amount of these upfront
expenditures.  The timing of these additional expenditures could
materially affect our cost of revenue, both in absolute dollars and as a
percentage of total revenue, in any particular period.  This could
cause downward pressure on services and total gross margins.  We
believe that we will experience increases in gross margin as our supply chain
reaches economies of scale and as software revenue, which has a higher gross
margin, increases as a percentage of our total revenue.





Research and Development
Expenses.  Research and development expenses increased
$4.1 million, or 21%, to $24.0 million in 2008 from $19.9 million
in 2007. Research and development employees increased to 137 at December 31,
2008 from 103 at December 30, 2007. The increase in expenses year over year
was primarily due to an increase in salaries and benefits and stock-based
compensation expense. Stock-based compensation expense related to research and
development increased to $1.2 million in 2008 from $702,000 in 2007. As a
percent of 2008 revenue, research and development expense fell slightly to 21%
from 22% in 2007.




Sales and Marketing
Expenses.  Sales and marketing expenses increased
$4.8 million, or 11%, to $47.4 million in 2008 from $42.6 million in
2007. Sales and marketing employees increased to 157 at December 31, 2008 from
141 at December 30, 2007. The year over year increase in sales and
marketing expenses was primarily due to variable compensation costs associated
with higher revenues, professional services fees and stock-based compensation
expense. Stock-based compensation expense included in sales and marketing
expenses was $2.3 million in 2008 compared with $1.6 million in 2007. As a
percent of 2008 revenue, sales and marketing expense decreased to 41% from 48%
in 2007.




General and Administrative
Expenses.  General and administrative expenses increased
$4.8 million, or 32%, to $19.7 million in 2008 from $14.9 million in
2007. General and administrative employees increased to 48 at December 31, 2008
from 44 at December 30, 2007. The increase year over year was primarily due
to professional service fees, which included $1.0 million in attorneys’ fees and
costs for legal proceedings, and $3.1 million in fees associated with our Audit
Committee investigation and restatement of prior period financial results
compared to $1.5 million in 2007. Also contributing to the increase were
increases in stock-based compensation and salaries and benefits.  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 $2.4 million in
2008 from $1.5 million in 2007. As a percent of 2008 revenue, general and
administrative expense remained flat at 17% compared to 2007.




Other Income (Expense),
Net.  Other income(expense), net decreased $2.4 million to $2.1
million in income in 2008 from $4.5 million in income in 2007.  The
decrease was entirely due to a decrease in our interest income of $2.4 million
related to a decrease in market interest rates on our investments as well as a
lower cash, cash equivalents, and marketable securities balance.




52
 Table of Contents





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.




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 incur expenditures related to 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.




53
 Table of Contents




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.








Liquidity
and Capital Resources




As of
December 31, 2008, our principal sources of liquidity consisted of cash,
cash equivalents, and marketable securities of $77.8 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. 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.




54
 Table of Contents




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.  For the
year ended December 31, 2008, the foreign currency effect on our cash and cash
equivalents was  a decrease of $176,000, compared to an increase of
$2,000 for the year ended December 30, 2007 and an increase of $4,000 for the
year ended December 31, 2006.




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




As
      ofDecember 31,
                    
                    
                    December 30,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006Restated(1)(In
      thousands)Working
      capital
                    
                    $
                    70,840
                    
                    
                    $
                    87,251
                    
                    
                    $
                    108,519Cash,
      cash equivalents and marketable securities
                    
                    
                    77,783
                    
                    
                    
                    85,861
                    
                    
                    
                    99,899




(1)
            See
      Note 2, "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 31,
                  
                  
                  December 30,
                  
                  
                  December 31,2008
                  
                  
                  2007
                  
                  
                  2006Restated(1)(In
      thousands)Net
      cash used in operating activities
                  
                  $
                  (2,193
                  )
                  
                  $
                  (6,950
                  )
                  
                  $
                  (17,300
                  )Net
      cash used in investing activities
                  
                  
                  (2,758
                  )
                  
                  
                  (53,870
                  )
                  
                  
                  (3,491
                  )Net
      cash provided by (used in) financing activities
                  
                  
                  470
                  
                  
                  
                  (82)
                  
                  
                  
                  109,833




(1)
            See
      Note 2, "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
expenditures incurred 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. Accounts receivable
levels at quarter-ends have historically been affected by the timing of orders
from our customers during the quarter.





55
 Table of Contents




Net cash
used in operating activities was $2.2 million, $7.0 million, and
$17.3 million in 2008, 2007, and 2006, respectively. Net cash used in
operating activities in 2008 consisted primarily of our net loss of $25.1
million offset by a $9.0 million increase in deferred revenue, $6.3 million of
depreciation and amortization expense, $5.9 million of stock based compensation
expense, and a $5.7 million decrease in accounts receivable.  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 of our net loss of $26.0 million and
a $ 15.4 million increase in net accounts receivable offset by a
$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.








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 2008 was $2.8 million, comprised of $6.6 million
of capital expenditures, primarily related to continued purchases of research
and development lab equipment, offset by $3.8 million of net sales of marketable
securities.





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.







Cash
Flows from Financing Activities




Net cash
provided by financing activities was $470,000 in 2008, primarily related to cash
proceeds from the issuance of common stock in connection with stock option
exercises.  Net cash used by financing activities was $82,000 in 2007
and net cash provided by financing activities were $109.8 million
in 2006.  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.




We
believe that our $77.8 million of cash, cash equivalents, and marketable
securities as of December 31, 2008, 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, our ability to achieve sustainable profitability, 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.




56
 Table of Contents




Contractual
Obligations




The
following is a summary of our contractual obligations as of December 31,
2008:




Payments
      Due by PeriodLess
      Than
                            
                            
                            1
      - 3
                            
                            
                            3
      - 5
                            
                            
                            More
      ThanTotal
                            
                            
                            1 Year
                            
                            
                            Years
                            
                            
                            Years
                            
                            
                            5 Years(In
      thousands)Operating
      lease obligations
                            
                            $
                            14,941
                            
                            
                            $
                            3,254
                            
                            
                            $
                            5,590
                            
                            
                            $
                            5,039
                            
                            
                            $
                            1,058Purchase
      obligations (1)
                            
                            
                            5,238
                            
                            
                            
                            5,238
                            
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            —Total
                            
                            $
                            20,179
                            
                            
                            $
                            8,492
                            
                            
                            $
                            5,590
                            
                            
                            $
                            5,039
                            
                            
                            $
                            1,058




(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 31, 2008,
      was $5.2 million.






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 31, 2008, we believe our exposure
related to the above guarantees and indemnities at December 31, 2008 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 31, 2008 and December 30, 2007.






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
No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods of those fiscal
years. In February 2008, the FASB released a FASB Staff Position No. 157,
Effective Date of FASB
Statement No. 157, which delays the effective date of SFAS
No. 157 for all nonfinancial assets and nonfinancial liabilities, except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually) to fiscal years beginning after
November 15, 2008. We do not expect the adoption of SFAS No. 157 for
nonfinancial assets and liabilities to have a material effect on our
consolidated results of operations and financial condition. The partial adoption
of SFAS No. 157 for financial assets and liabilities did not have a
material impact on our consolidated financial position, results of operations or
cash flows.





57
 Table of Contents





ITEM 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 Australian dollar, the Chinese yuan, 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 31,
2008, we had $1.6 million 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 $34 million and marketable securities
of $43 million as of December 31, 2008, which were held for working
capital purposes. We do not enter into investments for trading or speculative
purposes. The fair value of our marketable securities fluctuates based on
changes in market conditions and interest rates.  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 maturities of our investments, anticipated
declining interest rates will negatively impact our investment
income.  If overall interest rates had fallen by 10% in 2008, our
interest income on cash and cash equivalents would have declined approximately
$200,000, assuming consistent investment levels.


58
 Table of Contents





ITEM 8.Financial Statements and
Supplementary Data




INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS




PageReport
      of Independent Registered Public Accounting Firm
                60Consolidated
      Balance Sheets
                61Consolidated
      Statements of Operations
                62Consolidated
      Statements of Changes in Mandatorily Redeemable Convertible Preferred
      Stock and Stockholders’ Equity (Deficit) and Comprehensive
      Loss
                63Consolidated
      Statements of Cash Flows
                64Notes
      to Consolidated Financial Statements
                65




59
 Table of Contents





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM







ToThe 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 31, 2008 and December 30, 2007, and
the results of its operations and its cash flows for each of the three years in
the period ended December 31, 2008 in conformity with accounting principles
generally accepted in the United States of America.  In addition, in
our opinion, the schedule of valuation and qualifying accounts appearing under
Item 15 presents fairly, in all material respects, the information set forth
therein when read in conjunction with the related consolidated financial
statements.  Also in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2008, 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 and financial statement schedule, 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 Reporting
appearing under Item 9A.  Our responsibility is to express opinions on
these financial statements, on the financial statement schedule , and on the
Company's internal control over financial reporting based on our audits (which
were integrated audits in 2008 and 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 2 to the consolidated financial statements, the Company has
restated it 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


February
19, 2009




60
 Table of Contents





Isilon
Systems, Inc.


Consolidated
Balance Sheets





As
      ofDecember
      31,
                                        2008
                                      
                                      
                                      December
      30,
                                        2007(In
      thousands, except per share data)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                      
                                      $
                                      34,342
                                      
                                      
                                      $
                                      38,999Marketable
      securities
                                      
                                      
                                      43,441
                                      
                                      
                                      
                                      46,862Trade
      receivables, net of allowances of $250 and $324,
    respectively
                                      
                                      
                                      14,436
                                      
                                      
                                      
                                      20,152Inventories
                                      
                                      
                                      12,433
                                      
                                      
                                      
                                      9,430Other
      current assets
                                      
                                      
                                      4,243
                                      
                                      
                                      
                                      5,524Total
      current assets
                                      
                                      
                                      108,895
                                      
                                      
                                      
                                      120,967Property
      and equipment, net
                                      
                                      
                                      11,295
                                      
                                      
                                      
                                      10,571Total
      assets
                                      
                                      $
                                      120,190
                                      
                                      
                                      $
                                      131,538LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
                                      
                                      $
                                      9,779
                                      
                                      
                                      $
                                      10,962Accrued
      liabilities
                                      
                                      
                                      4,188
                                      
                                      
                                      
                                      5,182Accrued
      compensation and related benefits
                                      
                                      
                                      5,879
                                      
                                      
                                      
                                      5,180Deferred
      revenue
                                      
                                      
                                      18,209
                                      
                                      
                                      
                                      12,392Total
      current liabilities
                                      
                                      
                                      38,055
                                      
                                      
                                      
                                      33,716Deferred
      revenue, net of current portion
                                      
                                      
                                      8,954
                                      
                                      
                                      
                                      5,819Deferred
      rent, net of current portion
                                      
                                      
                                      3,158
                                      
                                      
                                      
                                      3,414Total
      liabilities
                                      
                                      
                                      50,167
                                      
                                      
                                      
                                      42,949Commitments
      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; 63,885 and
      62,918 shares issued and outstanding
                                      
                                      
                                      1
                                      
                                      
                                      
                                      1Additional
      paid-in capital
                                      
                                      
                                      197,685
                                      
                                      
                                      
                                      191,254Accumulated
      other comprehensive income (loss)
                                      
                                      
                                      5
                                      
                                      
                                      
                                      (76
                                      )Accumulated
      deficit
                                      
                                      
                                      (127,668
                                      )
                                      
                                      
                                      (102,590
                                      )Total
      stockholders' equity
                                      
                                      
                                      70,023
                                      
                                      
                                      
                                      88,589Total
      liabilities and stockholders' equity
                                      
                                      $
                                      120,190
                                      
                                      
                                      $
                                      131,538




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





61
 Table of Contents





Isilon
Systems, Inc.


Consolidated
Statements of Operations




Year
      EndedDecember
      31, 2008
                                                                                              
                                                                                              
                                                                                              December
      30, 2007
                                                                                              
                                                                                              
                                                                                              December
      31, 2006Restated(2)(In
      thousands, except per share data)Revenue:Product
                                                                                              
                                                                                              $
                                                                                              91,946
                                                                                              
                                                                                              
                                                                                              $
                                                                                              74,434
                                                                                              
                                                                                              
                                                                                              $
                                                                                              53,137Services
                                                                                              
                                                                                              
                                                                                              22,476
                                                                                              
                                                                                              
                                                                                              
                                                                                              14,564
                                                                                              
                                                                                              
                                                                                              
                                                                                              8,069Total
      revenue
                                                                                              
                                                                                              
                                                                                              114,422
                                                                                              
                                                                                              
                                                                                              
                                                                                              88,998
                                                                                              
                                                                                              
                                                                                              
                                                                                              61,206Cost
      of revenue:Product
                                                                                              
                                                                                              
                                                                                              36,775
                                                                                              
                                                                                              
                                                                                              
                                                                                              33,761
                                                                                              
                                                                                              
                                                                                              
                                                                                              25,186Services(1)
                                                                                              
                                                                                              
                                                                                              13,213
                                                                                              
                                                                                              
                                                                                              
                                                                                              8,975
                                                                                              
                                                                                              
                                                                                              
                                                                                              3,622Total
      cost of revenue
                                                                                              
                                                                                              
                                                                                              49,988
                                                                                              
                                                                                              
                                                                                              
                                                                                              42,736
                                                                                              
                                                                                              
                                                                                              
                                                                                              28,808Gross
      profit
                                                                                              
                                                                                              
                                                                                              64,434
                                                                                              
                                                                                              
                                                                                              
                                                                                              46,262
                                                                                              
                                                                                              
                                                                                              
                                                                                              32,398Operating
      expenses:Research
      and development(1)
                                                                                              
                                                                                              
                                                                                              24,049
                                                                                              
                                                                                              
                                                                                              
                                                                                              19,903
                                                                                              
                                                                                              
                                                                                              
                                                                                              16,524Sales
      and marketing(1)
                                                                                              
                                                                                              
                                                                                              47,363
                                                                                              
                                                                                              
                                                                                              
                                                                                              42,595
                                                                                              
                                                                                              
                                                                                              
                                                                                              24,390General
      and administrative(1)
                                                                                              
                                                                                              
                                                                                              19,700
                                                                                              
                                                                                              
                                                                                              
                                                                                              14,945
                                                                                              
                                                                                              
                                                                                              
                                                                                              7,411Total
      operating expenses
                                                                                              
                                                                                              
                                                                                              91,112
                                                                                              
                                                                                              
                                                                                              
                                                                                              77,443
                                                                                              
                                                                                              
                                                                                              
                                                                                              48,325Loss
      from operations
                                                                                              
                                                                                              
                                                                                              (26,678
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (31,181
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (15,927
                                                                                              )Other
      income (expense), netInterest
      income and other
                                                                                              
                                                                                              
                                                                                              2,069
                                                                                              
                                                                                              
                                                                                              
                                                                                              4,470
                                                                                              
                                                                                              
                                                                                              
                                                                                              230Interest
      expense
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              (1,751
                                                                                              )Warrant
      revaluation expense
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              (8,431
                                                                                              )Total
      other income (expense), net
                                                                                              
                                                                                              
                                                                                              2,069
                                                                                              
                                                                                              
                                                                                              
                                                                                              4,470
                                                                                              
                                                                                              
                                                                                              
                                                                                              (9,952
                                                                                              )Loss
      before income tax expense
                                                                                              
                                                                                              
                                                                                              (24,609
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (26,711
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (25,879
                                                                                              )Income
      tax expense
                                                                                              
                                                                                              
                                                                                              (469
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (221
                                                                                              )
                                                                                              
                                                                                              
                                                                                              (109
                                                                                              )Net
      loss
                                                                                              
                                                                                              $
                                                                                              (25,078
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (26,932
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (25,988
                                                                                              )Net
      loss per common share, basic and diluted
                                                                                              
                                                                                              $
                                                                                              (0.40
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (0.44
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (3.09
                                                                                              )Shares
      used in computing basic and diluted net loss per common
    share
                                                                                              
                                                                                              
                                                                                              63,318
                                                                                              
                                                                                              
                                                                                              
                                                                                              61,514
                                                                                              
                                                                                              
                                                                                              
                                                                                              8,423(1) Includes
      stock-based compensation expense as follows:Cost
      of services revenue
                                                                                              
                                                                                              $
                                                                                              124
                                                                                              
                                                                                              
                                                                                              $
                                                                                              149
                                                                                              
                                                                                              
                                                                                              $
                                                                                              24Research
      and development
                                                                                              
                                                                                              
                                                                                              1,165
                                                                                              
                                                                                              
                                                                                              
                                                                                              702
                                                                                              
                                                                                              
                                                                                              
                                                                                              160Sales
      and marketing
                                                                                              
                                                                                              
                                                                                              2,257
                                                                                              
                                                                                              
                                                                                              
                                                                                              1,601
                                                                                              
                                                                                              
                                                                                              
                                                                                              198General
      and administrative
                                                                                              
                                                                                              
                                                                                              2,359
                                                                                              
                                                                                              
                                                                                              
                                                                                              1,526
                                                                                              
                                                                                              
                                                                                              
                                                                                              258




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






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




62
 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 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
                                                                                                                                                    )
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    110,207Common
      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
                                                                                                                                                    )
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    88,589Common
      stock issued in connection with exercise of stock options
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    983
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    483
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    483Vesting
      of early-exercised stock options
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    73
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    73Repurchase
      of shares of unvested common stock
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    (16
                                                                                                                                                    )
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —Stock-based
      compensation expense
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    5,875
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    5,875Comprehensive
      loss:Net
      loss
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    (25,078
                                                                                                                                                    )Unrealized
      gain on marketable securities
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    288
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —Foreign
      currency translation adjustment
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    (207
                                                                                                                                                    )
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —Total
      comprehensive loss
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    (24,997)Balances
      as of December 31, 2008
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    —
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    63,885
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    1
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    197,685
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    5
                                                                                                                                                    
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    (127,668
                                                                                                                                                    )
                                                                                                                                                    
                                                                                                                                                    $
                                                                                                                                                    70,023




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
  Statements.





The
accompanying notes are an integral part of these consolidated financial
statement


63
 Table of Contents




Isilon
Systems, Inc.


Consolidated
Statements of Cash Flows




Year
      EndedDecember
      31,
                    2008
                  
                  
                  December
      30,
                    2007
                  
                  
                  December
      31,
                    2006Restated(1)(in
      thousands)Cash
      flows from operating activitiesNet
      loss
                  
                  $
                  (25,078
                  )
                  
                  $
                  (26,932
                  )
                  
                  $
                  (25,988
                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
                  
                  
                  6,255
                  
                  
                  
                  5,337
                  
                  
                  
                  4,169Realized
      gain on sale of marketable securities
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (14
                  )Non-cash
      interest expense
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  646Amortization
      of discount on marketable securities
                  
                  
                  (112
                  )
                  
                  
                  (182
                  )
                  
                  
                  —Stock-based
      compensation expense
                  
                  
                  5,905
                  
                  
                  
                  3,978
                  
                  
                  
                  640Loss
      on disposal of property and equipment
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  76Warrant
      revaluation expense
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  8,431Changes
      in operating assets and liabilities:Accounts
      receivable, net
                  
                  
                  5,715
                  
                  
                  
                  3,056
                  
                  
                  
                  (15,386
                  )Inventories
                  
                  
                  (3,112
                  )
                  
                  
                  (5,305
                  )
                  
                  
                  (1,167
                  )Other
      current assets
                  
                  
                  1,370
                  
                  
                  
                  (3,032
                  )
                  
                  
                  (1,810
                  )Accounts
      payable
                  
                  
                  (1,624)
                  
                  
                  
                  4,914
                  
                  
                  
                  3,201Accrued
      liabilities, compensation payable and deferred rent
                  
                  
                  (464)
                  
                  
                  
                  3,857
                  
                  
                  
                  2,134Deferred
      revenue
                  
                  
                  8,952
                  
                  
                  
                  7,359
                  
                  
                  
                  7,768Net
      cash used in operating activities
                  
                  
                  (2,193
                  )
                  
                  
                  (6,950
                  )
                  
                  
                  (17,300
                  )Cash
      flows from investing activitiesPurchases
      of property and equipment
                  
                  
                  (6,576
                  )
                  
                  
                  (7,284
                  )
                  
                  
                  (5,340
                  )Purchases
      of marketable securities
                  
                  
                  (53,359
                  )
                  
                  
                  (71,581
                  )
                  
                  
                  (691
                  )Proceeds
      from maturities of marketable securities
                  
                  
                  57,177
                  
                  
                  
                  24,995
                  
                  
                  
                  2,508Proceeds
      from sale of property and equipment
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  32Net
      cash used in investing activities
                  
                  
                  (2,758
                  )
                  
                  
                  (53,870
                  )
                  
                  
                  (3,491
                  )Cash
      flows from financing activitiesProceeds
      from issuance of preferred stock
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  9,945Proceeds
      from issuance of common stock
                  
                  
                  483
                  
                  
                  
                  782
                  
                  
                  
                  108,801Proceeds
      from issuance of common stock, employee stock purchase
plan
                  
                  
                  —
                  
                  
                  
                  365
                  
                  
                  
                  —Proceeds
      from notes payable
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  54,524Repurchases
      of unvested common stock
                  
                  
                  (13
                  )
                  
                  
                  (94
                  )
                  
                  
                  —Payment
      of offering costs
                  
                  
                  —
                  
                  
                  
                  (1,135
                  )
                  
                  
                  (1,376
                  )Payments
      of notes payable and capital lease obligations
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (62,061
                  )Net
      cash provided by (used in) financing activities
                  
                  
                  470
                  
                  
                  
                  (82
                  )
                  
                  
                  109,833Effect
      of exchange rate changes on cash and cash equivalents
                  
                  
                  (176)
                  
                  
                  
                  2
                  
                  
                  
                  4Net
      (decrease) increase in cash and cash equivalents
                  
                  
                  (4,657
                  )
                  
                  
                  (60,900
                  )
                  
                  
                  89,046Cash
      and cash equivalents at beginning of year
                  
                  
                  38,999
                  
                  
                  
                  99,899
                  
                  
                  
                  10,853Cash
      and cash equivalents at end of year
                  
                  $
                  34,342
                  
                  
                  $
                  38,999
                  
                  
                  $
                  99,899Supplemental
      dislosure of cash flow information:Cash
      paid for interest
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  1,141Cash
      paid for income taxes
                  
                  
                  391
                  
                  
                  
                  69
                  
                  
                  
                  17Non-cash
      investing and financing activities:Additions
      to property and equipment included in accounts payable
                  
                  
                  735
                  
                  
                  
                  449
                  
                  
                  
                  231Vesting
      of early exercise-excised stock options
                  
                  
                  73
                  
                  
                  
                  223
                  
                  
                  
                  143Additions
      to property and equipment provided by lessor
                  
                  
                  —
                  
                  
                  
                  1,209
                  
                  
                  
                  2,417Debt
      discount resulting from the issuance of warrants
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  540Unrealized gain
      on marketable securities
                  
                  
                  288
                  
                  
                  
                  94
                  
                  
                  
                  14Accrued
      initial public offering costs
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  1,033Conversion
      of mandatorily redeemable convertible preferred stock warrants to common
      stock warrants
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  9,338




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




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





64
 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 scale-out NAS
storage systems for storing and managing file-based data. 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.





Public
Offerings




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.








Significant
Accounting Policies




Fiscal
Year End




Through
the end of 2007, the Company operated 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 and its fiscal year 2006 ended on December 31,
2006. Beginning in fiscal 2008, the Company operates on a calendar year end with
fiscal year 2008 ending on December 31, 2008.




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, the reported amounts of revenue and expenses during the reporting
period, and the disclosure of contingent assets and liabilities at the date of
the financial statements. Significant estimates are inherent in the preparation
of the consolidated financial statements and include accounting for revenue, the
allowance for doubtful accounts, inventory valuation, the valuation allowance on
deferred tax assets, and the valuation of stock-based compensation expense. Some
of these estimates require difficult, subjective or complex judgment about
matters that are uncertain. Actual results could differ from those
estimates.




65
 Table of Contents




Cash,
Cash Equivalents and Marketable Securities




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 31,
                
                
                December 30,2008
                
                
                2007(In
      thousands)Bank
      deposits
                
                $
                10,384
                
                
                $
                4,971Money
      market funds
                
                
                22,858
                
                
                
                21,347Government
      agencies
                
                
                1,100
                
                
                
                12,681$
                34,342
                
                
                $
                38,999




Marketable
securities consisted of the following:




Gross
                              
                              
                              GrossAmortized
                              
                              
                              Unrealized
                              
                              
                              Unrealized
                              
                              
                              FairCost
                              
                              
                              Gains
                              
                              
                              Losses
                              
                              
                              Value(In
      thousands)As
      of December 31, 2008Commercial
      paper
                              
                              $
                              497
                              
                              
                              $
                              —
                              
                              
                              $
                              —
                              
                              
                              $
                              497Corporate
      bonds and notes
                              
                              
                              2,403
                              
                              
                              
                              —
                              
                              
                              
                              (3)
                              
                              
                              
                              2,400Government
      agencies
                              
                              
                              40,160
                              
                              
                              
                              385
                              
                              
                              
                              (1)
                              
                              
                              
                              40,544$
                              43,060
                              
                              
                              $
                              385
                              
                              
                              $
                              (4
                              )
                              
                              $
                              43,441As
      of December 31, 2007Commercial
      paper
                              
                              $
                              5,512
                              
                              
                              $
                              —
                              
                              
                              $
                              —
                              
                              
                              $
                              5,512Corporate
      bonds and notes
                              
                              
                              3,581
                              
                              
                              
                              —
                              
                              
                              
                              (1)
                              
                              
                              
                              3,580Government
      agencies
                              
                              
                              37,676
                              
                              
                              
                              97
                              
                              
                              
                              (3)
                              
                              
                              
                              37,770$
                              46,769
                              
                              
                              $
                              97
                              
                              
                              $
                              (4
                              )
                              
                              $
                              46,862




66
 Table of Contents




Allowance
for Doubtful Accounts




The
Company maintains an allowance for doubtful accounts for the estimated probable
losses on uncollectible accounts receivable.  The allowance is
determined 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 $250,000 and $324,000 as of December 31, 2008 and
December 30, 2007, respectively.




Inventories




Inventories
consist of finished systems, service spares and evaluation units. Spares
inventory consists of components and finished goods used to support the field
services organization.  Inventories are stated at the lower of cost or
market value. Cost is determined using the first-in, first-out method, 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.
Inherent in the Company’s estimates of market value in determining inventory
valuation reserves are estimates related to economic trends, future demand for
the Company’s products and technological obsolescence of the Company’s products.
If future demand or market conditions are less favorable than the Company’s
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. 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 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.
  67
 Table of Contents




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.




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.
  The Company does not require collateral to
support credit sales. Allowances are maintained for potential credit losses.
During 2008, no single customer accounted for more than10% of the Company’s
total revenue.  During 2007, Eastman Kodak Company accounted for 10%
of the Company’s total revenue.  During 2006, Comcast Corporation,
which purchased through one of the Company’s resellers, and Eastman Kodak
Company accounted for 15% and 10%, respectively, of the Company’s total
revenue.  As of December 31, 2008 and December 30, 2007, no single
customer represented more than 10% of the Company’s gross accounts
receivable.
  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
  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.
  68
 Table of Contents
  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 31, 2008
and December 30, 2007.


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 $207,000, $539,000 and
$734,000 in advertising costs during the years ended December 31, 2008,
December 30, 2007, and December 31, 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.




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.




69
 Table of Contents




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 income (loss) in stockholders’ equity
(deficit).




Accounting
for Stock-Based Compensation




On
January 2, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment, or
SFAS 123(R), using the prospective transition method, to account for
employee stock options. Under this method, the Company’s stock-based
compensation costs recognized beginning on January 2, 2006 are 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). The
Black-Scholes 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.




The
Company uses the straight-line method of allocating the fair value of
compensation expense 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 31, 2008, 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.  As required by SFAS 123(R), the
Company estimated expected forfeitures and recognized only the compensation cost
for those stock options expected vest.





For the
years ended December 31, 2008, December 30, 2007, and December 31, 2006,
the Company recorded non-cash stock-based compensation expense under
SFAS 123(R) of $5.9 million, $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 31, 2008, the Company’s total
unrecognized compensation cost related to stock-based awards granted since
January 2, 2006 to employees and non-employee directors was
$18.0 million, which will be recognized over the weighted-average remaining
requisite service period of 3.0 years. The Company recorded no tax benefit
related to these options during the year ended December 31, 2008, 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.




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 31, 2008 and December 30, 2007, no realized gains
or losses were reclassified into results of operations.  During the
year ended December 31, 2006, $14,000 was reclassified into results of
operations 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.




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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
No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods of those fiscal
years. In February 2008, the FASB released a FASB Staff Position No. 157,
Effective Date of FASB
Statement No. 157, which delays the effective date of SFAS
No. 157 for all nonfinancial assets and nonfinancial liabilities, except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually) to fiscal years beginning after
November 15, 2008. The Company do not expect the adoption of SFAS No.
157 for nonfinancial assets and liabilities to have a material effect on its
consolidated results of operations and financial condition. The partial adoption
of SFAS No. 157 for financial assets and liabilities did not have a
material impact on the Company’s  consolidated financial position,
results of operations or cash flows.







2.  Restatement
of Consolidated Financial Statements




As
announced on November 8, 2007, the Company’s Audit Committee, assisted by
independent forensic accountants and legal advisors, initiated an independent
investigation of certain of the Company’s sales to resellers and other customers
to determine whether commitments were made that had an impact on the timing and
treatment of revenue recognition, and whether the Company’s internal
controls relating to revenue recognition were sufficient. 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 the financial
statements.






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.






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.  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.




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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 the consolidated financial
statements.







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, compensation payable 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.





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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 were recorded, but the Audit Committee
concluded that the evidence about their roles, knowledge and intent is
conflicting, disputed, and ultimately inconclusive.





In 2008,
after the completion of the Audit Committee’s investigation, the law firm
retained by the Audit Committee (Heller Ehrman LLP) dissolved.  The
primary attorneys  representing the Committee joined the partnership
of Orrick, Herrington & Sutcliffe LLP.







3.  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. The Company’s marketable securities are
classified as available-for-sale, and are 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.


Marketable
securities totaled $43.4 million as of December 31, 2008, and consisted of
investments in commercial paper, corporate bonds and notes, and U.S. government
securities.  There were no realized gains or losses on the sales of
marketable securities for the year ended December 31, 2008.





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.





Fair
Value Measurements




Effective
December 31, 2007, the Company adopted SFAS No. 157, except as it
applies to the nonfinancial assets and nonfinancial liabilities subject to FSP
No. 157-2. SFAS No. 157 clarifies the definition of fair value as an
exit price, representing the amount that would be received to sell an asset or
the amount that would be paid to transfer a liability in an orderly transaction
between market participants.  As such, fair value is a market-based
measurement that should be determined based on assumptions that market
participants would use in pricing an asset or liability.  As a basis
for considering such assumptions, SFAS No. 157 establishes a three-tier
hierarchy, which prioritizes the inputs used in measuring fair value as
follows:





Level 1—Valuations based
on observable inputs such as quoted prices for identical assets and liabilities
in active markets.





Level 2—Valuations based
on observable inputs other than quoted prices included in Level 1, such as
quoted prices for similar assets and liabilities in active markets, quoted
prices for identical or similar assets and liabilities in markets that are not
active, or other inputs that are observable or can be corroborated by observable
market data.





Level 3—Valuations based
on unobservable inputs in which there is little or no market data, which
requires the Company to develop its own assumptions. These valuations require
significant judgment.




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 Table of Contents




The
Company’s cash equivalents and marketable securities instruments are classified
within Level 1 and Level 2 of the fair value hierarchy because they are
valued using quoted market prices, or broker-dealer quotations, or alternative
pricing sources with reasonable levels of price transparency. The types of
instruments valued based on quoted market prices in active markets include most
U.S. government and agency securities, and money market securities. Such
instruments are generally classified within Level 1 of the fair value
hierarchy. The types of instruments valued based on other observable inputs
include investment-grade corporate bonds, mortgage-backed and asset-backed
products, commercial paper, and state, municipal and provincial obligations.
Such instruments are generally classified within Level 2 of the fair value
hierarchy.





The
following table summarizes, by major security type, the Company’s assets that
are measured at fair value in accordance with SFAS No. 157 on a recurring basis
and are categorized using the fair value hierarchy as of December 31,
2008:





Quoted Prices
                    
                    
                    Significantin
      Active
                    
                    
                    OtherMarkets
      for
                    
                    
                    ObservableIdentical Assets
                    
                    
                    Inputs(Level
      1)
                    
                    
                    (Level
      2)(in
      thousands)Cash
      Equivalents:Money
      market fund
                    
                    $
                    22,857
                    
                    
                    $
                    —U.S.
      government agencies
                    
                    
                    —
                    
                    
                    
                    1,100Commercial
      paper
                    
                    
                    —
                    
                    
                    
                    —$
                    22,857
                    
                    
                    $
                    1,100Marketable
      securities:U.S.
      government agencies
                    
                    $
                    —
                    
                    
                    $
                    40,544Corporate
      debt securities
                    
                    
                    —
                    
                    
                    
                    2,400Commercial
      paper
                    
                    
                    —
                    
                    
                    
                    497$
                    —
                    
                    
                    $
                    43,441






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.





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 Table of Contents




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 31,
                  
                  
                  December 30,
                  
                  
                  December 31,2008
                  
                  
                  2007
                  
                  
                  2006Options
      to purchase common stock
                  
                  
                  10,056,218
                  
                  
                  
                  8,366,297
                  
                  
                  
                  6,753,969Common
      stock subject to vesting provisions
                  
                  
                  88,805
                  
                  
                  
                  187,952
                  
                  
                  
                  921,292Warrants
      to purchase common stock
                  
                  
                  129,992
                  
                  
                  
                  129,992
                  
                  
                  
                  129,99210,275,015
                  
                  
                  
                  8,684,241
                  
                  
                  
                  7,805,253






5.  Inventories




The
Company outsources the manufacturing of its products to a contract manufacturer
that assembles each product to the Company’s specifications. A portion of the
Company’s finished goods is comprised of units used to support the Company’s
field services organization. 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 $2.1 million and
$934,000 as of December 31, 2008, December 30, 2007,
respectively.




Inventories
consisted of the following:




As
      ofDecember 31,
                    
                    
                    December 30,2008
                    
                    
                    2007(In
      thousands)Components
                    
                    $
                    234
                    
                    
                    $
                    154Finished
      goods
                    
                    
                    7,774
                    
                    
                    
                    5,989Evaluation
      units
                    
                    
                    4,425
                    
                    
                    
                    3,287$
                    12,433
                    
                    
                    $
                    9,430




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 Table of Contents


6.  Property
and Equipment




Property
and equipment, net, consisted of the following:




As
      ofDecember 31,
                  
                  
                  December 30,2008
                  
                  
                  2007(In
      thousands)Software
      and computer equipment
                  
                  $
                  18,219
                  
                  
                  $
                  12,820Furniture,
      office equipment and other
                  
                  
                  7,705
                  
                  
                  
                  6,356Leasehold
      improvements
                  
                  
                  5,183
                  
                  
                  
                  5,04031,107
                  
                  
                  
                  24,216Less:
      accumulated depreciation and amortization
                  
                  
                  (19,812
                  )
                  
                  
                  (13,645
                  )$
                  11,295
                  
                  
                  $
                  10,571




Depreciation
and amortization expense was $6.3 million, $5.3 million, and
$4.2 million for the years ended December 31, 2008, December 30, 2007,
and December 31, 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 31, 2008 and December 30, 2007, 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.





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 Table of Contents




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 31, 2008 and December 30, 2007, 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 31,
                      
                      
                      December 30,Issue
      Date
                      
                      Price
                      
                      Date
                      
                      2008
                      
                      
                      2007Warrants
      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.




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 Table of Contents




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 31, 2008, the Company’s 2006 Plan has a total of
6,611,815 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 “ESPP Plan”) in the fourth
quarter of 2006. A total of 1,379,186 shares of the Company’s common stock
have been reserved for sale under the ESPP Plan, of which 1,333,148 shares
remain for issuance as of December 31, 2008. Under the 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 2008 the Company did not issue any shares under
the ESPP Plan.




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 31, 2008 and
December 30, 2007, there were 88,805 and 187,952 unvested shares,
respectively, of the Company’s common stock outstanding and $100,000 and
$189,000, respectively, of related recorded liability.




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




Number
      of
                  
                  
                  Weighted-AverageUnvested
      Shares
                  
                  
                  Exercise/PurchaseOutstanding
                  
                  
                  PriceBalance
      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
                  
                  
                  $
                  1.00Issued
                  
                  
                  —
                  
                  
                  $
                  —Vested
                  
                  
                  (83,169
                  )
                  
                  $
                  0.91Forfeited
                  
                  
                  (15,978
                  )
                  
                  $
                  0.82Balance
      as of December 31, 2008
                  
                  
                  88,805
                  
                  
                  $
                  1.13




78
 Table of Contents




Detail
related to stock option activity is as follows:




Weighted-Number
      of
                  
                  
                  AverageShares
                  
                  
                  ExerciseOutstanding
                  
                  
                  PriceBalance
      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
                  
                  
                  $
                  6.24Options
      granted
                  
                  
                  4,906,250
                  
                  
                  $
                  4.55Options
      exercised
                  
                  
                  (982,672
                  )
                  
                  $
                  0.49Options
      forfeited
                  
                  
                  (2,233,657
                  )
                  
                  $
                  7.22Balance
      as of December 31, 2008
                  
                  
                  10,056,218
                  
                  
                  $
                  5.76




The
total intrinsic value for options exercised in the years ended December 31,
2008, December 30, 2007, and December 31, 2006 was $4.2 million, $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 31, 2008, December 30, 2007, and December 31, 2006, the total
grant date fair value of options vested was $6.1 million, $1.8 million, and
$23,000, respectively.




79
 Table of Contents




The
following table summarizes information about all stock options
outstanding:




As
      of December 31, 2008Weighted-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 - 0.82
                                                                          
                                                                          
                                                                          1,268,814
                                                                          
                                                                          
                                                                          
                                                                          6.5
                                                                          
                                                                          
                                                                          $
                                                                          0.481.35
      - 4.40
                                                                          
                                                                          
                                                                          1,857,122
                                                                          
                                                                          
                                                                          
                                                                          9.0
                                                                          
                                                                          
                                                                          
                                                                          2.864.76
      - 4.94
                                                                          
                                                                          
                                                                          2,740,150
                                                                          
                                                                          
                                                                          
                                                                          9.4
                                                                          
                                                                          
                                                                          
                                                                          4.795.04
      - 5.75
                                                                          
                                                                          
                                                                          1,732,048
                                                                          
                                                                          
                                                                          
                                                                          9.0
                                                                          
                                                                          
                                                                          
                                                                          5.246.12
      - 12.21
                                                                          
                                                                          
                                                                          1,317,412
                                                                          
                                                                          
                                                                          
                                                                          8.2
                                                                          
                                                                          
                                                                          
                                                                          9.8913.00
      - 25.79
                                                                          
                                                                          
                                                                          1,140,672
                                                                          
                                                                          
                                                                          
                                                                          8.3
                                                                          
                                                                          
                                                                          
                                                                          14.74$
      0.12 - 25.79
                                                                          
                                                                          
                                                                          10,056,218
                                                                          
                                                                          
                                                                          
                                                                          8.6
                                                                          
                                                                          
                                                                          
                                                                          5.76
                                                                          
                                                                          
                                                                          $
                                                                          (24,870
                                                                          )Exercisable
                                                                          
                                                                          
                                                                          2,949,019
                                                                          
                                                                          
                                                                          
                                                                          7.0
                                                                          
                                                                          
                                                                          
                                                                          5.46
                                                                          
                                                                          
                                                                          $
                                                                          (6,412
                                                                          )Vested
      and expected to vest
                                                                          
                                                                          
                                                                          9,576,447
                                                                          
                                                                          
                                                                          
                                                                          8.6
                                                                          
                                                                          
                                                                          
                                                                          5.71
                                                                          
                                                                          
                                                                          $
                                                                          (23,201
                                                                          )




(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.




The fair
value of each employee option grant for the years ended December 31, 2008,
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
      31,
                      2008
                    December
      30,
                      2007
                    December
      31,
                      2006Risk-free
      interest rate
                    1.26%
      - 3.5%
                    3.4%
      - 5.1%
                    4.5%
      - 5.1%Expected
      term
                    4 years
                    4 years
                    4 yearsDividend
      yield
                    None
                    None
                    NoneVolatility
                    46
      - 50%
                    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.





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 Table of Contents




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 years ended December 31, 2008 and
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 $1.78
and $4.07, respectively.







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:




Year
      EndedDecember 31,
                      
                      
                      December 30,
                      
                      
                      December
      31,2008
                      
                      
                      2007
                      
                      
                      2006Restated(1)(In
      thousands)Domestic
                      
                      $
                      (25,000
                      )
                      
                      $
                      (27,029
                      )
                      
                      $
                      (26,127
                      )Foreign
                      
                      
                      391
                      
                      
                      
                      318
                      
                      
                      
                      248$
                      (24,609
                      )
                      
                      $
                      (26,711
                      )
                      
                      $
                      (25,879
                      )




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.




Income
tax expense consists of the following:




Year
      EndedDecember 31,
                        
                        
                        December 30,
                        
                        
                        December 31,2008
                        
                        
                        2007
                        
                        
                        2006(In
      thousands)Domestic —
      current and deferred
                        
                        $
                        —
                        
                        
                        $
                        —
                        
                        
                        $
                        —Foreign —
      current and deferred
                        
                        
                        469
                        
                        
                        
                        221
                        
                        
                        
                        109Total
      income tax expense
                        
                        $
                        469
                        
                        
                        $
                        221
                        
                        
                        $
                        109




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




Year
      EndedDecember 31,
                    
                    
                    December 30,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006Restated(1)Income
      tax at statutory rate
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %State
      taxes, net of federal benefit
                    
                    
                    0.3
                    
                    
                    
                    3.5
                    
                    
                    
                    2.1Foreign
      tax rate differential
                    
                    
                    (0.6
                    )
                    
                    
                    (0.7
                    )
                    
                    
                    —Permanent
      differences
                    
                    
                    (1.5
                    )
                    
                    
                    (0.2
                    )
                    
                    
                    —Change
      in valuation allowance
                    
                    
                    (34.1
                    )
                    
                    
                    (37.4
                    )
                    
                    
                    (25.4
                    )Warrant
      revaluation expense
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    (11.1
                    )Total
                    
                    
                    (1.9
                    )%
                    
                    
                    (0.8
                    )%
                    
                    
                    (0.4
                    )%




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.


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 Table of Contents


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




As
      ofDecember 31,
                                                                    
                                                                    
                                                                    December 30,2008
                                                                    
                                                                    
                                                                    2007(In
      thousands)Deferred
      tax assets, current:Inventories
                                                                    
                                                                    $
                                                                    998
                                                                    
                                                                    
                                                                    $
                                                                    520Accrued
      vacation
                                                                    
                                                                    
                                                                    440
                                                                    
                                                                    
                                                                    
                                                                    416Deferred
      revenue
                                                                    
                                                                    
                                                                    1,515
                                                                    
                                                                    
                                                                    
                                                                    991Other
                                                                    
                                                                    
                                                                    1,509
                                                                    
                                                                    
                                                                    
                                                                    658Total
      gross deferred taxes, current
                                                                    
                                                                    
                                                                    4,462
                                                                    
                                                                    
                                                                    
                                                                    2,585Deferred
      tax assets, non-current:Net
      operating loss carryforwards
                                                                    
                                                                    
                                                                    27,547
                                                                    
                                                                    
                                                                    
                                                                    21,366Capitalized
      research and development
                                                                    
                                                                    
                                                                    4,925
                                                                    
                                                                    
                                                                    
                                                                    6,012Deferred
      revenue
                                                                    
                                                                    
                                                                    632
                                                                    
                                                                    
                                                                    
                                                                    1,204Stock-based
      compensation
                                                                    
                                                                    
                                                                    2,932
                                                                    
                                                                    
                                                                    
                                                                    1,130Deferred
      rent
                                                                    
                                                                    
                                                                    —
                                                                    
                                                                    
                                                                    
                                                                    88Property
      and equipment
                                                                    
                                                                    
                                                                    1,846
                                                                    
                                                                    
                                                                    
                                                                    1,481Total
      gross deferred taxes, non-current
                                                                    
                                                                    
                                                                    37,882
                                                                    
                                                                    
                                                                    
                                                                    31,281Gross
      deferred tax assets
                                                                    
                                                                    
                                                                    42,344
                                                                    
                                                                    
                                                                    
                                                                    33,866Less:
      valuation allowance
                                                                    
                                                                    
                                                                    (42,344
                                                                    )
                                                                    
                                                                    
                                                                    (33,866
                                                                    )Net
      deferred tax assets
                                                                    
                                                                    $
                                                                    —
                                                                    
                                                                    
                                                                    $
                                                                    —




As of
December 31, 2008, the Company had total net operating loss carryforwards for
federal and state income tax purposes of $117.4 million.  As of December
31, 2008, the portion of the federal operating loss carryforwards which relates
to stock option benefits is approximately $8.8 million, the benefit of which
will be recorded to equity when realized for tax purposes . The benefits of net
operating losses and other deferred tax assets are 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. The valuation allowance increased by $8.5 million in the year ended
December 31, 2008, $9.9 million in the year ended December 30, 2007, and $5.7
million in the year ended December 31, 2006, respectively. If not utilized,
these net operating loss carryforwards will expire for federal purposes between
2021 and 2028. 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 by Internal Revenue
Code Section 382, 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 December 31, 2008 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 of income tax
expense.  During the years ended December 31, 2008 and December 30,
2007 the Company recognized no interest and penalties.





The Company files income tax returns in the U.S. federal jurisdiction and
various states.  The tax years 2005-2008 remain open to examination by
major taxing jurisdictions to which the Company is subject.




82
 Table of Contents




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 31, 2008, 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 scale-out NAS 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 30,
                    
                    
                    December 31,2007
                    
                    
                    2007
                    
                    
                    2006Restated(1)(In
      thousands)United
      States of America
                    
                    $
                    74,612
                    
                    
                    $
                    64,936
                    
                    
                    $
                    46,465Asia
                    
                    
                    21,840
                    
                    
                    
                    12,493
                    
                    
                    
                    8,137EMEA
                    
                    
                    15,200
                    
                    
                    
                    10,682
                    
                    
                    
                    4,172Other
                    
                    
                    2,770
                    
                    
                    
                    887
                    
                    
                    
                    2,432Total
                    
                    $
                    114,422
                    
                    
                    $
                    88,998
                    
                    
                    $
                    61,206




(1)
            See
      Note 2, "Restatement of Consolidated Financial Statements," of the
      Notes to Consolidated Financial
Statements.






83
 Table of Contents




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 31, 2008 were as follows (in thousands):




Fiscal
      2009
                    
                    $
                    3,254Fiscal
      2010
                    
                    
                    2,896Fiscal
      2011
                    
                    
                    2,694Fiscal
      2012
                    
                    
                    2,754Fiscal
      2013
                    
                    
                    2,285Thereafter
                    
                    
                    1,058$
                    14,941




Rent
expense incurred under operating leases was $3.3 million, $2.9 million, and
$1.7 million during the years ended December 31, 2008, December 30, 2007,
and December 31, 2006, respectively.







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 31, 2008, was
$5.2 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
thereunder, as well as under Sections 11, 12 and 15 of the Securities Act of
1933.  Substantially similar complaints were filed later in the same
court and all of these cases were subsequently consolidated.  On
April 18, 2008, lead plaintiffs filed a consolidated amended
complaint against the Company, certain of its current and former directors and
officers, underwriters, and venture capital firms.  The
consolidated complaint purports to be brought on behalf of a class of persons
who purchased or otherwise acquired the Company’s stock during the period
December 16, 2006 to October 3, 2007.  Plaintiffs allege that
defendants violated the federal securities laws by issuing a false and
misleading registration statement and prospectus in connection with the
Company’s December 16, 2006 initial public offering and by thereafter
misrepresenting the Company’s current and prospective business and financial
results, thereby causing the Company’s stock price to be artificially inflated
during the purported class period.  Plaintiffs seek unspecified
compensatory damages, interest, attorneys’ fees and costs, and injunctive
relief.





On
September 30, 2008, the Company and the other defendants moved to dismiss the
consolidated amended complaint.  Oral argument on the defendants’
motions was heard on December 16, 2008, and a decision was issued on December 29
granting in part and denying in part the motions.  All claims against
defendants Sequoia Capital (and related entities), Atlas Venture (and related
entities) and Madrona Venture Group LLC were dismissed.  The
Section 12 claims were dismissed as against defendants Isilon, its former
CEO Steven Goldman, and its former CFO Stuart Fuhlendorf, as were the Section
10(b) claims against Isilon directors William Ruckelshaus and Matthew
McIlwain.  The Court denied the remainder of the defendants’
motions.  All remaining defendants filed answers to the complaint on
January 30, 2009.





On March
18 and 24, 2008, shareholder derivative actions were 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.  On April 17, 2008, the court consolidated these actions and
appointed lead counsel.  The derivative complaints arise out of many
of the factual allegations at issue in the securities class action, and
generally 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 recognized in the Company’s
fiscal year ended December 31, 2006, and first and second quarters in fiscal
2007.  The complaints seek 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 to advance
the legal fees and costs incurred by the individual defendants.  On August
27, 2008, at the request of the parties, the court stayed the consolidated
derivative action pending resolution of the motions to dismiss in the securities
class action.





84
 Table of Contents




As noted
above, the motions in the securities case were resolved on December 29,
2008.  Thereafter, on January 12, 2009, the parties to the derivative
action stipulated, and asked the Court to order, that plaintiff amend his
complaint.  The parties also agreed, and asked the Court to order,
that the schedule for defendants’ motion(s) to dismiss the amended complaint
shall be decided and submitted for approval after receipt of any amended
derivative complaint.  The Court has not yet signed the proposed order
associated with this stipulation.




The
Company is unable to predict the outcome of these cases.  A court
determination against the Company in the class action, and the Company’s
indemnity obligations in the derivative actions, could result in significant
liability and could have a material adverse effect on the Company’s consolidated
financial position, results of operations or cash flows.




The
Company has been cooperating on a voluntary basis with an investigation being
conducted by the SEC concerning the Company’s prior financial
restatement.  The SEC has issued a formal order of nonpublic
investigation and has issued subpoenas to certain of the Company’s former
officers.  The SEC’s investigation is a nonpublic, fact-finding
inquiry to determine if there have been violations of the federal securities
laws.






13.  Quarterly
Results of Operations (unaudited)




Following
is a summary of unaudited quarterly financial information for fiscal years 2008
and 2007.




Condensed
      Consolidated Statement of OperationsThree
      Months EndedMarch
      31, 2008
                                                                
                                                                June
      30,2008
                                                                
                                                                
                                                                September
      30, 2008
                                                                
                                                                
                                                                December
      31, 2008(In
      thousands, except per share data)Total
      revenue
                                                                
                                                                $
                                                                24,124
                                                                
                                                                
                                                                $
                                                                28,182
                                                                
                                                                
                                                                $
                                                                30,332
                                                                
                                                                
                                                                $
                                                                31,784Gross
      profit
                                                                
                                                                
                                                                12,895
                                                                
                                                                
                                                                
                                                                16,034
                                                                
                                                                
                                                                
                                                                17,346
                                                                
                                                                
                                                                
                                                                18,159Total
      operating expenses
                                                                
                                                                
                                                                23,686
                                                                
                                                                
                                                                
                                                                22,449
                                                                
                                                                
                                                                
                                                                22,502
                                                                
                                                                
                                                                
                                                                22,475Loss
      from operations
                                                                
                                                                
                                                                (10,791
                                                                )
                                                                
                                                                
                                                                (6,415
                                                                )
                                                                
                                                                
                                                                (5,156
                                                                )
                                                                
                                                                
                                                                (4,316
                                                                )Net
      loss
                                                                
                                                                
                                                                (10,098)
                                                                
                                                                
                                                                
                                                                (5,819
                                                                )
                                                                
                                                                
                                                                (4,828
                                                                )
                                                                
                                                                
                                                                (4,333
                                                                )Net
      loss per common share, basic and diluted
                                                                
                                                                $
                                                                (0.16
                                                                )
                                                                
                                                                $
                                                                (0.09
                                                                )
                                                                
                                                                $
                                                                (0.08
                                                                )
                                                                
                                                                $
                                                                (0.07
                                                                )Shares
      used in computing basic and diluted net loss per common
    share
                                                                
                                                                
                                                                62,749
                                                                
                                                                
                                                                
                                                                63,147
                                                                
                                                                
                                                                
                                                                63,615
                                                                
                                                                
                                                                
                                                                63,760Three
      Months EndedApril
      1,2007
                                                                
                                                                
                                                                July
      1,2007
                                                                
                                                                
                                                                September
      30, 2007
                                                                
                                                                
                                                                December
      30, 2007Restated
                                                                
                                                                
                                                                Restated(In
      thousands, except per share data)Total
      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
                                                                
                                                                
                                                                
                                                                62,404




85
 Table of Contents




This
selected quarterly information has been restated for the first and second
quarters of 2007 from previously reported information filed on Form 10-Q. 
The Audit Committee investigation described in Note 2 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.




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




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
                )







86
 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 31, 2008, 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 31, 2008.





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 31, 2008. In making its assessment of
internal control over financial reporting, management used the criteria inInternal Control —
Integrated Framework  issued by the Committee of Sponsoring
Organizations of the Treadway Commission (“COSO”).  Based on this
assessment, management has concluded that, as of December 31, 2008, the
Company’s internal control over financial reporting was effective.





The
effectiveness of our internal control over financial reporting as of December
31, 2008 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.





CHANGES
IN INTERNAL CONTROL OVER FINANCIAL REPORTING





As described above there have been no changes in our internal control over
financial reporting as defined in Rules 13a – 15(f) and 15d – 15(f) under the
Exchange Act during the quarter ended December 31, 2008 that our certifying
officers concluded materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.







ITEM 9B.Other
Information




Our
insider trading policy allows directors, officers and other employees covered
under the policy to establish, under limited circumstances contemplated by Rule
10b5-1 under the Securities Exchange Act of 1934, as amended, written programs
that permit automatic trading of Isilon Systems stock or trading of Isilon
systems stock by an independent person (such as a broker or an investment bank)
who is not aware of material, nonpublic information at the time of the
trade.  In the fourth quarter of 2008, one of our officers and a
venture capital fund affiliated with one of our directors cancelled their
respective 10b5-1 trading plans.


87
 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, Executive
Officers and Corporate Governance




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 and Director Independence




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 59of this
report.







2.
            Financial
      Statement Schedules.




88
 Table of Contents





Schedule II —
Valuation and Qualifying Accounts and Reserves








Description
                  
                  Balance
      at
                    Beginning
                    of
      Period
                  
                  
                  Charges
      to
                    Cost
      and
                    Expenses
                  
                  
                  Deductions
                  
                  
                  Balance
      at
                    End
      of
                    Period(in
      thousands)Year
      ended December 31, 2008Allowance
      for doubtful accounts
                  
                  $
                  324
                  
                  
                  $
                  56
                  
                  
                  $
                  (130
                  )
                  
                  $
                  250Income
      tax valuation allowance
                  
                  
                  33,866
                  
                  
                  
                  8,478
                  
                  
                  
                  —
                  
                  
                  
                  42,344Year
      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
                  
                  
                  
                  —
                  
                  
                  
                  23,933







(1)
            See
      Note 2, "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 HereinNumber
                
                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




89
 Table of Contents






Exhibit
                                          
                                          
                                          Incorporation
      by Reference HereinNumber
                                          
                                          Description
                                          Form
                                          Date10.19*
                                          
                                          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, 2007.23.1
                                          
                                          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.




90
 Table of Contents





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




Dated:  February
18, 2009





91
 Table of Contents





POWER
OF ATTORNEY




KNOW ALL
PERSONS BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Keenan Conder, William 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)
            
            February 19,
      2009/s/
      William Richter
              
              William
      Richter
            
            Vice
      President and Interim Chief Financial Officer
              (Principal
      Accounting and
              Financial
      Officer)
            
            February 19,
      2009/s/ Elliott
      H. Jurgensen, Jr.
              
              Elliott
      H. Jurgensen, Jr.
            
            Director
            
            February 19,
      2009/s/
      William D. Ruckelshaus
              
              William D. Ruckelshaus
            
            Chairman
      of Board of Directors
              and
      Director
            
            February 19,
      2009/s/
      Barry J. Fidelman
              
              Barry J. Fidelman
            
            Director
            
            February 19,
      2009/s/
      Gregory
      L. McAdoo
              
              Gregory L. McAdoo
            
            Director
            
            February 19,
      2009/s/
      Matthew S. Mcllwain
              
              Matthew
      S. Mcllwain
            
            Director
            
            February 19,
      2009/s/
      James G. Richardson
              
              James G. Richardson
            
            Director
            
            February 19,
      2009/s/
      Peter H. van Oppen
              
              Peter H. van Oppen
            
            Director
            
            February 19,
      2009




92
 Table of Contents








INDEX
TO EXHIBITS






Exhibit
                
                
                Incorporation
      by Reference HereinNumber
                
                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




93
 Table of Contents




Exhibit
                          
                          
                          Incorporation by Reference
      HereinNumber
                          
                          Description
                          Form
                          Date10.19*
                          
                          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, 2007.23.1
                          
                          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.