<PAGE>   1
                                                                    EXHIBIT 10.7

                               [KTOC LETTERHEAD]


July 31, 1997


Mr. Pat Doneen
Director, Business Development and
  Systems Operations
VIXEL CORPORATION
11911 Northcreek Parkway South, Suite 100
Bothell, Washington 98011


Dear Mr. Doneen:

Enclosed please find the form of "Key Terms--Turnkey Manufacturing" you provided
to us with our proposed changes as marked on this form. If these changes and
the matters discussed in this letter are acceptable, please sign in the space
below and return a copy of this letter to me together with a copy of the
Key-Terms--Turnkey Manufacturing initialed by our changes.

The entire agreement between the parties consists solely of this letter
agreement, the enclosed Key-Terms--Turnkey Manufacturing and the Key
Relationship Elements--Turnkey Manufacturing form previously signed by the
parties. Any changes to this agreement must be in a written instrument signed
by both parties and no correspondence, purchase orders, etc. will add to or
modify this agreement unless agreed to by both parties in writing.

Please call me with any questions. I look forward to hearing from you.

Very truly yours,

/s/ CATHY O'LEARY
------------------------
Cathy O'Leary
Executive Vice President




AGREED TO:

VIXEL CORPORATION

BY: /s/ PAT DONEEN
--------------------------------------
NAME: Pat Doneen
--------------------------------------
TITLE: Director of Supplier Management
--------------------------------------
<PAGE>   2
                           KEY RELATIONSHIP ELEMENTS
                             TURNKEY MANUFACTURING

A. ORDERS

     o    Vixel to provide maximum 9 month purchase order visibility, added in
          3 month increments, at beginning of each quarter.
     o    Minimum 5 month coverage on blanket purchase agreement.
     o    Minimum 12 month forecast visibility provided.
     o    Vixel to provide weekly rolling MPS updates:
               o    first 3 months, weekly quantities.
               o    next 9 months, monthly quantities.

B. FINISHED GOODS

     o    K-Tec to manage finished goods buffer at no carrying charges.
     o    Goal is to keep level to 1 - 2 weeks.
     o    Vixel agrees to carrying charges if month end quantity > 2 months
          demand, to be negotiated in good faith.
     o    Invoiced when shipped from finished goods.

C. REPORTS & DATA

<TABLE>
<CAPTION>
                                      INITIALLY          GOAL
                                      ---------          ----
<S>                                   <C>              <C>
          o    Quality                  Weekly         Real-time
                    o yields
                    o pareto
          o    Finished Goods           Weekly           Daily
          o    WIP                      Weekly           Daily
          o    Raw Material             Weekly           Daily
          o         o    on hand
                    o    on order
                    o    forecasted
                    o    shortages
          o    Failure Analysis         Weekly           Daily
          o    Shipments/Delivery       Weekly           Daily
</TABLE>

     Other reports provided as necessary as relationship develops and needs have
     been defined.

D. MATERIALS MANAGEMENT

     o    K-Tec to provide visibility to suppliers consistent with Vixel MPS.
     o    Visibility to suppliers to be provided to Vixel.
     o    Help preserve and participate in strategic supplier relationships.
     o    K-Tec to initiate and drive lead-time reduction process with all long
          lead-time materials.


Agreed To: /s/ PAT DONEEN   5/5/97   Vixel
          ------------------------

Agreed To: /s/ CATHY O'LEARY         K-Tec
          ------------------------
<PAGE>   3

                           KEY RELATIONSHIP ELEMENTS
                             TURNKEY MANUFACTURING

E.   REVIEWS

          o    Business Reviews              Quarterly

          o    Pricing Reviews               Quarterly

          o    Operations Reviews            Weekly

          o    DFM Reviews                   As necessary

          o    DFT Reviews                   As necessary

          o    Mfg. Technical Reviews        As necessary

F.   TEAM

          o    K-Tec to provide top-rated team.

          o    K-Tec to provide team continuity.

          o    Inform Vixel of changes to team.

          o    Provide means for Vixel to provide feedback and/or score team
               performance.

G.   LOCAL PRESENCE

          o    K-Tec to accommodate visits by Vixel working team as deemed
               necessary by Vixel.

          o    K-Tec to allow and house a Vixel product engineer.

          o    Vixel to welcome and accommodate K-Tec team as necessary for
               work in Washington.

H.   MANUFACTURING AGREEMENT

          o    K-Tec and Vixel to execute manufacturing agreement within 45
               days.

I.   PRICING

          o    Committed to 6 quarters of pricing.

          o    Reviewed, and adjusted as appropriate, quarterly.

J.   COST REDUCTIONS

          o    Vixel receives 100% of Vixel-initiated cost reductions.

          o    Vixel receives 50% of K-Tec-initiated cost reductions.

K.   PERFORMANCE

          o    K-Tec to execute business to attached performance requirements.



Agreed To: /s/ PAT DONEEN         5/5/97        Vixel
          -------------------------------------

Agreed to:  /s/ CATHY O'LEARY                   K-Tec
           ------------------------------------


<PAGE>   4

                           KEY RELATIONSHIP ELEMENTS
                             TURNKEY MANUFACTURING


L.   RMA/FAILURE ANALYSIS

          o    K-Tec to administer RMA's and provide failure analysis, per
               attached performance requirements.

          o    K-Tec to own and manage swap stock inventory to allow
               performance targets to be met.

          o    K-Tec agrees to maintain and repair (@ agreeable cost) non-K-Tec
               units, (e.g.; initial units built at Solectron - qty.: <100
               boxes, <1000 boards).

M.   OTHER

          o    Vixel desires to be used as customer reference.







Agreed To:  /s/ PAT DONEEN         5/5/97       Vixel
          -------------------------------------

Agreed to:  /s/ CATHY O'LEARY                   K-Tec
           ------------------------------------


<PAGE>   5
                VIXEL TURNKEY MANUFACTURING PERFORMANCE TARGETS


Vixel Product:    "Tinman" HUB
               ------------------

<TABLE>
<CAPTION>
           PARAMETER               Q297      Q397     Q497       Q198      Q298      Q398
           ---------              ------    ------   ------     ------    ------    ------
<S>                                <C>       <C>       <C>       <C>       <C>       <C>
LEADTIME                           8 wk      6 wk      5 wk      4 wk      4 wk      3 wk
UPSIDE %
  <15 days                         20%       20%        25%       25%       25%       25%
  15-30 days                       30%       30%        50%       50%       50%       50%
  31-60 days                       50%       50%       100%      100%      150%      150%

WARRANTY                           1 yr      1 yr      1 yr      1 yr      1 yr      1 yr
  Extended to 3 yr                                        Cost TBD

ON-TIME DELIVERY                   100%      100%      100%      100%      100%      100%

QUALITY
  SMT Yield                        85%       92%       95%       95%       95.5%     96%
  ICT Yield                        87%       92%       95%       95%       95.5%     96%
  PWB FQA                          99%       99%       99%       99%       99%       99%
  Mech. Assembly                   99%       99%       99.2%     99.2%     99.5%     99.5%
  Functional Test                  93%       93.5%     93.8%     94%       94.5%     95%
  FQA                              99%       TBD       TBD       TBD       TBD       TBD
  DPPM Rate                        <6000     4000      2000      1800      1500      1200

COMMITTED CAPACITY
  Available                        1.5k/mo   3k/mo     6k/mo     7k/mo     7k/mo     9k/mo

FA/RMA RESPONSE (FIELD RETURNS)
  Acknowledge                      2 days    2 days    2 days    1 day     1 day     1 day
  Replacement                      4 days    3 days    3 days    3 days    3 days    3 days
  Verification                     3 days    3 days    3 days    2 days    2 days    2 days
  Root Cause                       3 wks     3 wks     2 wks     2 wks     2 wks     2 wks
  Corrective Action                  tbd       tbd       tbd       tbd       tbd       tbd
  RMA Cycle Time                   8 days    8 days    7 days    7 days    6 days    6 days
</TABLE>


Date: 05/09/97
Rev:   97-5.0
<PAGE>   6


                                   KEY TERMS

                             TURNKEY MANUFACTURING


1.0  CANCELLATION

     o  Vixel may cancel any Purchase Orders
     o  Upon a cancellation, Vixel and K-Tec agree to negotiate in good faith
        Vixel's liability within 15 days of cancellation notice.

     o  Vixel liability will not exceed the following:
          --  contract price for all finished goods.
          --  material cost, material margin and labor cost incurred for all
              work-in-process
          --  cost plus 8% mark-up of any raw material inventory on order or on
              hand.

     o  K-Tec shall undertake a reasonable effort for a period not to exceed 30
        days to cancel all applicable component purchase orders and reduce
        component inventory through returns, or allocate components to
        alternative programs.

2.0  RESCHEDULE

     o  Vixel has right to reschedule product at no charge, if the reschedule
        results in less than 2 months of additional finished goods inventory on
        top of the finished goods buffer managed by K-Tec, as described in
        Section B

     o  Reschedules resulting in more than this amount of finished goods
        inventory will be received by Vixel.

     o  Reschedules of greater than 6 months from original schedule date will be
        treated as cancellations.

3.0  TERM

     o  Agreement commenced on 5/13/97.
     o  Initial term is 12 months.
     o  Will be automatically renewed for successive 6 month increments.

4.0  TERMINATION

     o  Agreement will terminate upon written notice.
     o  120 days notice shall be given by K-Tee of its intention to terminate
        this Agreement.
     o  60 days notice shall be given by Vixel of its intention to terminate
        this Agreement.

5.0  PAYMENT TERM

     o  Net 30 days from Invoice Date.


AGREED TO: /s/ Pat Doneen                   7/15/97          Vixel
          --------------------------------------------------------
AGREED TO: /s/ Cathy O'Leary                10/97            K-Tec
          --------------------------------------------------------











<PAGE>   7

                                   KEY TERMS

                             TURNKEY MANUFACTURING

6.0  ENGINEERING/MANUFACTURING CHANGES

     -    Vixel may request engineering change to product.
     -    Vixel is responsible for ensuring changes properly documented and
          communicated to K-Tec.
     -    Changes resulting in price changes of greater than 5% will result in
          a change to the contract price at the time the change becomes
          effective.
     -    Changes resulting in price changes of less than 5% will be treated as
          a piece price variance, with appropriate price adjustment and
          payments reconciled at the quarterly pricing review.
     -    K-Tec is encouraged to suggest ECO's under the following guidelines:
               = proposed changes given in writing.
               = no changes made without written approval from Vixel.
               = Vixel agrees to approve or disapprove of suggested changes
                 within 14 days of receipt.

7.0  WARRANTY

     -    K-Tec warrants for a period of one (1) year from the date of assembly
          and test of the Product, that (i) the Product will conform to the
          specifications applicable at the time of its assembly and test; (ii)
          such Product will be of good material and workmanship and free from
          defects; (iii) such Product will be free and clear of all liens and
          encumbrances and that K-Tec will convey good and marketable title to
          such Product. In the event that any Product manufactured shall not be
          in conformity with the foregoing warranties, K-Tec shall, at K-Tec's
          option, either credit Vixel for any such nonconformity (not to exceed
          the purchase price paid by Vixel for such Product plus expenses
          associated with the return of the defective Products), or, at K-Tec's
          expense, replace, repair, or correct such Product. The shipment of any
          non-conforming Products from Vixel's customers' premises to K-Tec
          shall be at K-Tec's expense so long as shipments are within the
          continental United States and K-Tec shall be responsible for
          in-transit risks of loss or damage.

8.0  FORCE MAJEURE

     -    Neither party shall be liable for any failure or delay in its
          performance under this Agreement due to acts of God, acts of civil or
          military authority, fires, floods, earthquakes, riots, wars or any
          other cause beyond the reasonable control of the delayed party
          provided that the delayed party: (i) gives the other party written
          notice of such cause within fifteen (15) days of the discovery of the
          event; and (ii) uses its reasonable efforts to remedy such delay in
          its performance. In the event that K-Tec fails to deliver Products to
          Vixel due to such causes and fails to provide within the five (5) day
          notification a plan for remedy which is acceptable to Vixel, Vixel may
          suspend this agreement in whole or in part for the duration of such
          delaying cause and, at its option, buy the products from another
          source and deduct the quantity so purchased from any unsatisfied
          Purchase Order to K-Tec.


AGREED TO: /s/ Pat Doneen            7/15/97  Vixel
          -----------------------------------------

AGREED TO: /s/ Cathy O'Leary                  K-Tec
          -----------------------------------------