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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-K

(Mark One)

|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

For the fiscal year ended December 31, 2008

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 000-32743





ZHONE TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 22-3509099                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)

7001 Oakport Street

Oakland, California 94621

(Address of principal executive office)

Registrants telephone number, including area code: (510) 777-7000

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



|                               |  |                                            
|------------------------------ |  | -------------------------------------------
|Common Stock, $0.001 Par Value |  | The Nasdaq Stock Market LLC                
|(Title of class)               |  | (Name of each exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act: None

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

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

Indicate by check
mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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  x    No   ̈

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will
not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   x

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 definitions of accelerated filer, large accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act (Check one):



|                          |  |                     |  |                                               |  |                            
|------------------------- |  | ------------------- |  | --------------------------------------------- |  | ---------------------------
|Large accelerated filer  ̈ |  | Accelerated filer x |  | Non-accelerated filer  ̈                       |  | Smaller reporting company  ̈
|                          |  |                     |  | (Do not check if a smaller reporting company) |  |                            

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

As of January 31, 2009, there were 150,684,109 shares outstanding of the registrants common stock, $0.001 par value. As of June 30, 2008 (the last business day of the
registrants most recently completed second fiscal quarter), the aggregate market value of common stock held by non-affiliates of the registrant was approximately $81,469,800.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants
definitive Proxy Statement for the 2009 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K where indicated.









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TABLE OF CONTENTS



|           |  |                                                                                                              |  |     
|---------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|           |  |                                                                                                              |  | Page
|PART I     |  |                                                                                                             
|           |  |                                                                                                             
|Item 1.    |  | Business                                                                                                     |  | 3   
|           |  |                                                                                                             
|Item 1A.   |  | Risk Factors                                                                                                 |  | 13  
|           |  |                                                                                                             
|Item 1B.   |  | Unresolved Staff Comments                                                                                    |  | 26  
|           |  |                                                                                                             
|Item 2.    |  | Properties                                                                                                   |  | 26  
|           |  |                                                                                                             
|Item 3.    |  | Legal Proceedings                                                                                            |  | 26  
|           |  |                                                                                                             
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                          |  | 27  
|           | 
|PART II    |  |                                                                                                             
|           |  |                                                                                                             
|Item 5.    |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 29  
|           |  |                                                                                                             
|Item 6.    |  | Selected Financial Data                                                                                      |  | 30  
|           |  |                                                                                                             
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 31  
|           |  |                                                                                                             
|Item 7A.   |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 47  
|           |  |                                                                                                             
|Item 8.    |  | Financial Statements and Supplementary Data                                                                  |  | 49  
|           |  |                                                                                                             
|Item 9.    |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                         |  | 82  
|           |  |                                                                                                             
|Item 9A.   |  | Controls and Procedures                                                                                      |  | 82  
|           |  |                                                                                                             
|Item 9B.   |  | Other Information                                                                                            |  | 83  
|           | 
|PART III   |  |                                                                                                             
|           |  |                                                                                                             
|Item 10.   |  | Directors, Executive Officers and Corporate Governance                                                       |  | 84  
|           |  |                                                                                                             
|Item 11.   |  | Executive Compensation                                                                                       |  | 84  
|           |  |                                                                                                             
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 84  
|           |  |                                                                                                             
|Item 13.   |  | Certain Relationships and Related Transactions, and Director Independence                                    |  | 84  
|           |  |                                                                                                             
|Item 14.   |  | Principal Accountant Fees and Services                                                                       |  | 84  
|           | 
|PART IV    |  |                                                                                                             
|           |  |                                                                                                             
|Item 15.   |  | Exhibits, Financial Statement Schedules                                                                      |  | 85  
|           | 
|Signatures |  | 86                                                                                                          
|           | 
|Exhibits   |  | 87                                                                                                          



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Forward-looking Statements

This Annual Report on Form 10-K, including Managements Discussion and Analysis of Financial Condition and Results of
Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on
current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. We use words such as anticipate, believe, continue,
could, estimate, expect, goal, intend, may, plan, project, seek, should, target, will, would,
variations of such words and similar expressions to identify forward-looking statements. In addition, statements that refer to projections of earnings, revenue, costs or other financial items; anticipated growth and trends in our business or key
markets; future growth and revenues from our Single Line Multi-Service (SLMS) products; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and other
characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to
predict, including those identified under the heading Risk Factors in Item 1A, elsewhere in this report and our other filings with the SEC. Therefore, actual results may differ materially and adversely from those expressed in any
forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.

PART I



|ITEM 1. | BUSINESS
|------- | --------

Company Overview

We design, develop and manufacture communications network equipment for telephone companies and cable operators
worldwide. We believe that these network service providers can increase their revenues and lower their operating costs by using our products to deliver video and interactive entertainment services in addition to their existing voice and data service
offerings, all on a platform that permits a seamless migration from legacy technologies to a converged packet-based architecture. Our Single Line Multi-Service (SLMS) architecture provides cost-efficiency and feature flexibility with support for
voice over internet protocol (VoIP) and IP video (IPTV). Within this versatile SLMS architecture, our products allow service providers to deliver all of these converged packet services over their existing copper lines while providing support for
fiber build-out. With our products, network service providers can seamlessly migrate from traditional circuit-based networks to packet-based networks and from copper-based access lines to fiber-based access lines without abandoning the investments
they have made in their existing infrastructures.

Corporate Information

We were incorporated in Delaware under the name Zhone Technologies, Inc. in June 1999, and in November 2003, we consummated our merger
with Tellium, Inc. Although Tellium acted as the legal acquirer, due to various factors, including the relative voting rights, board control and senior management composition of the combined company, Zhone was treated as the acquirer for
accounting purposes. Following the merger, the combined company was renamed Zhone Technologies, Inc. and retained substantially all of Zhones previous management and operating structure. The mailing address of our worldwide headquarters is
7001Oakport Street, Oakland, California 94621, and our telephone number at that location is (510) 777-7000. Our website address is www.zhone.com. The information on our website does not constitute part of this report. Through a link on
the Investor Relations section of our website, we make available the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: our Annual Report on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. All such filings are available free of charge.



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Industry Background

Over the past several years, the communications network industry has experienced rapid expansion as the internet and the proliferation of bandwidth intensive applications and services have led to
an increased demand for high bandwidth communications networks. The broad adoption of new technologies such as MP3 players, digital cameras and high definition televisions allow music, pictures, user-generated content (as found on the many
video-sharing sites) and high definition video to be a growing part of consumers regular exchange of information. All of these new technologies share a common dependency on high bandwidth communication networks and sophisticated traffic
management tools. However, network service providers have struggled to meet the increased demand for high speed broadband access due to the constraints of the existing communications network infrastructure. This infrastructure consists of two
interconnected networks:



| |  |  | the core network, which interconnects service providers with each other; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | the access network, which connects end-users to a service providers closest facility.
| | - |  | ----------------------------------------------------------------------------------------

To address the increased demand for higher transmission speeds via greater bandwidth, service providers have expended significant capital
over the past decade to upgrade the core network by replacing much of their copper infrastructure with high-speed optical infrastructure. While the use of fiber optic equipment in the core network has relieved the bandwidth capacity constraints in
the core network between service providers, the access network continues to be a bottleneck that severely limits the transmission speed between service providers and end-users. As a result, communications in the core network can travel
at up to 10 gigabits per second, while in stark contrast, many communications over the access network throughout the world still occur at a mere 56 kilobits per second, a speed that is 175,000 times slower. At 56 kilobits per second, it may
take several minutes to access even a modestly media laden website and several hours to download large files. Fiber access lines have the potential to remedy this disparity, but re-wiring every home or business with fiber optic cable is both
cost prohibitive and extremely time consuming. Consequently, solving the access network bottleneck has typically required more efficient use of the existing copper wire infrastructure and support for the gradual migration from copper to fiber.

In an attempt to deliver high bandwidth services over existing copper wire in the access network, service providers began
deploying digital subscriber line (DSL) technology over a decade ago. However, this early DSL technology has practical limitations. Copper is a distance sensitive medium in that the amount of bandwidth available over a copper wire is inversely
proportional to the length of the copper wire. In other words, the greater the distance between the service providers equipment and the customers premises, the lower the bandwidth. Unfortunately, most DSL services available today are
provided by first generation DSL access multiplexer (DSLAM) equipment. These large unwieldy devices require conditioned power and a climate controlled environment typically found only in a telephone companys central office, which is often at
great distance from the customer. While adequate for basic data services, these first generation DSLAMs were not designed to meet the needs of todays high bandwidth applications. The modest bandwidth provided by existing DSLAM equipment is
often incapable of delivering even a single channel of standard definition video, much less multiple channels of standard definition video or high definition video.

More recently, regulatory changes have introduced new competitors in the telecommunication services industry. Cable operators, with extensive networks designed originally to provide only video
programming, have collaborated to adopt new packet technologies that leverage their hybrid fiber/coaxial cable infrastructure. Using more recent technologies, cable operators have begun to cost-effectively deliver new service bundles. The new
service offerings provide not only enhanced features and capabilities, but also allow the cable operators to deliver these services over a common network. The resulting cost-efficiencies realized by cable operators are difficult for incumbent
telephone companies to match. Even with the telephone companies legacy voice switches fully paid for, maintaining separate networks for their circuit-based voice and packet-based video and data networks is operationally non-competitive.
Perhaps even more important than economic efficiencies, by integrating these services over a common packet infrastructure, cable operators will realize levels of integration between applications and new features that will be difficult to achieve
from a multi-platform solution. Despite these benefits, coaxial cable has its own share of limitations. Unlike DSL, coaxial cable shares its bandwidth among all customers



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connected to it. Consequently, as new customers are added to coaxial cable networks, performance decreases. As a shared medium, large numbers of subscribers
who simultaneously access the same segment of the coaxial cable network can potentially compromise performance and security. This represents a source of strategic advantage for telecom operators who employ technology designed to maximize their
service capabilities on the point-to-point (i.e. not shared) architecture of their copper infrastructure. This increased competition has placed significant pressure on all network service providers. With significant service revenues at risk, these
service providers have started to make investments to upgrade their networks and broaden their service offerings. In response to these competitive pressures, existing service providers have commenced a search for ways to modernize their legacy
networks, to enable delivery of additional high bandwidth, high margin services, and to lower the cost of delivering these services.

The Zhone Solution

We believe that we are the first company dedicated solely to developing the full
spectrum of next-generation access network solutions to cost-effectively deliver high bandwidth services while simultaneously preserving the investment in todays networks. Our next-generation solutions are based upon our Single Line
Multi-Service, or SLMS, architecture. From its inception, this SLMS architecture was specifically designed for the delivery of multiple classes of subscriber services (such as voice, data and video distribution), rather than being based on a
particular protocol or media. In other words, our SLMS products are built to support the migration from legacy circuit to packet technologies and from copper to fiber technologies. This flexibility and versatility allows our products to adapt to
future technologies while allowing service providers to focus on the delivery of additional high bandwidth services. Because this SLMS architecture is designed to interoperate with existing legacy equipment, service providers can leverage their
existing networks to deliver a combination of voice, data and video services today, while they migrate, either simultaneously or at a future date, from legacy equipment to next-generation equipment with minimal interruption. We believe that our SLMS
solution provides an evolutionary path for service providers using their existing infrastructures, as well as giving newer service providers the capability to deploy cost-effective, multi-service networks that can support voice, data and video.

Triple Play Services with Converged Voice, Data and Video SLMS simplifies the access network by
consolidating new and existing services onto a single line. This convergence of services and networks simplifies provisioning and operations, ensures quality of service and reliability, and reduces the time required to provide services. SLMS
integrates access, transport, customer premises equipment, and management functions in a standards-based system that provides scalability, interoperability and functionality for voice, data and video services.

Packet Migration SLMS is a flexible multi-service architecture that provides current services while simultaneously
supporting migration to a pure packet network. This flexibility allows service providers to cost-effectively provide carrier class performance, and functionality for current and future services without interrupting existing services or abandoning
existing subscribers. SLMS also protects the value of the investments made by residential and commercial subscribers in equipment, inside wiring and applications, thereby minimizing transition impact and subscriber attrition.

Fiber to the Home, Premise, Node, or Curb (FTTx)  We provide support for the full range of fiber-based access network
architectures that are seeing increased use by todays carriers. In many markets worldwide, both business and residential demand for bandwidth is growing to the point where the deployment of fiber in the access network is increasingly
desirable. Where copper loops are plentiful and where civil restrictions make fiber deployment all the way to the customer premises prohibitively expensive, if not impossible, many operators are choosing to deploy fiber from central offices to
neighborhoods and then using VDSL2 over copper to deliver broadband connectivity over the last hundred meters or so. In other circumstances operators choose to deploy passive optical networks (PON) all the way to the customer premises, where a
single fibers bandwidth is shared through splitters with up to 64 subscribers. Some circumstances demand so-called home run fiber networks



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(with dedicated fiber resources linking every customer directly to the central office) to maximize bandwidth or service segmentation. By supporting all these
architectures within a common SLMS-based platform, we provide carriers maximum flexibility to build the network that best suits their needs.

Ethernet Service Delivery We offer a complete array of equipment that allows carriers to deliver ethernet services over copper or fiber. For business subscribers, our ethernet over copper product family
allows carriers to quickly deliver ethernet services over existing copper SHDSL or T1/E1 circuits. Multiple circuits can be bonded to provide over 70 Megabits per second, enough to deliver ample ethernet bandwidth to satisfy business
subscribers growing service requirements. This copper-based solution provides a compelling alternative to burying fiber and dedicating valuable fiber strands to long-haul ethernet services to small and medium enterprises.

The Zhone Strategy

Our strategy has been to combine internal development with acquisitions of established access equipment vendors to achieve the critical mass required of telecommunications equipment providers. We expect that our future growth will focus
primarily on organic growth in emerging technology markets. Going forward, the key elements of our strategy include:



| |  |  | Expand Our Infrastructure to Meet Service Provider Needs. Network service providers require extensive support and integration with manufacturers to
deliver reliable, innovative and cost-effective services. By combining advanced, computer-aided design, test and manufacturing systems with experienced, customer-focused management and technical staff, we believe that we have established the
critical mass required to fully support global service provider requirements. We continue to expand our infrastructure through ongoing development and strategic relationships, continuously improving quality, reducing costs and accelerating delivery
of advanced solutions.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continue the Advancement and Introduction of Our SLMS Products. Our SLMS architecture is the cornerstone of our product development strategy. The design
criteria for SLMS products include carrier-class reliability, multi-protocol and multi-service support, and ease of provisioning. We intend to continue to introduce SLMS products that offer the configurations and feature sets that our customers
require. In addition, we have introduced products that adhere to the standards, protocols and interfaces dictated by international standards bodies and service providers. To facilitate the rapid development of our SLMS architecture and products, we
have established engineering teams responsible for each critical aspect of the architecture and products. We intend to continue to leverage our expertise in voice, data and video technologies to enhance our SLMS architecture, supporting new
services, protocols and technologies as they emerge. To further this objective, we intend to continue investing in research and development efforts to extend the SLMS architecture and introduce new SLMS products.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Deliver Full Customer Solutions. In addition to delivering hardware and software product solutions, we provide customers with pre-sales and post-sales
support, education and professional services to enable our customers to more efficiently deploy and manage their networks. We provide customers with application notes, business planning information, web-based and phone-based troubleshooting
assistance and installation guides. Our support programs provide a comprehensive portfolio of support tools and resources that enable our customers to effectively sell to, support and expand their subscriber base using our products and solutions.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Product Portfolio

Our products provide the framework around which we are designing and developing high speed communications software and equipment for the access network. All of the products listed below are currently available and
being shipped to customers. Our products span two distinct categories:

SLMS Products

Our SLMS products address three areas of customer requirements. Our Broadband Aggregation and Service products aggregate, concentrate and
optimize communications traffic from copper and fiber networks. These products are deployed in central offices, remote offices, points of presence, curbsides, data and co-location centers, and large enterprises. Our Customer Premise Equipment, or
CPE, products offer a cost-effective solution for combining analog voice and data services to the subscribers premises over a single platform. The Zhone Management System, or ZMS, product provides optional software tools to help manage
aggregation and customer premises network hardware. These products deliver voice, data and video interface connectivity for broadcast and subscription television, internet routers and traditional telephony equipment.

Our SLMS products include:



|                                  |  |                       |  |                                                       
|--------------------------------- |  | --------------------- |  | ------------------------------------------------------
|Category                          |  | Product               |  | Function                                              
|Broadband Aggregation and Service |  | MALC                  |  | Multi-Access Line Concentrator                        
|                                  |  | Raptor                |  | Scalable DSLAM                                        
|                                  |  | MALC-OLT              |  | FTTx Optical Line Terminal                            
|                                  |  | 4000 /8000 /12000     |  | DSLAMs                                                
|Customer Premise Equipment (CPE)  |  | EtherXtend            |  | Ethernet Over Copper                                  
|                                  |  | 16xx, 17xx, 6xxx zNID |  | Wireline/Wireless DSL Modems Optical Network Terminals
|Network and Subscriber Management |  | ZMS                   |  | Zhone Management System                               

Legacy, Service and Other Products

Our legacy products support a variety of voice and data services, and are broadly deployed by service providers worldwide. Our legacy
products during 2008 and 2007 included:



|            |  |                         
|----------- |  | ------------------------
|Product     |  | Function                
|IMACS       |  | Multi-Access Multiplexer
|Access Node |  | Access Concentrator     
|GigaMux     |  | Optical Transport       

In December 2007, we sold our legacy Access Node product line and in January 2008,
we sold our legacy GigaMux product line.

Global Service & Support

In addition to our product offerings, we provide a broad range of service offerings through our Global Service & Support
organization. We supplement our standard and extended product warranties with programs that offer technical support, product repair, education services and enhanced support services. These services enable our customers to protect their network
investments, manage their networks more efficiently and minimize downtime for mission-critical systems. Technical support services are designed to help ensure that our products operate efficiently, remain highly available, and benefit from recent
software releases. Through our education services program, we offer in-depth training courses covering network design, installation, configuration, operation, trouble-shooting and maintenance. Our enhanced services offering is a comprehensive
program that



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provides network engineering, configuration, integration, project management and other consultative support to maximize the results of our customers during
the design, deployment and operational phases. As part of our commitment to ensure around-the-clock support, we maintain a technical assistance center and a staff of qualified network support engineers to provide customers with 24-hour service,
seven days a week.

Technology

We believe that our future success is built upon our investment in the development of advanced technologies. SLMS is based on a number of technologies that provide sustainable advantages, including the following:



| |  |  | Services-Centric Architecture. SLMS has been designed from inception for the delivery of multiple classes of subscriber services (such as voice, data or
video distribution), rather than being based on a particular protocol or media. Our SLMS products are built to interoperate in networks supporting packet, cell and circuit technologies. This independence between services and the underlying
transportation is designed to position our products to be able to adapt to future transportation technologies within established architectures and to allow our customers to focus on service delivery.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Common Code Base. Our SLMS products share a common base of software code, which is designed to accelerate development, improve software quality, enable
rapid deployment, and minimize training and operations costs, in conjunction with network management software.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Network Management and Operations. Our ZMS product provides management capabilities that enable rapid, cost-effective, and secure control of the network;
standards-based interfaces for seamless integration with supporting systems; hierarchical service and subscriber profiles to allow rapid service definition and provisioning, and to enable wholesaling of services; automated and intelligent CPE
provisioning to provide the best end-user experience and accelerate service turn-up; load-balancing for scalability; and full security features to ensure reliability and controlled access to systems and data.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Test Methodologies. Our SLMS architecture provides for interoperability with a variety of products that reside in networks in which we will deploy our
products. To ensure interoperability, we have built a testing facility to conduct extensive multi-vendor trials and to ensure full performance under valid network conditions. Testing has included participation with partners certification and
accreditation programs for a wide range of interoperable products, including softswitches, SAN equipment and management software. The successful completion of these processes is required by our largest customers to ensure interoperability with their
existing software and systems.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Acquired Technologies. Since our inception, we have completed twelve acquisitions pursuant to which we acquired products, technology and additional
technical expertise.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Customers

We sell our products and services to network service providers that offer voice, data and video services to businesses, governments, utilities and residential consumers. Our global customer base includes regional,
national and international telecommunications carriers. To date, our products are deployed by over 700 network service providers on six continents worldwide. No customer accounted for 10% or more of total revenue in 2008 or 2007.

Research and Development

The
industry in which we compete is subject to rapid technological developments, evolving industry standards, changes in customer requirements, and continuing developments in communications service offerings. Our continuing ability to adapt to these
changes, and to develop new and enhanced products, is a significant factor in maintaining or improving our competitive position and our prospects for growth. Therefore, we continue to make significant investments in product development.



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We conduct the majority of our research and product development activities at our
Oakland, California campus. In Oakland, we have built an extensive communications laboratory with hundreds of access infrastructure products from multiple vendors that serve as an interoperability and test facility. This facility allows us to
emulate a communications network with serving capacity equivalent to that supporting a city of 350,000 residents. We also have focused engineering staff and activities at additional development centers located in Alpharetta, Georgia, Largo, Florida,
Westlake Village, California, and Portsmouth, New Hampshire.

Our product development activities focus on products to
support both existing and emerging technologies in the segments of the communications industry that we consider viable revenue opportunities. We are actively engaged in continuing to refine our SLMS architecture, introducing new products under our
SLMS architecture, and creating additional interfaces and protocols for both domestic and international markets.

We
continue our commitment to invest in leading edge technology research and development. Our research and product development expenditures were $27.1 million, $32.7 million, and $36.1 million, in 2008, 2007 and 2006, respectively. All of our
expenditures for research and product development costs, as well as stock-based compensation expense relating to research and product development, have been expensed as incurred. These amounts include stock-based compensation of $0.5 million, $0.7
million, and $1.6 million reported under Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R) for 2008, 2007, and 2006, respectively. We plan to continue to support the development of new
products and features, while seeking to carefully manage associated costs through expense controls.

Intellectual Property

We seek to establish and maintain our proprietary rights in our technology and products through the use of patents, copyrights, trademarks
and trade secret laws. We also seek to maintain our trade secrets and confidential information by nondisclosure policies and through the use of appropriate confidentiality agreements. We have obtained a number of patents and trademarks in the United
States and in other countries. There can be no assurance, however, that these rights can be successfully enforced against competitive products in every jurisdiction. Although we believe the protection afforded by our patents, copyrights, trademarks
and trade secrets has value, the rapidly changing technology in the networking industry and uncertainties in the legal process make our future success dependent primarily on the innovative skills, technological expertise, and management abilities of
our employees rather than on the protection afforded by patent, copyright, trademark, and trade secret laws. In addition, we sold certain of our non-strategic patents for $1.1 million, $5.0 million, and $9.0 million in 2008, 2007, and 2006,
respectively.

Many of our products are designed to include software or other intellectual property licensed from third
parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, we believe, based upon past experience and standard industry practice, that such licenses generally could be obtained on
commercially reasonable terms. Nonetheless, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all. Our inability to obtain certain licenses or other rights or to obtain such licenses or rights on
favorable terms, or the need to engage in litigation regarding these matters, could have a material adverse effect on our business, operating results and financial condition.

The communications industry is characterized by rapidly changing technology, a large number of patents, and frequent claims and related litigation regarding patent and other intellectual property
rights. We cannot assure you that our patents and other proprietary rights will not be challenged, invalidated or circumvented, that others will not assert intellectual property rights to technologies that are relevant to us, or that our rights will
give us a competitive advantage. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as the laws of the United States.



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Sales and Marketing

We have a sales presence in various domestic and foreign locations, and we sell our products and services both directly and indirectly through channel partners with support from our sales force. Channel partners
include distributors, resellers, system integrators and service providers. These partners sell directly to end customers and often provide system installation, technical support, professional services and support services in addition to the network
equipment sale. Our sales efforts are generally organized according to geographical regions:



| |  |  | U.S. Sales. Our U.S. Sales organization establishes and maintains direct relationships with domestic customers, which include communication service
providers, cable operators, independent operating companies, or IOCs, as well as competitive carriers, developers and utilities. In addition, this organization is responsible for managing our distribution and original equipment manufacturer, or OEM,
partnerships.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | International Sales. Our International Sales organization targets foreign based service providers and is staffed with individuals with specific experience
dealing with service providers in their designated international territories.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Our marketing team works
closely with our sales, research and product development organizations, and our customers by providing communications that keep the market current on our products and features. Marketing also identifies and sizes new target markets for our products,
creates awareness of our company and products, generates contacts and leads within these targeted markets and performs outbound education and public relations.

Backlog

Our backlog consists of purchase orders for products and services that we expect to ship or perform
within the next year. At December 31, 2008, our backlog was $4.2 million, as compared to $14.0 million at December 31, 2007. We consider backlog to be an indicator, but not the sole predictor, of future sales because our customers may
cancel or defer orders without penalty.

Competition

We compete in the communications equipment market, providing products and services for the delivery of voice, data and video services. This market is characterized by rapid change, converging technologies and a
migration to solutions that offer superior advantages. These market factors represent both an opportunity and a competitive threat to us. We compete with numerous vendors, including Alcatel-Lucent, Calix, Huawei, and Occam Networks, among others. In
addition, a number of companies have introduced products that address the same network needs that our products address, both domestically and abroad. The overall number of our competitors may increase, and the identity and composition of competitors
may change. As we continue to expand our sales globally, we may see new competition in different geographic regions. Barriers to entry are relatively low, and new ventures to create products that do or could compete with our products are regularly
formed. Many of our competitors have greater financial, technical, sales and marketing resources than we do.

The principal
competitive factors in the markets in which we presently compete and may compete in the future include:



| |  |  | product performance;
| | - |  | --------------------



| |  |  | interoperability with existing products;
| | - |  | ----------------------------------------



| |  |  | scalability and upgradeability;
| | - |  | -------------------------------



| |  |  | conformance to standards;
| | - |  | -------------------------



| |  |  | breadth of services;
| | - |  | --------------------



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| |  |  | reliability;
| | - |  | ------------



| |  |  | ease of installation and use;
| | - |  | -----------------------------



| |  |  | geographic footprints for products;
| | - |  | -----------------------------------



| |  |  | ability to provide customer financing;
| | - |  | --------------------------------------



| |  |  | price;
| | - |  | ------



| |  |  | technical support and customer service; and
| | - |  | -------------------------------------------



| |  |  | brand recognition.
| | - |  | ------------------

While we believe that we compete successfully with respect to each of these factors, we expect to face intense competition in our market. In addition, the inherent nature of communications networking requires interoperability. As such, we
must cooperate and at the same time compete with many companies.

Manufacturing

We manufacture our products using a strategic combination of procurement from qualified suppliers, in-house manufacturing at our facility
in Florida, and the use of original design manufactures (ODM) located in the Far East. Since our acquisition of Paradyne Networks, Inc., or Paradyne, in September 2005, we have been manufacturing a significant majority of our more complex products
at our manufacturing facility in Florida.

Our parts and components are procured from a variety of qualified suppliers in
the U.S., Far East, Mexico, and other countries around the world per our Approved Supplier List and detailed engineering specifications. We also acquire completed products from certain suppliers and configure and ship from our facility. Some of
these purchases are significant. We purchase both standard off-the-shelf parts and components, which are generally available from more than one supplier, and single-source parts and components. We have generally been able to obtain adequate supplies
to meet customer demand in a timely manner from our current vendors, or, when necessary, from alternate vendors. We believe that alternate vendors can be identified if current vendors are unable to fulfill our needs, or design changes can be made to
employ alternate parts.

We design, specify, and monitor all of the tests that are required to meet our internal and
external quality standards. Our manufacturing and test engineers work closely with our design engineers to ensure manufacturability and testability of our products, and to ensure that manufacturing and testing processes evolve as our technologies
evolve. Our manufacturing engineers specify, build, or procure our test stations, establish quality standards and protocols, and develop comprehensive test procedures and processes to assure the reliability and quality of our products. These
processes and tests are reviewed by our design engineers to ensure they meet the intent of the design. Products that are procured complete or partially complete are inspected, tested, and audited for quality control.

Our manufacturing quality system is ISO-9001 and is certified to ISO-9001 by our external registrar. ISO-9001 ensures our processes are
documented, followed, and continuously improved. Internal audits are conducted on a regular schedule by our quality assurance personnel, and external audits are conducted by our external registrar every six months. Our quality system is based upon
our model for quality assurance in design, development, production, installation, and service to ensure our products meet rigorous quality standards.

We believe that we have sufficient production capacity to meet current and future demand for our product offerings through a combination of existing and added capacity, additional employees, or the outsourcing of
products or components.



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Compliance with Regulatory and Industry Standards

Our products must comply with a significant number of voice and data regulations and standards which vary between the U.S. and
international markets, and which vary between specific international markets. Standards for new services continue to evolve, and we may need to modify our products or develop new versions to meet these standards. Standards setting and compliance
verification in the U.S. are determined by the Federal Communications Commission, or FCC, Underwriters Laboratories, Quality Management Institute, Telcordia Technologies, Inc., and other communications companies. In international markets, our
products must comply with standards issued by the European Telecommunications Standards Institute, or ETSI, and implemented and enforced by the telecommunications regulatory authorities of each nation.

Environmental Matters

Our operations
and manufacturing processes are subject to federal, state, local and foreign environmental protection laws and regulations. These laws and regulations relate to the use, handling, storage, discharge and disposal of certain hazardous materials and
wastes, the pre-treatment and discharge of process waste waters and the control of process air pollutants.

We believe that
our operations and manufacturing processes currently comply in all material respects with applicable environmental protection laws and regulations. If we fail to comply with any present and future regulations, we could be subject to future
liabilities, the suspension of production or a prohibition on the sale of our products. In addition, such regulations could require us to incur other significant expenses to comply with environmental regulations, including expenses associated with
the redesign of any non-compliant product. From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and enforced. For example, in 2003 the European Union enacted the Restriction on the
Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive (RoHS) and the Waste Electrical and Electronic Equipment Directive (WEEE), for implementation in European Union member states. We are aware of similar legislation
that is currently in force or is being considered in the United States, as well as other countries. Our failure to comply with any of such regulatory requirements or contractual obligations could result in our being liable for costs, fines,
penalties and third-party claims, and could jeopardize our ability to conduct business in countries in the jurisdictions where these regulations apply.

Employees

As of December 31, 2008, we employed 359 individuals worldwide. We consider the
relationships with our employees to be positive. Competition for technical personnel in our industry is intense. We believe that our future success depends in part on our continued ability to hire, assimilate and retain qualified personnel. To date,
we believe that we have been successful in recruiting qualified employees, but there is no assurance that we will continue to be successful in the future.

Executive Officers

Set forth below is information concerning our executive officers and their ages as of
December 31, 2008.



|               |  |     |  |                                                                          
|-------------- |  | --- |  | -------------------------------------------------------------------------
|Name           |  | Age |  | Position                                                                 
|Morteza Ejabat |  | 58  |  | Chief Executive Officer, President and Chairman of the Board of Directors
|Kirk Misaka    |  | 50  |  | Chief Financial Officer, Corporate Treasurer and Secretary               

Morteza Ejabatis a co-founder of Zhone and has served as Chairman of the
Board of Directors, President and Chief Executive Officer since June 1999. Prior to co-founding Zhone, from June 1995 to June 1999,



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Mr. Ejabat was President and Chief Executive Officer of Ascend Communications, Inc., a provider of telecommunications equipment which was acquired by
Lucent Technologies, Inc. in June 1999. Previously, Mr. Ejabat held various senior management positions with Ascend from September 1990 to June 1995, most recently as Executive Vice President and Vice President, Operations. Mr. Ejabat
holds a B.S. in Industrial Engineering and an M.S. in Systems Engineering from California State University at Northridge and an M.B.A. from Pepperdine University.

Kirk Misakahas served as Zhones Corporate Treasurer since November 2000 and as Chief Financial Officer and Secretary since July 2003. Prior to joining Zhone, Mr. Misaka was a
Certified Public Accountant with KPMG LLP from 1980 to 2000, becoming a partner in 1989. Mr. Misaka earned a B.S. and an M.S. in Accounting from the University of Utah, and an M.S. in Tax from Golden Gate University.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

Set forth below and
elsewhere in this report and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report.

Our future operating results are difficult to predict and our stock price may continue to be volatile.

As a result of a variety of factors discussed in this report, our revenues for a particular quarter are difficult to predict. Our revenue
and operating results may vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control. The primary factors that may affect our results of operations include the following:



| |  |  | commercial acceptance of our SLMS products;
| | - |  | -------------------------------------------



| |  |  | fluctuations in demand for network access products;
| | - |  | ---------------------------------------------------



| |  |  | the timing and size of orders from customers;
| | - |  | ---------------------------------------------



| |  |  | the ability of our customers to finance their purchase of our products as well as their own operations;
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | new product introductions, enhancements or announcements by our competitors;
| | - |  | ----------------------------------------------------------------------------



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



| |  |  | changes in our pricing policies or the pricing policies of our competitors;
| | - |  | ---------------------------------------------------------------------------



| |  |  | the ability of our company and our contract manufacturers to attain and maintain production volumes and quality levels for our products;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain sufficient supplies of sole or limited source components;
| | - |  | -------------------------------------------------------------------------------



| |  |  | increases in the prices of the components we purchase, or quality problems associated with these components;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | unanticipated changes in regulatory requirements which may require us to redesign portions of our products;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | changes in accounting rules, such as recording expenses for employee stock option grants;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | integrating and operating any acquired businesses;
| | - |  | --------------------------------------------------



| |  |  | our ability to achieve targeted cost reductions;
| | - |  | ------------------------------------------------



| |  |  | how well we execute on our strategy and operating plans; and
| | - |  | ------------------------------------------------------------



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| |  |  | general economic conditions as well as those specific to the communications, internet and related industries.
| | - |  | -------------------------------------------------------------------------------------------------------------

Any of the foregoing factors, or any other factors discussed elsewhere herein, could have a material adverse effect on our business,
results of operations, and financial condition that could adversely affect our stock price. In addition, public stock markets have experienced, and may in the future experience, extreme price and trading volume volatility, particularly in the
technology sectors of the market. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to or disproportionately impacted by the operating performance of these
companies. These broad market fluctuations may adversely affect the market price of our common stock. In addition, if our average market capitalization falls below the carrying value of our assets for an extended period of time such as in 2008, this
may indicate that the fair value of our net assets is below their carrying value, and may result in recording impairment charges.

We
have incurred significant losses to date and expect that we will continue to incur losses in the foreseeable future. If we fail to generate sufficient revenue to achieve or sustain profitability, our stock price could decline.

We have incurred significant losses to date and expect that we will continue to incur losses in the foreseeable future. Our net losses for
2008 and 2007 were $92.5 million and $12.1 million, respectively, and we had an accumulated deficit of $1,005.6 million at December 31, 2008. We have significant fixed expenses and expect that we will continue to incur substantial
manufacturing, research and product development, sales and marketing, customer support, administrative and other expenses in connection with the ongoing development of our business. In addition, we may be required to spend more on research and
product development than originally budgeted to respond to industry trends. We may also incur significant new costs related to acquisitions and the integration of new technologies and other acquisitions that may occur in the future. We may not be
able to adequately control costs and expenses or achieve or maintain adequate operating margins. As a result, our ability to achieve and sustain profitability will depend on our ability to generate and sustain substantially higher revenue while
maintaining reasonable cost and expense levels. If we fail to generate sufficient revenue to achieve or sustain profitability, we will continue to incur substantial operating losses and our stock price could decline.

We have significant debt obligations, which could adversely affect our business, operating results and financial condition.

As of December 31, 2008, we had approximately $34.1 million of total debt, of which $15.4 million was current and $18.7 million was
long-term. Our debt obligations could materially and adversely affect us in a number of ways, including:



| |  |  | limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or general corporate purposes;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limiting our flexibility to plan for, or react to, changes in our business or market conditions;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | requiring us to use a significant portion of any future cash flow from operations to repay or service the debt, thereby reducing the amount of cash available for
other purposes;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | making us more highly leveraged than some of our competitors, which may place us at a competitive disadvantage; and
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | making us more vulnerable to the impact of adverse economic and industry conditions and increases in interest rates.
| | - |  | --------------------------------------------------------------------------------------------------------------------

We cannot assure you that we will be able to generate sufficient cash flow in amounts sufficient to enable us to service our debt or to
meet our working capital and capital expenditure requirements. If we are unable to



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generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, due to borrowing base restrictions or otherwise, we may be
required to sell assets, reduce capital expenditures or obtain additional financing. We cannot assure you that we will be able to engage in any of these actions on reasonable terms, if at all.

If we are unable to obtain additional capital to fund our existing and future operations, we may be required to reduce the scope of our planned product development, and marketing and sales
efforts, which would harm our business, financial condition and results of operations.

The development and marketing of
new products, and the expansion of our direct sales operations and associated support personnel requires a significant commitment of resources. We may continue to incur significant operating losses or expend significant amounts of capital if:



| |  |  | the market for our products develops more slowly than anticipated;
| | - |  | ------------------------------------------------------------------



| |  |  | we fail to establish market share or generate revenue at anticipated levels;
| | - |  | ----------------------------------------------------------------------------



| |  |  | our capital expenditure forecasts change or prove inaccurate; or
| | - |  | ----------------------------------------------------------------



| |  |  | we fail to respond to unforeseen challenges or take advantage of unanticipated opportunities.
| | - |  | ---------------------------------------------------------------------------------------------

As a result, we may need to raise substantial additional capital. Additional capital, if required, may not be available on acceptable
terms, or at all. For example, U.S. credit markets have recently experienced significant dislocations and liquidity disruptions which have caused the spreads on prospective debt financings to widen considerably. These circumstances have materially
impacted liquidity in debt markets, making financing terms for borrowers less attractive and resulting in the general unavailability of many forms of debt financing. Continued uncertainty in credit markets may negatively impact our ability to access
debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include covenants,
restrictions and financial ratios that may restrict our ability to operate our business. Likewise, equity financing could result in additional dilution of our stockholders. The recent events in the U.S. credit markets have also had an adverse effect
on other U.S. financial markets and have adversely affected the trading prices of equity securities of many U.S. companies, including Zhone, which may make it more difficult or costly for us to raise capital through the issuance of common stock,
preferred stock or other equity securities. If we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development
and sales and marketing efforts beyond the reductions that we have previously taken, which could have a material adverse effect on our business, financial condition and results of operations.

Our lack of liquid funds and other sources of financing may limit our ability to maintain our existing operations, grow our business and compete effectively.

Our continued losses reduced our cash, cash equivalents and short-term investments in 2007 and 2008. As of December 31, 2008, we had
approximately $36.2 million in cash, cash equivalents and short-term investments and $15.0 million outstanding under our bank lending facility. In order to meet our liquidity needs and finance our capital expenditures and working capital needs for
our business, we may be required to sell assets, or to borrow on potentially unfavorable terms. We may be unable to sell assets, or access additional indebtedness to meet these needs. As a result, we may become unable to pay our ordinary expenses,
including our debt service, on a timely basis. Our current lack of liquidity could harm us by:



| |  |  | increasing our vulnerability to adverse economic conditions in our industry or the economy in general;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



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| |  |  | limiting our ability to plan for, or react to, changes in our business and industry; and
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | influencing investor and customer perceptions about our financial stability and limiting our ability to obtain financing or acquire customers.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------

The recent downturn in the equity and debt markets generally makes it more difficult for us to obtain
financing through the issuance of equity or debt securities in the capital markets. We cannot be certain that additional financing, if needed, will be available on acceptable terms or at all. If we cannot raise any necessary additional financing on
acceptable terms, we may not be able to fund our business expansion, take advantage of future opportunities, meet our existing debt obligations or respond to competitive pressures or unanticipated capital requirements, any of which could have a
material adverse effect on our business, financial condition and results of operations. Further, if we issue additional equity or debt securities, stockholders may experience additional dilution or the new equity securities may have rights,
preference or privileges senior to those of existing holders of our common stock.

We face a number of risks related to unfavorable
economic and market conditions and severe tightening in the global credit markets.

Recent global market and economic
conditions have been unprecedented and challenging, with tighter credit conditions and recession in most major economies continuing into 2009. Continued concerns about the systemic impact of potential long-term and widespread recession, energy
costs, geopolitical issues, the availability and cost of credit, and the global housing and mortgage markets have contributed to increased market volatility and diminished expectations for western and emerging economies. In the second half of 2008,
federal government interventions in the U.S. financial system led to increased market uncertainty and instability in both U.S. and international capital and credit markets. These conditions, combined with volatile oil prices, declining business and
consumer confidence and increased unemployment, have contributed to volatility of unprecedented levels. These global unfavorable economic and market conditions and the financial crisis could impact our business in a number of ways, including:

Potential deferment of purchases and orders by customers: Uncertainty about current and future global economic conditions may cause
consumers, businesses and governments to defer purchases in response to significant decreases in their revenues, tighter credit, decreased cash availability and declining consumer confidence. Accordingly, future demand for our products could differ
materially from our current expectations.

Customers inability to obtain financing to make purchases from Zhone and/or maintain
their business:Some of our customers require substantial financing in order to finance their business operations, including capital expenditures on new equipment and equipment upgrades, and make purchases from Zhone. The inability of these
customers to access the capital needed to finance purchases of our products and meet their payment obligations to us could adversely impact our financial condition and results of operations. If the financial crisis results in insolvencies for our
customers, it could have a material adverse impact on our business, financial condition and results of operations.

Negative impact from
increased financial pressures on third-party dealers, distributors and retailers: We make sales in certain regions through third-party dealers, distributors and retailers. These third parties may be impacted by the significant decrease in
available credit that has resulted from the current financial crisis. If credit pressures or other financial difficulties result in insolvency for these third parties and we are unable to successfully transition end customers to purchase our
products from other third parties, or from us directly, it could adversely impact our financial condition and results of operations.

Negative impact from increased financial pressures on key suppliers:Our ability to meet customers demands depends, in part, on our ability to obtain timely and adequate delivery of quality materials, parts and components



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from our suppliers. Certain of our components are available only from a single source or limited sources. If certain key suppliers were to become capacity
constrained or insolvent as a result of the financial crisis, it could result in a reduction or interruption in supplies or a significant increase in the price of supplies and adversely impact our financial condition and results of operations. In
addition, credit constraints of key suppliers could result in accelerated payment of accounts payable by Zhone, impacting our cash flow.

If the economic, market and geopolitical conditions in the United States and the rest of the world do not improve, or if they continue to deteriorate, we may experience material adverse impacts on our business,
operating results and financial condition.

Our common stock may be delisted from The Nasdaq Global Market, which could negatively
impact the price of our common stock and our ability to access the capital markets.

Our common stock is listed on The
Nasdaq Global Market. On June 11, 2008, we received a letter from The Nasdaq Stock Market, or Nasdaq, indicating that, for the last 30 consecutive business days preceding the date of the letter, the bid price of our common stock had closed
below the $1.00 minimum per share bid price required for continued inclusion on The Nasdaq Global Market under Marketplace Rule 4450(a)(5). In accordance with Marketplace Rule 4450(e)(2), we were given 180 calendar days from the date of the Nasdaq
letter, or until December 8, 2008, to regain compliance with the minimum bid price rule. Our stock price has not closed above $1.00 since the date of the receipt of the letter from Nasdaq. On October 22, 2008, we received a letter from
Nasdaq indicating that there was a temporary suspension of the minimum bid price rule through January 16, 2009. As a result, we were given until March 16, 2009 to regain compliance with the minimum bid price rule. On December 23,
2008, we received a letter from Nasdaq further extending the temporary suspension of the minimum bid price rule until April 20, 2009. Nasdaq has advised us that they will notify us of our new compliance deadline prior to the lifting of this
suspension. We anticipate that we will have until June 2009 to regain compliance with the minimum bid price rule.

To
regain compliance, the closing bid price of our common stock must be at or above $1.00 per share for a minimum of 10 consecutive business days. Nasdaq may, in its discretion, require us to maintain a bid price of at least $1.00 per share for a
period in excess of 10 consecutive business days, but generally no more than 20 consecutive business days, before determining that we have demonstrated an ability to maintain long-term compliance. If we do not regain compliance by the applicable
compliance deadline, Nasdaq will provide written notification to us that our common stock will be delisted. At that time, we may appeal Nasdaqs delisting determination to a Nasdaq Listing Qualifications Panel. Alternatively, we could apply to
transfer our common stock to The Nasdaq Capital Market if we satisfy all of the requirements, other than the minimum bid price requirement, for initial listing on The Nasdaq Capital Market set forth in Marketplace Rule 4310(c). If we were to elect
to apply for such transfer and if such application were approved, we would have an additional 180 days to regain compliance with the minimum bid price rule while listed on The Nasdaq Capital Market. In October 2008, Zhones stockholders
approved an amendment to our restated certificate of incorporation to effect a reverse stock split at an exchange ratio ranging from one-for-five to one-for-ten, with the exchange ratio determined by Zhone. We are currently actively monitoring the
bid price for our common stock, and will consider available options to resolve the deficiency and regain compliance with the Nasdaq minimum bid price requirement.

Delisting from The Nasdaq Global Market could have an adverse effect on our business and on the trading of our common stock. If a delisting of our common stock were to occur, our common stock
would trade on the OTC Bulletin Board or on the pink sheets maintained by the National Quotation Bureau, Inc. Such alternatives are generally considered to be less efficient markets, and our stock price, as well as the liquidity of our
common stock, may be adversely impacted as a result. Delisting from The Nasdaq Global Market could also have other negative results, including the potential loss of confidence by suppliers and employees, the loss of institutional investor interest
and fewer business development opportunities.



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If demand for our SLMS products does not develop, then our results of operations and financial
condition will be adversely affected.

Our future revenue depends significantly on our ability to successfully develop,
enhance and market our SLMS products to the network service provider market. Most network service providers have made substantial investments in their current infrastructure, and they may elect to remain with their current architectures or to adopt
new architectures, such as SLMS, in limited stages or over extended periods of time. A decision by a customer to purchase our SLMS products will involve a significant capital investment. We must convince our service provider customers that they will
achieve substantial benefits by deploying our products for future upgrades or expansions. We do not know whether a viable market for our SLMS products will develop or be sustainable. If this market does not develop or develops more slowly than we
expect, our business, financial condition and results of operations will be seriously harmed.

We depend upon the development of new
products and enhancements to existing products, and if we fail to predict and respond to emerging technological trends and customers changing needs, our operating results and market share may suffer.

The markets for our products are characterized by rapidly changing technology, evolving industry standards, changes in end-user
requirements, frequent new product introductions and changes in communications offerings from network service provider customers. Our future success depends on our ability to anticipate or adapt to such changes and to offer, on a timely and
cost-effective basis, products that meet changing customer demands and industry standards. We may not have sufficient resources to successfully and accurately anticipate customers changing needs and technological trends, manage long
development cycles or develop, introduce and market new products and enhancements. The process of developing new technology is complex and uncertain, and if we fail to develop new products or enhancements to existing products on a timely and
cost-effective basis, or if our new products or enhancements fail to achieve market acceptance, our business, financial condition and results of operations would be materially adversely affected.

Because our products are complex and are deployed in complex environments, our products may have defects that we discover only after full deployment
by our customers, which could seriously harm our business.

We produce highly complex products that incorporate
leading-edge technology, including both hardware and software. Software typically contains defects or programming flaws that can unexpectedly interfere with expected operations. In addition, our products are complex and are designed to be deployed
in large quantities across complex networks. Because of the nature of these products, they can only be fully tested when completely deployed in large networks with high amounts of traffic, and there is no assurance that our pre-shipment testing
programs will be adequate to detect all defects. As a result, our customers may discover errors or defects in our hardware or software, or our products may not operate as expected, after they have been fully deployed by our customers. If we are
unable to cure a product defect, we could experience damage to our reputation, reduced customer satisfaction, loss of existing customers and failure to attract new customers, failure to achieve market acceptance, reduced sales opportunities, loss of
revenue and market share, increased service and warranty costs, diversion of development resources, legal actions by our customers, and increased insurance costs. Defects, integration issues or other performance problems in our products could also
result in financial or other damages to our customers. Our customers could seek damages for related losses from us, which could seriously harm our business, financial condition and results of operations. A product liability claim brought against us,
even if unsuccessful, would likely be time consuming and costly. The occurrence of any of these problems would seriously harm our business, financial condition and results of operations.

A shortage of adequate component supply or manufacturing capacity could increase our costs or cause a delay in our ability to fulfill orders, and our failure to estimate customer demand
properly may result in excess or obsolete component inventories that could adversely affect our gross margins.



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Occasionally, we may experience a supply shortage, or a delay in receiving, certain
component parts as a result of strong demand for the component parts and/or capacity constraints or other problems experienced by suppliers. If shortages or delays persist, the price of these components may increase, or the components may not be
available at all, and we may also encounter shortages if we do not accurately anticipate our needs. Conversely, we may not be able to secure enough components at reasonable prices or of acceptable quality to build new products in a timely manner in
the quantities or configurations needed. Accordingly, our revenue and gross margins could suffer until other sources can be developed. Our operating results would also be adversely affected if, anticipating greater demand than actually develops, we
commit to the purchase of more components than we need. Furthermore, as a result of binding price or purchase commitments with suppliers, we may be obligated to purchase components at prices that are higher than those available in the current
market. In the event that we become committed to purchase components at prices in excess of the current market price when the components are actually used, our gross margins could decrease.

We rely on contract manufacturers for a portion of our manufacturing requirements.

We rely on contract manufacturers to perform a portion of the manufacturing operations for our products. These contract manufacturers build product for other companies, including our competitors.
In addition, we do not have contracts in place with some of these providers and may not be able to effectively manage those relationships. We cannot be certain that our contract manufacturers will be able to fill our orders in a timely manner. We
face a number of risks associated with this dependence on contract manufacturers including reduced control over delivery schedules, the potential lack of adequate capacity during periods of excess demand, poor manufacturing yields and high costs,
quality assurance, increases in prices, and the potential misappropriation of our intellectual property. We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality,
insufficient quantities and late delivery of products.

We depend on a limited source of suppliers for several key components. If we are
unable to obtain these components on a timely basis, we will be unable to meet our customers product delivery requirements, which would harm our business.

We currently purchase several key components from a limited number of suppliers. If any of our limited source of suppliers become insolvent, cease business or experience capacity constraints,
work stoppages or any other reduction or disruption in output, they may be unable to meet our delivery schedules. Our suppliers may enter into exclusive arrangements with our competitors, be acquired by our competitors, stop selling their products
or components to us at commercially reasonable prices, refuse to sell their products or components to us at any price or be unable to obtain or have difficulty obtaining components for their products from their suppliers. If we do not receive
critical components from our limited source of suppliers in a timely manner, we will be unable to meet our customers product delivery requirements. Any failure to meet a customers delivery requirements could materially adversely affect
our business, operating results and financial condition and could materially damage customer relationships.

Our target customer base is
concentrated, and the loss of one or more of our customers could harm our business.

The target customers for our
products are network service providers that operate voice, data and video communications networks. There are a limited number of potential customers in our target market. While no customer accounted for more than 10% of our revenue in 2008 or 2007,
we expect that a significant portion of our future revenue will depend on sales of our products to a limited number of customers. Any failure of one or more customers to purchase products from us for any reason, including any downturn in their
businesses, would seriously harm our business, financial condition and results of operations.



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Industry consolidation may lead to increased competition and may harm our operating results.

There has been a trend toward industry consolidation in the communications equipment market for several years. We
expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. We believe that industry consolidation may result in stronger
competitors that are better able to compete as sole-source vendors for customers. This could have a material adverse effect on our business, financial condition and results of operations. Furthermore, rapid consolidation could result in a decrease
in the number of customers we serve. Loss of a major customer could have a material adverse effect on our business, financial condition and results of operations.

We are exposed to the credit risk of some of our customers and to credit exposures in weakened markets, which could result in material losses.

The current financial crisis, industry and economic conditions have weakened the financial position of some of our customers and their
ability to access capital to finance their business operations, including capital expenditures. To sell to some of these customers, we may be required to assume incremental risks of uncollectible accounts or to extend credit or credit support. While
we monitor these situations carefully and attempt to take appropriate measures to protect ourselves, including factoring credit arrangements to financial institutions, it is possible that we may have to defer revenue until cash is collected or write
down or write off uncollectible accounts. Such write-downs or write-offs, if large, could have a material adverse effect on our operating results and financial condition.

The market we serve is highly competitive and we may not be able to compete successfully.

Competition in the communications equipment market is intense. This market is characterized by rapid change, converging technologies and a migration to networking solutions that offer superior advantages. We are aware of many companies in
related markets that address particular aspects of the features and functions that our products provide. Currently, our primary competitors include Alcatel-Lucent, Calix, Huawei, and Occam Networks, among others. We also may face competition from
other large communications equipment companies or other companies that may enter our market in the future. In addition, a number of companies have introduced products that address the same network needs that our products address, both domestically
and abroad. Many of our competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical, sales and marketing resources than we do and may be able to undertake more extensive marketing
efforts, adopt more aggressive pricing policies and provide more customer financing than we can. In particular, we are encountering price-focused competitors from Asia, especially China, which places pressure on us to reduce our prices. If our
competitors offer deep discounts on certain products, we may need to lower prices or offer other favorable terms in order to compete successfully. Moreover, our competitors may foresee the course of market developments more accurately than we do and
could develop new technologies that render our products less valuable or obsolete.

In our markets, principal competitive
factors include:



| |  |  | product performance;
| | - |  | --------------------



| |  |  | interoperability with existing products;
| | - |  | ----------------------------------------



| |  |  | scalability and upgradeability;
| | - |  | -------------------------------



| |  |  | conformance to standards;
| | - |  | -------------------------



| |  |  | breadth of services;
| | - |  | --------------------



| |  |  | reliability;
| | - |  | ------------



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| |  |  | ease of installation and use;
| | - |  | -----------------------------



| |  |  | geographic footprints for products;
| | - |  | -----------------------------------



| |  |  | ability to provide customer financing;
| | - |  | --------------------------------------



| |  |  | price;
| | - |  | ------



| |  |  | technical support and customer service; and
| | - |  | -------------------------------------------



| |  |  | brand recognition.
| | - |  | ------------------

If we are unable to compete successfully against our current and future competitors, we may have difficulty obtaining or retaining customers, and we could experience price reductions, order cancellations, increased expenses and reduced
gross margins, any of which could have a material adverse effect on our business, financial condition and results of operations.

Our
success largely depends on our ability to retain and recruit key personnel, and any failure to do so would harm our ability to meet key objectives.

Our future success depends upon the continued services of our executive officers and our ability to identify, attract and retain highly skilled technical, managerial, sales and marketing personnel who have critical
industry experience and relationships that we rely on to build our business, including Morteza Ejabat, our co-founder, Chairman, President and Chief Executive Officer, and Kirk Misaka, our Chief Financial Officer. The loss of the services of any of
our key employees, including Messrs. Ejabat and Misaka, could delay the development and production of our products and negatively impact our ability to maintain customer relationships, which would harm our business, financial condition and results
of operations.

Any strategic acquisitions or investments we make could disrupt our operations and harm our operating results.

As of December 31, 2008, we had acquired twelve companies or product lines since we were founded in 1999. Further,
we may acquire additional businesses, products or technologies in the future. On an ongoing basis, we may evaluate acquisitions of, or investments in, complementary companies, products or technologies to supplement our internal growth. Also, in the
future, we may encounter difficulties identifying and acquiring suitable acquisition candidates on reasonable terms.

If we
do complete future acquisitions, we could:



| |  |  | issue stock that would dilute our current stockholders percentage ownership;
| | - |  | -----------------------------------------------------------------------------



| |  |  | consume a substantial portion of our cash resources;
| | - |  | ----------------------------------------------------



| |  |  | incur substantial debt;
| | - |  | -----------------------



| |  |  | assume liabilities;
| | - |  | -------------------



| |  |  | increase our ongoing operating expenses and level of fixed costs;
| | - |  | -----------------------------------------------------------------



| |  |  | record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | incur amortization expenses related to certain intangible assets;
| | - |  | -----------------------------------------------------------------



| |  |  | incur large and immediate write-offs; and
| | - |  | -----------------------------------------



| |  |  | become subject to litigation.
| | - |  | -----------------------------



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Any acquisitions or investments that we make in the future will involve numerous risks,
including:



| |  |  | difficulties in integrating the operations, technologies, products and personnel of the acquired companies;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | unanticipated costs;
| | - |  | --------------------



| |  |  | diversion of managements time and attention away from normal daily operations of the business and the challenges of managing larger and more widespread
operations resulting from acquisitions;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in entering markets in which we have no or limited prior experience;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | insufficient revenues to offset increased expenses associated with acquisitions and where competitors in such markets have stronger market positions; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | potential loss of key employees, customers, distributors, vendors and other business partners of the companies we acquire following and continuing after
announcement of acquisition plans.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Mergers and acquisitions of high-technology companies are inherently
risky and subject to many factors outside of our control, and we cannot be certain that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results or financial condition. We do not
know whether we will be able to successfully integrate the businesses, products, technologies or personnel that we might acquire in the future or that any strategic investments we make will meet our financial or other investment objectives. Any
failure to do so could seriously harm our business, financial condition and results of operations.

Sales to communications service
providers are especially volatile, and weakness in sales orders from this industry may harm our operating results and financial condition.

Sales activity in the service provider industry depends upon the stage of completion of expanding network infrastructures, the availability of funding, and the extent to which service providers are affected by
regulatory, economic and business conditions in the country of operations. Although some service providers may be increasing capital expenditures over the depressed levels that have prevailed over the last few years, weakness in orders from this
industry could have a material adverse effect on our business, operating results and financial condition. Slowdowns in the general economy, overcapacity, changes in the service provider market, regulatory developments and constraints on capital
availability have had a material adverse effect on many of our service provider customers, with many of these customers going out of business or substantially reducing their expansion plans. These conditions have materially harmed our business and
operating results, and we expect that some or all of these conditions may continue for the foreseeable future. Finally, service provider customers typically have longer implementation cycles; require a broader range of service including design
services; demand that vendors take on a larger share of risks; often require acceptance provisions, which can lead to a delay in revenue recognition; and expect financing from vendors. All these factors can add further risk to business conducted
with service providers.

Decreased effectiveness of share-based compensation could adversely affect our ability to attract and retain
employees.

We have historically used stock options as a key component of our employee compensation program in order to
align the interests of our employees with the interests of our stockholders, encourage employee retention and provide competitive compensation and benefit packages. In the first quarter of 2006, we adopted SFAS 123R, which required the measurement
and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. As a result, starting with fiscal 2006, our operating results contain a charge for share-based compensation
expense related to employee stock options and employee stock purchases. This charge is in addition to share-based compensation expense we have recognized in prior periods related to stock options under APB Opinion No. 25. As a result of the
adoption of SFAS 123R, beginning with fiscal 2006, our earnings were lower than they would have been had we not been required to



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adopt SFAS 123R. This will continue to be the case for future periods. We cannot predict the effect that this adverse impact on our reported operating
results will have on the trading price of our common stock. If the trading price of our common stock declines, this would reduce the value of our share-based compensation to our present employees and could affect our ability to retain them. In
addition, in recent periods, some of our employee stock options have had exercise prices in excess of our stock price, which reduces their value to employees and could affect our ability to retain present, or attract prospective employees. To
address these issues, in the fourth quarter of 2008, we conducted an exchange offer, or the Exchange Offer, in which eligible employees, officers and directors of Zhone could exchange outstanding options to purchase shares of Zhone common stock
previously granted under our equity incentive compensation plans with an exercise price per share equal to or greater than $0.35 on a one-for-one basis for the grant of new options to purchase shares of Zhone common stock. Options to acquire
approximately 14.5 million shares of Zhone common stock were tendered in the Exchange Offer for new options with an exercise price of $0.10 per share. Difficulties relating to obtaining stockholder approval of equity compensation plans could
also make it harder or more expensive for us to grant share-based payments to employees in the future.

Due to the international nature
of our business, political or economic changes or other factors in a specific country or region could harm our future revenue, costs and expenses and financial condition.

We currently have international operations consisting of sales and technical support teams in various locations around the world. We expect to continue expanding our international operations in
the future. The successful management and expansion of our international operations requires significant human effort and the commitment of substantial financial resources. Further, our international operations may be subject to certain risks and
challenges that could harm our operating results, including:



| |  |  | trade protection measures and other regulatory requirements which may affect our ability to import or export our products into or from various countries;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | political considerations that affect service provider and government spending patterns;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | differing technology standards or customer requirements;
| | - |  | --------------------------------------------------------



| |  |  | developing and customizing our products for foreign countries;
| | - |  | --------------------------------------------------------------



| |  |  | fluctuations in currency exchange rates;
| | - |  | ----------------------------------------



| |  |  | longer accounts receivable collection cycles and financial instability of customers;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | difficulties and excessive costs for staffing and managing foreign operations;
| | - |  | ------------------------------------------------------------------------------



| |  |  | potentially adverse tax consequences; and
| | - |  | -----------------------------------------



| |  |  | changes in a countrys or regions political and economic conditions.
| | - |  | ---------------------------------------------------------------------

Any of these factors could harm our existing international operations and business or impair our ability to continue expanding into
international markets.

Compliance or the failure to comply with current and future environmental regulations could cause us significant
expense.

We are subject to a variety of federal, state, local and foreign environmental regulations. If we fail to
comply with any present and future regulations, we could be subject to future liabilities, the suspension of production or a prohibition on the sale of our products. In addition, such regulations could require us to incur other significant expenses
to comply with environmental regulations, including expenses associated with the redesign of any non-compliant product. From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and
enforced. For example, in 2003 the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment



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Directive (RoHS) and the Waste Electrical and Electronic Equipment Directive (WEEE), for implementation in European Union member states. We are aware of
similar legislation that is currently in force or is being considered in the United States, as well as other countries, such as Japan and China. Our failure to comply with any of such regulatory requirements or contractual obligations could result
in our being liable for costs, fines, penalties and third-party claims, and could jeopardize our ability to conduct business in countries in the jurisdictions where these regulations apply.

Adverse resolution of litigation may harm our operating results or financial condition.

We are a party to various lawsuits and claims in the normal course of our business. Litigation can be expensive, lengthy, and disruptive to normal business operations. Moreover, the results of complex legal
proceedings are difficult to predict. An unfavorable resolution of a particular lawsuit could have a material adverse effect on our business, operating results and financial condition. For additional information regarding litigation in which we are
involved, see Item 3, Legal Proceedings, contained in Part I of this report.

Our intellectual property rights may
prove difficult to protect and enforce.

We generally rely on a combination of copyrights, patents, trademarks and trade
secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our
proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our technology is difficult, and we do
not know whether the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as extensively as in the United States. We cannot assure you that our
pending, or any future, patent applications will be granted, that any existing or future patents will not be challenged, invalidated, or circumvented, or that any existing or future patents will be enforceable. While we are not dependent on any
individual patents, if we are unable to protect our proprietary rights, we may find ourselves at a competitive disadvantage to others who need not incur the substantial expense, time and effort required to create the innovative products.

We may be subject to intellectual property infringement claims that are costly and time consuming to defend and could limit our ability to use some
technologies in the future.

Third parties have in the past and may in the future assert claims or initiate litigation
related to patent, copyright, trademark and other intellectual property rights to technologies and related standards that are relevant to us. The asserted claims or initiated litigation can include claims against us or our manufacturers, suppliers
or customers alleging infringement of their proprietary rights with respect to our existing or future products, or components of those products. We have received correspondence from companies claiming that many of our products are using technology
covered by or related to the intellectual property rights of these companies and inviting us to discuss licensing arrangements for the use of the technology. Regardless of the merit of these claims, intellectual property litigation can be time
consuming and costly, and result in the diversion of technical and management personnel. Any such litigation could force us to stop selling, incorporating or using our products that include the challenged intellectual property, or redesign those
products that use the technology. In addition, if a party accuses us of infringing upon its proprietary rights, we may have to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all. If we are
unsuccessful in any such litigation, we could be subject to significant liability for damages and loss of our proprietary rights. Any of these results could have a material adverse effect on our business, financial condition and results of
operations.

We rely on the availability of third party licenses.

Many of our products are designed to include software or other intellectual property licensed from third parties. It may be necessary in
the future to seek or renew licenses relating to various elements of the technology



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used to develop these products. We cannot assure you that our existing and future third-party licenses will be available to us on commercially reasonable
terms, if at all. Our inability to maintain or obtain any third-party license required to sell or develop our products and product enhancements could require us to obtain substitute technology of lower quality or performance standards, or at greater
cost.

The long and variable sales cycles for our products may cause revenue and operating results to vary significantly from quarter to
quarter.

The target customers for our products have substantial and complex networks that they traditionally expand in
large increments on a periodic basis. Accordingly, our marketing efforts are focused primarily on prospective customers that may purchase our products as part of a large-scale network deployment. Our target customers typically require a lengthy
evaluation, testing and product qualification process. Throughout this process, we are often required to spend considerable time and incur significant expense educating and providing information to prospective customers about the uses and features
of our products. Even after a company makes the final decision to purchase our products, it may deploy our products over extended periods of time. The timing of deployment of our products varies widely, and depends on a number of factors, including
our customers skill sets, geographic density of potential subscribers, the degree of configuration and integration required to deploy our products, and our customers ability to finance their purchase of our products as well as their
operations. As a result of any of these factors, our revenue and operating results may vary significantly from quarter to quarter.

The
communications industry is subject to government regulations, which could harm our business.

The FCC has jurisdiction
over the entire communications industry in the United States and, as a result, our existing and future products and our customers products are subject to FCC rules and regulations. Changes to current FCC rules and regulations and future FCC
rules and regulations could negatively affect our business. The uncertainty associated with future FCC decisions may cause network service providers to delay decisions regarding their capital expenditures for equipment for broadband services. In
addition, international regulatory bodies establish standards that may govern our products in foreign markets. Changes to or future domestic and international regulatory requirements could result in postponements or cancellations of customer orders
for our products and services, which would harm our business, financial condition and results of operations. Further, we cannot be certain that we will be successful in obtaining or maintaining regulatory approvals that may, in the future, be
required to operate our business.

The ability of unaffiliated stockholders to influence key transactions, including changes of control,
may be limited by significant insider ownership, provisions of our charter documents and provisions of Delaware law.

At
December 31, 2008, our executive officers, directors and entities affiliated with them beneficially owned, in the aggregate, approximately 32% of our outstanding common stock. These stockholders, if acting together, will be able to influence
substantially all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Circumstances may arise in which the interests of these stockholders could
conflict with the interests of our other stockholders. These stockholders could delay or prevent a change in control of our company even if such a transaction would be beneficial to our other stockholders. In addition, provisions of our certificate
of incorporation, bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to certain stockholders.

Our business and operations are especially subject to the risks of earthquakes and other natural catastrophic events.

Our corporate headquarters, including a significant portion of our research and development operations, are located in Northern California, a region known for seismic activity. Additionally, some
of our facilities,



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including our manufacturing facilities, are located near geographic areas that have experienced hurricanes in the past. A significant natural disaster, such
as an earthquake, hurricane, fire, flood or other catastrophic event, could severely affect our ability to conduct normal business operations, and as a result, our future operating results could be materially and adversely affected.



|ITEM 1B. | UNRESOLVED STAFF COMMENTS
|-------- | -------------------------

None.



|ITEM 2. | PROPERTIES
|------- | ----------

Our worldwide
headquarters are located at our Oakland, California campus. In March 2001, we purchased the land and buildings in Oakland, California which we had previously leased under a synthetic lease agreement. As part of the financing for the purchase, we
granted a deed of trust on the property to the lender and were required to transfer the land and buildings to a new wholly-owned consolidated subsidiary, Zhone Technologies Campus, LLC, from which we currently lease the land and buildings. We are
the sole member and manager of Zhone Technologies Campus, LLC. Our lease for this facility will expire in March 2011. The Oakland campus consists of three buildings with an aggregate of approximately 180,000 square feet, and is used for our
executive offices, research and product development activities, and administrative and marketing activities.

In addition
to our Oakland campus, we also lease facilities for manufacturing, research and development purposes at locations including Largo, Florida, Alpharetta, Georgia, Portsmouth, New Hampshire and Westlake Village, California. We also maintain smaller
offices to provide sales and customer support at various domestic and international locations. We believe that our existing facilities are suitable and adequate for our present purposes.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

Paradyne Matters

As a result of our acquisition of Paradyne, we became involved in various legal proceedings, claims and litigation,
including those identified below, relating to the operations of Paradyne prior to our acquisition of Paradyne.

A purported
stockholder class action complaint was filed in December 2001 in the United States District Court in the Southern District of New York against Paradyne, Paradynes then-current directors and executive officers, and each of the underwriters (the
Underwriter Defendants) who participated in Paradynes initial public offering and follow-on offering (collectively, the Paradyne Offerings). The complaint alleges that, in connection with the Paradyne Offerings, the
Underwriter Defendants charged excessive commissions, inflated transaction fees not disclosed in the applicable registration statements and allocated shares of the Paradyne Offerings to favored customers in exchange for purported promises by such
customers to purchase additional shares in the aftermarket, thereby allegedly inflating the market price for the Paradyne Offerings. The complaint seeks damages in an unspecified amount for the purported class for the losses suffered during the
class period. This action has been consolidated with hundreds of other securities class actions commenced against more than 300 companies (collectively, the Issuer Defendants) and approximately 40 investment banks in which the plaintiffs
make substantially similar allegations as those made against Paradyne with respect to the initial public offerings and/or follow-on offerings at issue in those other cases. All of these actions have been consolidated before Judge Shira Scheindlin
under the caption In re: Initial Public Offering Securities Litigation(the IPO Actions).

In 2003, the
Issuer Defendants participated in a global settlement among the plaintiffs and the insurance companies that provided directors and officers insurance coverage to the Issuer Defendants (the Issuer



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Settlement). The Issuer Settlement agreements provided for the Issuer Defendants (including Paradyne) to be fully released and dismissed from the IPO
Actions. Under the terms of the Issuer Settlement agreements, Paradyne would not have been required to make any cash payment to the plaintiffs. Although the District Court preliminarily approved the Issuer Settlement, the preliminary approval
remained subject to a future final settlement order, after notice of settlement had been provided to class members and they had been afforded the opportunity to oppose or opt out of the settlement. However, before the District Court could conduct
its final settlement hearing, on December 5, 2006, the United States Court of Appeals for the Second Circuit (the Second Circuit) reversed an October 13, 2004 order of the District Court in which Judge Scheindlin had granted
class certification for six test cases in the IPO Actions. On April 4, 2007, the Second Circuit denied the plaintiffs petition for rehearing of the December 5, 2006 ruling. The District Court has since made clear
that the Issuer Settlement cannot be approved  in its current form  as a class action settlement in light of the Second Circuits December 5, 2006 ruling and has declined to schedule a final approval hearing with respect to the
Issuer Settlement for that reason. Counsel for the plaintiffs, for the Issuer Defendants and for the insurance companies that provided directors and officers insurance to the Issuer Defendants are currently engaged in discussions to
restructure and salvage the Issuer Settlement. There can be no assurance that a restructured Issuer Settlement will be reached by the parties or that any such future settlement will meet the conditions for final approval by the District Court.

Other Matters

We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs
to resolve these matters will have a material adverse effect on our consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling
were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------

On October 16, 2008, Zhone held a special meeting of stockholders to vote on the following five proposals:

Proposal 1: To approve an amendment to Zhones restated certificate of incorporation to effect a reverse stock split, pursuant to which the existing shares of Zhone common stock would be combined into new shares
of Zhone common stock at an exchange ratio ranging from one-for-five to one-for-ten, with the exchange ratio to be determined by Zhone, and the total number of shares of common stock that Zhone is authorized to issue would be correspondingly
reduced.



|            |  |           |  |             |  |          
|----------- |  | --------- |  | ----------- |  | ---------
|For         |  | Against   |  | Abstentions |  | Not Voted
|124,717,786 |  | 9,748,667 |  | 1,010,979   |  | 0        

Proposal 2: To approve an amendment to the Zhone Technologies, Inc. Amended and
Restated 2001 Stock Incentive Plan to (a) permit the repricing of stock options and (b) increase the number of shares of common stock reserved for issuance by 1,700,000.



|           |  |            |  |             |  |           
|---------- |  | ---------- |  | ----------- |  | ----------
|For        |  | Against    |  | Abstentions |  | Not Voted 
|44,378,784 |  | 25,936,690 |  | 458,435     |  | 64,703,523

Proposal 3: To approve an amendment to the Zhone Technologies, Inc. 1999 Stock
Option Plan to permit the repricing of stock options.



|           |  |            |  |             |  |           
|---------- |  | ---------- |  | ----------- |  | ----------
|For        |  | Against    |  | Abstentions |  | Not Voted 
|44,604,940 |  | 25,717,966 |  | 451,003     |  | 64,703,523



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Proposal 4: To approve an amendment to the Paradyne Networks, Inc. 2000 Broad-Based Stock
Plan to permit the repricing of stock options.



|           |  |            |  |             |  |           
|---------- |  | ---------- |  | ----------- |  | ----------
|For        |  | Against    |  | Abstentions |  | Not Voted 
|44,557,758 |  | 25,754,910 |  | 461,241     |  | 64,703,523

Proposal 5: To approve an amendment to the Paradyne Networks, Inc. Amended and
Restated 1996 Equity Incentive Plan to permit the repricing of stock options.



|           |  |            |  |             |  |           
|---------- |  | ---------- |  | ----------- |  | ----------
|For        |  | Against    |  | Abstentions |  | Not Voted 
|44,604,428 |  | 25,754,910 |  | 461,241     |  | 64,703,523



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PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
|------- | ------------------------------------------------------------------------------------------------------------

Price Range of Common Stock

Our
common stock is listed on the Nasdaq Global Market under the symbol ZHNE. The following table sets forth, for the periods indicated, the high and low per share sales prices of our common stock as reported on Nasdaq.



|                                       |  |      |      |     |   |     
|-------------------------------------- |  | ---- | ---- | --- | - | ----
|2008:                                  |  |      |      |     |   |     
|                                       |  | High |      | Low
|Fourth Quarter ended December 31, 2008 |  | $    | 0.28 |     | $ | 0.05
|Third Quarter ended September 30, 2008 |  |      | 0.76 |     |   | 0.16
|Second Quarter ended June 30, 2008     |  |      | 1.07 |     |   | 0.70
|First Quarter ended March 31, 2008     |  |      | 1.22 |     |   | 0.86
|                                       |  |     
|2007:                                  |  |      |      |     |   |     
|                                       |  | High |      | Low
|Fourth Quarter ended December 31, 2007 |  | $    | 1.64 |     | $ | 1.16
|Third Quarter ended September 30, 2007 |  |      | 1.45 |     |   | 1.06
|Second Quarter ended June 30, 2007     |  |      | 1.58 |     |   | 1.17
|First Quarter ended March 31, 2007     |  |      | 1.37 |     |   | 1.12

As of December 31, 2008, there were 1,534 registered stockholders of record.
A substantially greater number of holders of Zhone common stock are street name or beneficial holders, whose shares are held of record by banks, brokers and other financial institutions.

Dividend Policy

We have never paid
or declared any cash dividends on our common stock or other securities and do not anticipate paying cash dividends in the foreseeable future. Any future determination to pay cash dividends will be at the discretion of the Board of Directors, subject
to any applicable restrictions under our debt and credit agreements, and will be dependent upon our financial condition, results of operations, capital requirements, general business condition and such other factors as the Board of Directors may
deem relevant.

Recent Sales of Unregistered Securities

There were no unregistered sales of equity securities during 2008.



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|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------

The
following selected financial data has been derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto, and with Managements Discussion and Analysis of
Financial Condition and Results of Operations. During the years ended December 31, 2008, 2007, 2006, 2005 and 2004, we recorded charges of $70.4 million, zero, $113.7 million, $102.1 million, and $0.2 million, respectively, related
to the impairment of acquisition related intangibles and goodwill as discussed in Note 3 to the consolidated financial statements.



|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|------------------------------------------------------------- |  | ------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | -------- | - |  | ---- | -------- | - |  | - | ------- | -
|                                                              |  | As of December 31,                    |        
|                                                              |  | 2008                                  |         |   | 2007 |   |         | 2006 |  |   | 2005     |   |  | 2004 |         
|                                                              |  | (in thousands, except per share data) |        
|Statement of Operations Data:                                 |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Net revenue                                                   |  | $                                     | 146,160 |   |      | $ | 175,448 |      |  | $ | 194,344  |   |  | $    | 151,828  |   |  | $ | 97,168  |  
|Cost of revenue (1)                                           |  |                                       | 101,096 |   |      |   | 116,370 |      |  |   | 131,749  |   |  |      | 88,958   |   |  |   | 55,305  |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Gross profit                                                  |  |                                       | 45,064  |   |      |   | 59,078  |      |  |   | 62,595   |   |  |      | 62,870   |   |  |   | 41,863  |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Operating expenses:                                           |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Research and product development (1)                          |  |                                       | 27,063  |   |      |   | 32,720  |      |  |   | 36,099   |   |  |      | 27,062   |   |  |   | 23,791  |  
|Sales and marketing (1)                                       |  |                                       | 28,269  |   |      |   | 33,192  |      |  |   | 38,225   |   |  |      | 29,756   |   |  |   | 22,417  |  
|General and administrative (1)                                |  |                                       | 15,609  |   |      |   | 10,170  |      |  |   | 14,036   |   |  |      | 14,534   |   |  |   | 10,772  |  
|Purchased in-process research and development                 |  |                                       |        |   |      |   |        |      |  |   |         |   |  |      | 1,190    |   |  |   | 8,631   |  
|Gain on sale of fixed assets                                  |  |                                       | (455    | ) |      |   | (659    | )    |  |   |         |   |  |      |         |   |  |   |        |  
|Gain on sale of intangible assets                             |  |                                       | (4,397  | ) |      |   | (5,000  | )    |  |   |         |   |  |      |         |   |  |   |        |  
|Amortization of intangible assets                             |  |                                       |        |   |      |   |        |      |  |   | 2,764    |   |  |      | 12,452   |   |  |   | 9,893   |  
|Impairment of intangible assets and goodwill                  |  |                                       | 70,401  |   |      |   |        |      |  |   | 113,666  |   |  |      | 102,106  |   |  |   | 239     |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Total operating expenses                                      |  |                                       | 136,490 |   |      |   | 70,423  |      |  |   | 204,790  |   |  |      | 187,100  |   |  |   | 75,743  |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Operating loss                                                |  |                                       | (91,426 | ) |      |   | (11,345 | )    |  |   | (142,195 | ) |  |      | (124,230 | ) |  |   | (33,880 | )
|Interest expense                                              |  |                                       | (1,625  | ) |      |   | (2,213  | )    |  |   | (2,774   | ) |  |      | (3,357   | ) |  |   | (3,991  | )
|Interest income                                               |  |                                       | 708     |   |      |   | 1,813   |      |  |   | 2,328    |   |  |      | 1,433    |   |  |   | 1,312   |  
|Other income (expense), net                                   |  |                                       | 78      |   |      |   | 37      |      |  |   | 239      |   |  |      | (522     | ) |  |   | 1,118   |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Loss before income taxes                                      |  |                                       | (92,265 | ) |      |   | (11,708 | )    |  |   | (142,402 | ) |  |      | (126,676 | ) |  |   | (35,441 | )
|Income tax provision                                          |  |                                       | 270     |   |      |   | 394     |      |  |   | 264      |   |  |      | 215      |   |  |   | 205     |  
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Net loss                                                      |  | $                                     | (92,535 | ) |      | $ | (12,102 | )    |  | $ | (142,666 | ) |  | $    | (126,891 | ) |  | $ | (35,646 | )
|                                                              |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Basic and diluted net loss per share                          |  | $                                     | (0.62   | ) |      | $ | (0.08   | )    |  | $ | (0.96    | ) |  | $    | (1.13    | ) |  | $ | (0.42   | )
|Shares used in per-share calculation                          |  |                                       | 150,342 |   |      |   | 149,623 |      |  |   | 148,727  |   |  |      | 112,004  |   |  |   | 85,745  |  
|(1) Amounts include stock-based compensation cost as follows: |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Cost of revenue                                               |  | $                                     | 158     |   |      | $ | 296     |      |  | $ | 892      |   |  | $    | 153      |   |  | $ | 210     |  
|Research and product development                              |  |                                       | 479     |   |      |   | 717     |      |  |   | 1,632    |   |  |      | 223      |   |  |   | 581     |  
|Sales and marketing                                           |  |                                       | 511     |   |      |   | 603     |      |  |   | 1,380    |   |  |      | 226      |   |  |   | 459     |  
|General and administrative                                    |  |                                       | 1,203   |   |      |   | 1,250   |      |  |   | 1,601    |   |  |      | 2,670    |   |  |   | 356     |  
|                                                              | 
|                                                              |  | As of December 31,                    |        
|                                                              |  | 2008                                  |         |   | 2007 |   |         | 2006 |  |   | 2005     |   |  | 2004 |         
|                                                              |  | (in thousands)                        |        
|Balance Sheet Data:                                           |  |                                       |         |   |      |   |         |      |  |   |          |   |  |      |          |   |  |   |         |  
|Cash, cash equivalents and short-term investments             |  | $                                     | 36,243  |   |      | $ | 50,165  |      |  | $ | 64,310   |   |  | $    | 71,140   |   |  | $ | 65,216  |  
|Working capital                                               |  |                                       | 62,007  |   |      |   | 77,496  |      |  |   | 83,872   |   |  |      | 102,521  |   |  |   | 71,789  |  
|Total assets                                                  |  |                                       | 123,449 |   |      |   | 223,406 |      |  |   | 240,182  |   |  |      | 380,105  |   |  |   | 325,227 |  
|Long-term debt, including current portion                     |  |                                       | 19,078  |   |      |   | 19,405  |      |  |   | 27,049   |   |  |      | 29,767   |   |  |   | 41,313  |  
|Stockholders equity                                          |  | $                                     | 59,297  |   |      | $ | 149,547 |      |  | $ | 157,604  |   |  | $    | 291,789  |   |  | $ | 229,784 |  



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|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

Overview

We believe that we are the first company dedicated solely to developing the
full spectrum of next-generation access network solutions to cost-effectively deliver high bandwidth services while simultaneously preserving the investment in todays networks. Our next-generation solutions are based upon our Single Line Multi
Service, or SLMS, architecture. From its inception, this SLMS architecture was specifically designed for the delivery of multiple classes of subscriber services (such as voice, data and video distribution), rather than being based on a particular
protocol or media. In other words, our SLMS products are built to support the migration from legacy circuit to packet technologies and from copper to fiber technologies. This flexibility and versatility allows our products to adapt to future
technologies while allowing service providers to focus on the delivery of additional high bandwidth services. Because this SLMS architecture is designed to interoperate with existing legacy equipment, service providers can leverage their existing
networks to deliver a combination of voice, data and video services today, while they migrate, either simultaneously or at a future date, from legacy equipment to next-generation equipment with minimal interruption. We believe that our SLMS solution
provides an evolutionary path for service providers from their existing infrastructures, as well as gives newer service providers the capability to deploy cost-effective, multi-service networks that can support voice, data and video.

Our product offerings fall within two categories: (1) the SLMS product family and (2) legacy, services, and other. Commencing
with the first quarter of 2007, we have reported our optical transport business with our legacy, services and other product category. We have reclassified prior period balances in order to conform to the current periods presentation. We sold
our legacy iMarc product line in December 2006, our legacy Access Node product line in December 2007 and our legacy GigaMux product line in January 2008.

Our global customer base includes regional, national and international telecommunications carriers. To date, our products are deployed by over 700 network service providers on six continents worldwide. We believe that
we have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive set of next-generation solutions to the bandwidth bottleneck in the access network and the other problems encountered by network
service providers when delivering communications services to subscribers.

Since inception, we have incurred significant
operating losses and had an accumulated deficit of $1,005.6 million as of December 31, 2008.

Going forward, our
key financial objectives include the following:



| |  |  | Increasing revenue while continuing to carefully control costs;
| | - |  | ---------------------------------------------------------------



| |  |  | Continued investments in strategic research and product development activities that will provide the maximum potential return on investment; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Minimizing consumption of our cash and short-term investments.
| | - |  | --------------------------------------------------------------

Recent global market and economic conditions have been unprecedented and challenging, with tighter credit conditions and recession in most major economies continuing into 2009. Continued concerns
about the systemic impact of potential long-term and widespread recession, energy costs, geopolitical issues, the availability and cost of credit, and the global housing and mortgage markets have contributed to increased market volatility and
diminished expectations for western and emerging economies. In the second half of 2008, federal government interventions in the U.S. financial system led to increased market uncertainty and instability in both U.S. and international capital and
credit markets. These conditions, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have contributed to volatility of unprecedented levels. These global unfavorable economic and market
conditions and the financial crisis may result in an adverse effect on our financial condition and results of operations.



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Sale of Legacy Inventory and Other Assets

In January 2008, we sold our GigaMux legacy product line to a third party. The sale of the GigaMux legacy product line was not treated as a discontinued operation since it did not represent
a component of the company that had operations and cash flows that were clearly distinguishable, operationally and for financial reporting purposes, from the rest of the entity. We allocated the proceeds received to receivables, inventory, fixed
assets and intangible assets based on the relative fair value of the assets sold. We recognized a gain of $1.3 million on the sale of the inventory related to this product line in the first quarter of 2008 that was recorded in cost of revenue. We
also recognized a gain of $0.5 million and $3.2 million on the sale of fixed assets and intangible assets, respectively, in the first quarter of 2008 that was recorded as a component of operating expenses. We are entitled to additional contingent
consideration for the sale of the GigaMux legacy product line upon the buyers usage of inventory and/or attainment of certain performance targets through December 2010. Additional contingent consideration, if any, will be recorded upon receipt
of cash as an additional gain in cost of revenue. During 2008, we received contingent consideration of $1.1 million related to the buyers usage of inventory related to the GigaMux legacy product line.

In December 2007, we sold inventory and certain assets related to our Access Node legacy product line to a third party. The sale of the
Access Node product line was not treated as a discontinued operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable, operationally and for financial reporting purposes, from
the rest of the entity. Upon sale of the Access Node inventory, we recognized a gain of $1.7 million in 2007 that was recorded in cost of revenue. In 2008, we recognized an additional gain of $0.2 million that was recorded in cost of revenue. We
will continue to record additional gain in the future contingent upon attainment of certain earnout provisions. In addition to the sale of the inventory, we also sold fixed assets related to the Access Node product line, which resulted in a gain of
$0.7 million in 2007 that was recorded as a component of operating expenses.

During December 2006, we entered into an
agreement to sell inventory and certain assets related to our iMarc legacy product line to a third party. The sale of the iMarc legacy product line was not treated as a discontinued operation since it did not represent a component of the company
that had operations and cash flows that were clearly distinguishable, operationally and for financial reporting purposes, from the rest of the entity. Upon the performance of certain obligations and delivery of the assets in the first quarter of
2007, we recognized a gain of $1.8 million that was recorded in cost of revenue. Upon the sale of the remaining iMarc inventory during the second quarter of 2007, we recognized an additional gain of $1.1 million that was recorded in cost of revenue.

Critical Accounting Policies and Estimates

Managements discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting
principles in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related
disclosure of contingent assets and liabilities. The policies discussed below are considered by management to be critical because changes in such estimates can materially affect the amount of our reported net income or loss. For all of these
policies, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.

Revenue
Recognition

We recognize revenue when the earnings process is complete. We recognize product revenue upon shipment of
product under contractual terms which transfer title to customers upon shipment, under normal credit terms, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery
obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such



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obligations are fulfilled. Our arrangements generally do not have any significant post-delivery obligations. We offer products and services such as support,
education and training, hardware upgrades and post-warranty support. For multiple element revenue arrangements, we establish the fair value of these products and services based primarily on sales prices when the products and services are sold
separately. If fair value cannot be established for undelivered elements, all of the revenue under the arrangement is deferred until those elements have been delivered. When collectibility is not reasonably assured, revenue is recognized when cash
is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. We make certain sales to product distributors. These customers are given certain privileges to return a portion
of inventory. Return privileges generally allow distributors to return inventory based on a percent of purchases made within a specific period of time. We recognize revenue on sales to distributors that have contractual return rights when the
products have been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. In those instances when revenue is recognized upon shipment to distributors, we
use historical rates of return from the distributors to provide for estimated product returns in accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists. We
accrue for warranty costs, sales returns and other allowances at the time of shipment based on historical experience and expected future costs.

Allowances for Sales Returns and Doubtful Accounts

We record an allowance for sales returns for estimated
future product returns related to current period product revenue. The allowance for sales returns is recorded as a reduction of revenue and an allowance against our accounts receivable. We base our allowance for sales returns on periodic assessments
of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, our future revenue could be adversely affected. We
record an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments for amounts owed to us. The allowance for doubtful accounts is recorded as a charge to general and administrative expenses. We
base our allowance on periodic assessments of our customers liquidity and financial condition through analysis of information obtained from credit rating agencies, financial statement reviews and historical collection trends. Additional
allowances may be required in the future if the liquidity or financial condition of our customers deteriorates, resulting in impairment in their ability to make payments.

Valuation of Long-Lived Assets, Including Goodwill and Other Acquisition-Related Intangible Assets

Our long-lived assets have consisted primarily of goodwill, other acquisition-related intangible assets and property and equipment. We review goodwill for impairment in November of each year, or more frequently if
events or circumstances indicate the carrying value of an asset may not be recoverable in accordance with SFAS No. 142, Goodwill and Other Intangible Assets(SFAS 142). Such events or circumstances include, but are not limited to, a
significant decrease in the benefits realized from an acquired business, difficulty and delays in integrating an acquired business, a significant change in the operations of an acquired business, or significant negative economic trends, such as
stock price movements. The provisions of SFAS 142 require that a two-step impairment test be performed on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. We have determined that we operate in a
single segment with one operating unit. We estimate the fair value of our reporting unit based on a combination of the market, income and replacement cost approaches. In the application of the impairment testing, we are required to make estimates of
future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates. If the fair value of the reporting unit exceeds the carrying
value, goodwill is not impaired and we are not required to perform further testing. If the carrying value exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied
fair value of the reporting unit. An impairment loss is recognized to the extent that the carrying amount exceeds the implied fair value of the reporting unit.



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During 2008, 2006 and 2005, we determined that indicators of impairment existed,
resulting in an impairment charge to goodwill of $70.4 million, $110.5 million and $55.2 million, respectively. As of December 31, 2008, we had no remaining goodwill.

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we review long-lived assets, including intangible assets subject to amortization and
property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable based on expected undiscounted cash flows attributable to that asset. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future net undiscounted
cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset.

During 2006 and 2005, we determined that indicators of impairment related to our intangible assets existed and an impairment analysis was performed, resulting in an impairment loss to amortizable intangible assets of
$3.2 million and $46.9 million, respectively. As a result of the impairment charges, our amortizable intangible assets at December 31, 2008 and December 31, 2007 were zero. At December 31, 2008, our other long-lived assets consisted
of $20.0 million of net property and equipment.

Stock-Based Compensation

We estimate the fair value of stock-based payment awards on the date of grant using the Black Scholes pricing model, which is affected by our stock price as well as assumptions regarding a number
of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee option exercise behaviors, risk free interest rate and expected dividends. The expected stock
price volatility is based on the weighted average of the historical volatility of our common stock over the most recent period commensurate with the estimated expected life of our stock options. We base our expected life assumption on our historical
experience and on the terms and conditions of the stock awards we grant to employees. Risk free interest rates reflect the yield on zero-coupon U.S. Treasury securities. We do not anticipate paying any cash dividends in the foreseeable future and
therefore use an expected dividend yield of zero.

If factors change, and we employ different assumptions for estimating
stock-based compensation expense in future periods, or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could materially affect our operating income,
net loss and net loss per share. We are also required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates.

Fair value stock-based compensation expense under SFAS 123R (revised 2004), Share-Based Payment(SFAS 123R), for the year ended
December 31, 2008 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS
No. 123, Accounting for Stock-Based Compensation, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of
SFAS 123R. In conjunction with the provisions of SFAS 123R, we changed our method of attributing the value of stock-based compensation to expense from the accelerated method to the straight line method. Compensation expense for all employee
share-based payment awards granted on or prior to December 31, 2005 will continue to be recognized using the accelerated method while compensation expense for all share-based payment awards granted subsequent to December 31, 2005 is
recognized using the straight line method.



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In addition, stock-based compensation expense was recorded for options issued to
non-employees. These options are generally immediately exercisable and expire seven to ten years from the date of grant. We value non-employee options using the Black Scholes model. Non-employee options subject to vesting are valued as they become
vested.

In November 2008, we completed our Exchange Offer to exchange certain stock options issued to eligible employees,
officers and directors of Zhone under Zhones equity incentive compensation plans. Stock options previously granted that had an exercise price per share of equal to or greater than $0.35 per share were eligible to be exchanged on a one-for-one
basis for new stock options with an exercise price equal to the last reported sale price of Zhone common stock on The Nasdaq Global Market on the date of grant. Options for an aggregate of 14.5 million shares of common stock were exchanged. The
new stock options issued pursuant to the Exchange Offer have an exercise price of $0.10, will vest over a four-year period with no credit for past vesting and have a seven-year term. The Exchange Offer will result in incremental stock-based
compensation of approximately $0.7 million to be recognized over the four-year vesting period. The remaining unrecognized compensation expense of the original grant will be amortized over the original requisite service period. The primary purpose of
the Exchange Offer was to motivate, retain and reward talented employees and directors.

Inventories

Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. In
assessing the net realizable value of inventories, we are required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net
realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or we experience a higher incidence of inventory obsolescence due to rapidly
changing technology and customer requirements, we may incur significant charges for excess inventory.

Operating Lease Liabilities

As a result of our acquisition of Paradyne in September 2005, we assumed certain lease liabilities for facilities in Largo, Florida. In
accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination (EITF 95-3), we accrued a liability for the excess portion of these facilities. The computation of
the estimated liability includes a number of assumptions and subjective variables. These variables include the level and timing of future sublease income, amount of contractual variable costs, future market rental rates, discount rate, and other
estimated expenses. If circumstances change, and we employ different assumptions in future periods, the lease liability may differ significantly from what we have recorded in the current period and could materially affect our net loss and net loss
per share. During the second quarter of 2008, we increased the excess lease liability balance by $3.3 million with a corresponding charge to general and administrative expenses.



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RESULTS OF OPERATIONS

We list in the tables below the historical consolidated statement of operations as a percentage of revenue for the periods indicated.



|                                             |  |                         |    |  |      |    |  |      |   
|-------------------------------------------- |  | ----------------------- | -- |  | ---- | -- |  | ---- | --
|                                             |  | Year Ended December 31, |   
|                                             |  | 2008                    |    |  | 2007 |    |  | 2006 |   
|Net revenue                                  |  | 100                     | %  |  | 100  | %  |  | 100  | % 
|Cost of revenue                              |  | 69                      | %  |  | 66   | %  |  | 68   | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Gross profit                                 |  | 31                      | %  |  | 34   | %  |  | 32   | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Operating expenses:                          |  |                         |    |  |      |    |  |      |   
|Research and product development             |  | 19                      | %  |  | 19   | %  |  | 19   | % 
|Sales and marketing                          |  | 19                      | %  |  | 19   | %  |  | 20   | % 
|General and administrative                   |  | 11                      | %  |  | 6    | %  |  | 7    | % 
|Gain on sale of fixed assets                 |  | 0                       | %  |  | 0    | %  |  | 0    | % 
|Gain on sale of intangible assets            |  | (3                      | )% |  | (3   | )% |  | 0    | % 
|Amortization of intangible assets            |  | 0                       | %  |  | 0    | %  |  | 1    | % 
|Impairment of intangible assets and goodwill |  | 48                      | %  |  | 0    | %  |  | 58   | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Total operating expenses                     |  | 94                      | %  |  | 41   | %  |  | 105  | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Operating loss                               |  | (63                     | )% |  | (7   | )% |  | (73  | )%
|Interest expense                             |  | (1                      | )% |  | (1   | )% |  | (1   | )%
|Interest income                              |  | 1                       | %  |  | 1    | %  |  | 1    | % 
|Other income                                 |  | 0                       | %  |  | 0    | %  |  | 0    | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Loss before income taxes                     |  | (63                     | )% |  | (7   | )% |  | (73  | )%
|Income tax provision                         |  | 0                       | %  |  | 0    | %  |  | 0    | % 
|                                             |  |                         |    |  |      |    |  |      |   
|Net loss                                     |  | (63                     | )% |  | (7   | )% |  | (73  | )%
|                                             |  |                         |    |  |      |    |  |      |   

2008 COMPARED WITH 2007

Revenue

Information about our revenue for products and services for 2008 and 2007 is
summarized below (in millions):



|         |  |      |       |      |   |          |  |   |         |   |  |     |   
|-------- |  | ---- | ----- | ---- | - | -------- |  | - | ------- | - |  | --- | --
|         |  | 2008 |       | 2007 |   | Decrease |  |   | %change |  
|Products |  | $    | 141.9 |      | $ | 164.6    |  | $ | (22.7   | ) |  | (14 | )%
|Services |  |      | 4.3   |      |   | 10.8     |  |   | (6.5    | ) |  | (60 | )%
|         |  |      |       |      |   |          |  |   |         |   |  |     |   
|         |  | $    | 146.2 |      | $ | 175.4    |  | $ | (29.2   | ) |  | (17 | )%
|         |  |      |       |      |   |          |  |   |         |   |  |     |   



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Information about our revenue for North America and International markets for 2008 and
2007 is summarized below (in millions):



|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|--------------------------- |  | ---- | ----- | ---- | - | ------------------ |  | - | ------- | - |  | --- | --
|                            |  | 2008 |       | 2007 |   | Increase(Decrease) |  |   | %change |  
|Revenue by geography:       |  |      |       |      |   |                    |  |   |         |   |  |     |   
|United States               |  | $    | 60.8  |      | $ | 79.4               |  | $ | (18.6   | ) |  | (23 | )%
|Canada                      |  |      | 5.4   |      |   | 10.5               |  |   | (5.1    | ) |  | (49 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total North America         |  |      | 66.2  |      |   | 89.9               |  |   | (23.7   | ) |  | (26 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Latin America               |  |      | 32.2  |      |   | 37.8               |  |   | (5.6    | ) |  | (15 | )%
|Europe, Middle East, Africa |  |      | 43.9  |      |   | 42.2               |  |   | 1.7     |   |  | 4   | % 
|Asia Pacific                |  |      | 3.9   |      |   | 5.5                |  |   | (1.6    | ) |  | (29 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total International         |  |      | 80.0  |      |   | 85.5               |  |   | (5.5    | ) |  | (6  | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total                       |  | $    | 146.2 |      | $ | 175.4              |  | $ | (29.2   | ) |  | (17 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   

Total revenue decreased 17% or $29.2 million to $146.2 million for 2008 compared
to $175.4 million for 2007 of which $24.5 million of the decrease was due to the sales of our Access Node and GigaMux legacy product lines in December 2007 and January 2008, respectively.

Product revenue accounted for the majority of the total decrease in revenue. In 2008, product revenue decreased 14% or $22.7 million and
service revenue decreased 60% or $6.5 million compared to 2007. Service revenue represents revenue from maintenance and other services associated with product shipments.

International revenue decreased 6% or $5.5 million to $80.0 million in 2008 and represented 55% of total revenue compared with 49% in 2007. The increase in the concentration of international
revenue represents the relative demand for our next-generation products in both existing and new network deployments among emerging international carriers compared to carriers in developed countries. Revenues in North America were adversely impacted
by sale of legacy product lines, the global economic recession and credit contraction which caused many of our customers to defer or reduce their network expansion in 2008.

While no customer accounted for 10% or more of net revenue in 2008 or 2007, we anticipate that our results of operations in any given period may depend to a large extent on sales to a small
number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.

Cost of Revenue and Gross Profit

Total cost of revenue, including stock-based
compensation, decreased $15.3 million, or 13% to $101.1 million for 2008, compared to $116.4 million for 2007. Total cost of revenue was 69% of revenue for 2008, compared to 66% of revenue for 2007. Gross profit percentage decreased from 34% in
2007 to 31% in 2008 due to an overall decline in net revenue and product mix. Personnel-related costs for 2008 decreased over 2007 by $2.4 million due to headcount reductions as a result of the consolidation of our manufacturing operations into one
facility.

In December 2006, we entered into an agreement to sell inventory and certain assets related to our iMarc legacy
product line to a third party. The sale of the iMarc product line was not treated as a discontinued operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable, operationally
and for financial reporting purposes, from the rest of the entity. Upon performance of certain obligations and delivery of assets in the first quarter of 2007, we recognized a gain of $1.8 million that was recorded in cost of revenue. Upon sale of
the remaining iMarc inventory during the second quarter of 2007, we recognized an additional gain of $1.1 million that was recorded in cost of revenue.



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In December 2007, we sold inventory and certain assets related to our Access Node legacy
product line to a third party. The sale of the Access Node product line was not treated as a discontinued operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable,
operationally and for financial reporting purposes, from the rest of the entity. Upon sale of the Access Node inventory, we recognized a gain of $1.7 million that was recorded in cost of revenue in 2007. In 2008, we recognized an additional gain of
$0.2 million that was recorded in cost of revenue. We will continue to record additional gain in the future contingent upon attainment of certain earnout provisions.

In January 2008, we sold inventory and certain assets related to our GigaMux legacy product line to a third party. The sale of the GigaMux legacy product line was not treated as a discontinued
operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable, operationally and for financial reporting purposes, from the rest of the entity. Upon sale of the GigaMux legacy
product line, we recognized a gain of $1.3 million during the first quarter of 2008 that was recorded in cost of revenue. Additional gains of $1.1 million were recognized in 2008 related to certain earnout provisions which were recorded in cost of
revenue.

We expect that in the future, our cost of revenue will also vary as a percentage of net revenue depending on the
mix and average selling prices of products sold in the future. In addition, competitive and economic pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory charges relating to discontinued
products and excess or obsolete inventory.

Research and Product Development Expenses

Research and product development expenses decreased 17% or $5.6 million to $27.1 million for 2008 compared to $32.7 million for 2007. The
decrease was primarily due to restructuring efforts to streamline processes which reduced personnel-related costs by $4.1 million and prototype costs by $0.5 million. We intend to continue to invest in research and product development to attain our
strategic product development objectives, while seeking to manage the associated costs through expense controls.

Sales and Marketing Expenses

Sales and marketing expenses decreased 15% or $4.9 million to $28.3 million for 2008 compared to $33.2 million for
2007. The decrease was primarily attributable to reduced personnel-related costs of $2.5 million from lower headcount as we realigned our resources to focus on emerging markets and also due to lower commission expenses of $1.1 million related to
decreased sales, and reduced travel expenses of $0.7 million.

General and Administrative Expenses

General and administrative expenses increased 53% or $5.4 million to $15.6 million for 2008 compared to $10.2 million for 2007. During the
second quarter of 2008, we significantly reduced our assumptions regarding estimated future sublease income primarily as a result of the deteriorating real estate market. Accordingly, during the second quarter of 2008, we increased the excess lease
liability for our Largo, Florida facility by $3.3 million with a corresponding charge to general and administrative expenses. In addition, the general and administrative expenses increased over prior year due to a higher allocation of
facility-related expenses of $1.9 million due to consolidation of certain facilities.

Gain on sale of fixed assets

Gain on sale of fixed assets decreased $0.2 million to $0.5 million for 2008 compared to $0.7 million for 2007. The gain in 2008 was
attributable to the sale of fixed assets associated with our sale of the GigaMux legacy product line in January 2008, while the gain in 2007 was primarily attributable to the sale of fixed assets associated with our sale of the Access Node legacy
product line in December 2007.



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Gain on sale of intangible assets

Gain on sale of intangible assets decreased $0.6 million to $4.4 million for 2008 compared to $5.0 million for 2007. The gain in 2008 was attributable to the sale of intangible assets related to
our GigaMux legacy product line sold in January 2008 and the sale of non-strategic legacy patents. The gain in 2007 was attributable to the sale of non-strategic legacy patents.

Impairment of Intangible Assets and Goodwill

We review goodwill and other long-lived
assets, including intangible assets, for impairment annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In June 2008, we reviewed goodwill for impairment due to the significant
decrease in our market capitalization in the three months ended June 30, 2008 as well as subsequent to period end. We determined that indicators of impairment existed, resulting in a goodwill impairment loss of $70.4 million during the second
quarter of 2008. No impairment of goodwill or intangible assets was recorded in 2007.

Interest Expense

Interest expense for 2008 decreased by $0.6 million to $1.6 million compared to $2.2 million in 2007 due to a decrease in the outstanding
debt balances and a reduction in interest rates during 2008.

Interest Income

Interest income for 2008 decreased by $1.1 million to $0.7 million compared to $1.8 million in 2007 due to lower average balances of cash
and short-term investments and a reduction in interest rates during 2008.

Income Tax Provision

During the years ended December 31, 2008 and 2007, we recorded an income tax provision of $0.3 million and $0.4 million,
respectively, related to foreign and state taxes. No material provision or benefit for income taxes was recorded in 2008 and 2007, due to our recurring operating losses and the significant uncertainty regarding the realization of our net deferred
tax assets, against which we have continued to record a full valuation allowance.

2007 COMPARED WITH 2006

Revenue

Information about our revenue
for products and services for 2007 and 2006 is summarized below (in millions):



|         |  |      |       |      |   |          |  |   |         |   |  |     |   
|-------- |  | ---- | ----- | ---- | - | -------- |  | - | ------- | - |  | --- | --
|         |  | 2007 |       | 2006 |   | Decrease |  |   | %change |  
|Products |  | $    | 164.6 |      | $ | 181.9    |  | $ | (17.3   | ) |  | (10 | )%
|Services |  |      | 10.8  |      |   | 12.4     |  |   | (1.6    | ) |  | (13 | )%
|         |  |      |       |      |   |          |  |   |         |   |  |     |   
|         |  | $    | 175.4 |      | $ | 194.3    |  | $ | (18.9   | ) |  | (10 | )%
|         |  |      |       |      |   |          |  |   |         |   |  |     |   



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##### Table of Contents

Information about our revenue for North America and International markets for 2007 and
2006 is summarized below (in millions):



|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|--------------------------- |  | ---- | ----- | ---- | - | ------------------ |  | - | ------- | - |  | --- | --
|                            |  | 2007 |       | 2006 |   | Increase(Decrease) |  |   | %change |  
|Revenue by geography:       |  |      |       |      |   |                    |  |   |         |   |  |     |   
|United States               |  | $    | 79.4  |      | $ | 105.1              |  | $ | (25.7   | ) |  | (24 | )%
|Canada                      |  |      | 10.5  |      |   | 10.6               |  |   | (0.1    | ) |  | (1  | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total North America         |  |      | 89.9  |      |   | 115.7              |  |   | (25.8   | ) |  | (22 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Latin America               |  |      | 37.8  |      |   | 25.2               |  |   | 12.6    |   |  | 50  | % 
|Europe, Middle East, Africa |  |      | 42.2  |      |   | 45.4               |  |   | (3.2    | ) |  | (7  | )%
|Asia Pacific                |  |      | 5.5   |      |   | 8.0                |  |   | (2.5    | ) |  | (31 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total International         |  |      | 85.5  |      |   | 78.6               |  |   | 6.9     |   |  | 9   | % 
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   
|Total                       |  | $    | 175.4 |      | $ | 194.3              |  | $ | (18.9   | ) |  | (10 | )%
|                            |  |      |       |      |   |                    |  |   |         |   |  |     |   

Total revenue decreased 10% or $18.9 million to $175.4 million for 2007 compared
to $194.3 million for 2006. The decrease in total revenue was due to decreased demand for our legacy, service and other products compared to the prior year, particularly in the domestic region. Additionally, a reduction in customers capital
expenditure spending contributed to the overall decrease in revenue.

Product revenue accounted for the majority of the
total decrease in revenue. In 2007, product revenue decreased 10% or $17.3 million and service revenue decreased 13% or $1.6 million compared to 2006. Service revenue represents revenue from maintenance and other services associated with product
shipments.

International revenue increased 9% or $6.9 million to $85.5 million in 2007 and represented 49% of total
revenue compared with 40% in 2006. The increase in international revenue represents the increasing opportunity for our next-generation products in both existing and new network deployments among emerging international carriers in Latin America.

Cost of Revenue and Gross Profit

Total cost of revenue, including stock-based compensation, decreased $15.3 million, or 12% to $116.4 million for 2007, compared to $131.7 million for 2006. Total cost of revenue was 66% of revenue for 2007,
compared to 68% of revenue for 2006. The decrease in cost of revenue for 2007 compared to 2006 was primarily due to a significantly decreased obsolescence provision for legacy products. As compared to 2006, the 2007 provision for obsolescence
decreased by $7.1 million. In addition, gains of $4.6 million related to the sale of the Access Node and iMarc product lines during 2007 further reduced cost of revenue as compared to the prior year. Finally, personnel related costs for 2007
decreased over 2006 by $3.3 million due to the operating leverage on fixed manufacturing costs as a result of the consolidation of our manufacturing operations into one facility.

In December 2006, we entered into an agreement to sell inventory and certain assets related to our iMarc legacy product line to a third
party. The sale of the iMarc product line was not treated as a discontinued operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable, operationally and for financial
reporting purposes, from the rest of the entity. Upon performance of certain obligations and delivery of assets in the first quarter of 2007, we recognized a gain of $1.8 million that was recorded in cost of revenue. Upon sale of the remaining iMarc
inventory during the second quarter of 2007, we recognized an additional gain to cost of revenue of $1.1 million related to the sale of the legacy iMarc product line.



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In December 2007, we sold inventory and certain assets related to our Access Node legacy
product line to a third party. The sale of the Access Node product line was not treated as a discontinued operation since it did not represent a component of our company that had operations and cash flows that were clearly distinguishable,
operationally and for financial reporting purposes, from the rest of the entity. Upon sale of the Access Node inventory, we recognized a gain of $1.7 million that was recorded in cost of revenue.

Research and Product Development Expenses

Research and product development expenses decreased 9% or $3.4 million to $32.7 million for 2007 compared to $36.1 million for 2006. The decrease was primarily due to approximately $1.4 million in non-recurring specific new product
development efforts expended during 2006. Additionally, for the year ended December 31, 2007, approximately $0.7 million of stock-based compensation expense was included in research and product development expenses, compared to $1.6 million
during the year ended December 31, 2006. The decrease was primarily due to the decline in stock price as well as reduced volatility rate assumptions, increased forfeitures, and the decline in interest rates.

Sales and Marketing Expenses

Sales
and marketing expenses decreased 13% or $5.0 million to $33.2 million for 2007 compared to $38.2 million in 2006. The decrease was primarily attributable to reduced personnel related costs of $1.2 million from lower headcount as we realigned
our resources to focus on emerging markets, and reduced demonstration and trade show expenses of $1.8 million. Additionally, for the year ended December 31, 2007, approximately $0.6 million of stock-based compensation expense was included in
sales and marketing expenses, compared to $1.4 million during the year ended December 31, 2006. The decrease was primarily due to the decline in stock price as well as reduced volatility rate assumptions, increased forfeitures, and the decline
in interest rates.

General and Administrative Expenses

General and administrative expenses decreased 27% or $3.8 million to $10.2 million for 2007 compared to $14.0 million for 2006. The decrease was primarily due to the reversal of certain
contingent liabilities of $1.1 million in the third quarter of 2007, reduced accounting and legal fees of $1.4 million over the prior year, the reversal of certain liabilities of $0.4 million in the first quarter of 2007, and a $1.5 million
favorable legal settlement in the second quarter of 2007, offset by a $0.5 million accrual for acquired lease liabilities during the third quarter of 2007. Additionally, for the year ended December 31, 2007, approximately $1.3 million of
stock-based compensation expense was included in general and administrative expenses, compared to $1.6 million during the year ended December 31, 2006. The decrease was primarily due to the decline in stock price as well as reduced volatility
rate assumptions, increased forfeitures, and the decline in interest rates.

Gain on sale of fixed assets

Gain on sale of fixed assets increased from zero in 2006 to $0.7 million in 2007. The gain in 2007 was primarily attributable to the sale
of fixed assets associated with our sale of the Access Node legacy product line in December 2007.

Gain on sale of intangible assets

Gain on sale of intangible assets increased from zero in 2006 to $5.0 million in 2007. The gain in 2007 was attributable to the sale of
non-strategic legacy patents originally acquired from Paradyne.



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Amortization of Intangible Assets

There was no amortization of intangible assets for 2007 compared to $2.8 million for 2006 because the intangible assets were fully amortized as of December 31, 2006.

Impairment of Intangible Assets and Goodwill

We review goodwill and other long-lived assets, including intangible assets, for impairment annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. During the third
quarter of 2006, we determined that indicators of impairment existed as we experienced an adverse change in our business as evidenced by a decline in our projected revenue due to technology transition issues with our largest international customers,
and a resulting decline in our market capitalization. We performed an impairment analysis which resulted in a non-cash goodwill impairment charge of $110.5 million as the fair value of our reporting unit was less than book value. See Note 3 to the
consolidated financial statements for further detail. We also recorded a non-cash impairment charge for other intangible assets of $3.2 million, which represented the amount by which the carrying value of the intangible assets exceeded the fair
value. No impairment of goodwill or intangible assets was recorded in 2007.

Interest Expense

Interest expense for 2007 decreased by $0.6 million to $2.2 million compared to 2006 due primarily to a decrease in the outstanding debt
balances.

Interest Income

Interest income for 2007 decreased by $0.5 million to $1.8 million compared to 2006 due to lower average balances of cash and short-term investments.

Other Income, Net

Other income for 2007 decreased by $0.2 million to $0.04 million compared to $0.2 million
for 2006. The decrease was primarily due to foreign exchange losses of $0.1 million on foreign currencies in the current year compared to exchange gains of $0.2 million in the prior year. We transact business in various foreign countries and are
exposed to currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily intercompany receivables and payables.

Income Tax Provision

During the years ended December 31, 2007 and 2006, we recorded an income tax
provision of $0.4 million and $0.3 million, respectively, related to foreign and state taxes. No material provision or benefit for income taxes was recorded, due to our recurring operating losses and the significant uncertainty regarding the
realization of our net deferred tax assets, against which we have continued to record a full valuation allowance.

LIQUIDITY AND CAPITAL RESOURCES

Our operations are financed through a combination of our existing cash, cash equivalents and investments, available credit
facilities, and sales of equity and debt instruments, based on our operating requirements and market conditions.

At
December 31, 2008, cash, cash equivalents and short-term investments were $36.2 million compared to $50.2 million at December 31, 2007. Total debt was $34.1 million at December 31, 2008 as compared to $34.4 million at
December 31, 2007. The decrease in cash and cash equivalents of $4.5 million was attributable to net cash used in operating activities and changes in exchange rates of $17.2 million and $0.4 million, respectively, offset by net cash provided by
investing activities of $13.1 million.



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Operating Activities

For fiscal year 2008, net cash used in operating activities consisted of a net loss of $92.5 million, adjusted for non-cash charges totaling $77.9 million and a decrease in operating assets totaling $2.2 million,
offset by a gain on sales of assets and intangible assets of $0.5 million and $4.4 million, respectively. The most significant components of the changes in net operating assets were decreases in accounts receivable and inventories of $6.5 million
and $4.0 million, respectively, offset by a decrease in accounts payable of $8.6 million. The decrease in accounts receivable was primarily a result of lower revenue due to the global credit contraction. The decrease in inventories was primarily the
result of the sale of the GigaMux legacy product line in January 2008 in which we allocated proceeds of $8.5 million to the sale of such inventories.

For fiscal year 2007, net cash used in operating activities consisted of the net loss of $12.1 million, adjusted for non-cash charges totaling $8.4 million, and offset by a gain on sale of assets of $5.7 million and
increases in net operating assets totaling $5.4 million. The most significant components of the increases in net operating assets in 2007 were an increase in accounts receivable of $4.7 million and a decrease in accrued and other liabilities of $4.0
million, offset by an increase in accounts payable of $2.4 million.

Investing Activities

For fiscal year 2008, net cash provided by investing activities consisted primarily of proceeds from the sale and maturity of short-term
investments of $20.4 million and proceeds from the sale of assets and intangible assets of $4.9 million, offset by purchases of short-term investments of $10.9 million and equipment purchases of $1.4 million. The proceeds from the sale of assets and
intangible assets of $4.9 million were related to the sale of the GigaMux legacy product line in January 2008, and sale of non-strategic legacy patents in November 2008.

For fiscal year 2007, net cash provided by investing activities consisted primarily of cash acquired through the net sale of short-term investments of $5.4 million and proceeds from the sale of
assets of $7.3 million, offset by capital equipment purchases of $1.4 million.

Financing Activities

For fiscal year 2008, net cash used in financing activities consisted primarily of repayment of debt of $0.3 million, offset by proceeds
from the issuance of common stock of $0.3 million.

For fiscal year 2007, net cash used in financing activities consisted
primarily of repayment of debt of $7.6 million, partially offset by proceeds from the issuance of common stock of $0.7 million and borrowings under credit facilities of $0.5 million.

Cash Management

Our primary source of liquidity comes from our cash and cash
equivalents and short-term investments, which totaled $36.2 million at December 31, 2008, and our $25.0 million revolving line of credit and letter of credit facility, and an accounts receivable purchase facility with Silicon Valley Bank (the
SVB Facilities). Our cash and cash equivalents are held in accounts managed by third party financial institutions and consist of invested cash and cash in our operating accounts. To date, we have experienced no loss of access to our cash or cash
equivalents; however, there can be no assurance that access to our cash and cash equivalents will not be impacted by adverse conditions in the financial markets.

Our short-term investments are classified as available-for-sale and consist of securities that are readily convertible to cash, including certificates of deposits, commercial paper and government
securities, with original maturities at the date of acquisition ranging from 90 days to one year. Our short-term investments are available for use in current operations or other activities. To date, we have experienced no significant realized losses
or



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other-than-temporary impairment losses with respect to our short-term investments; however, there can be no assurance that our short-term investments will
not be affected by future volatility and uncertainty in the financial markets. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents and short-term investments will continue to be consumed by
operations.

Under the SVB Facilities, we have the option of borrowing funds at agreed upon rates of interest, so long as
the aggregate amount of outstanding borrowings does not exceed $25.0 million. In addition, we may sell specific accounts receivables to Silicon Valley Bank, on a non-recourse basis, at agreed upon discounts to the face amount of those accounts
receivables, so long as the aggregate amount of the outstanding accounts receivables does not exceed $10.0 million.

Under
the SVB Facilities, $15.0 million was outstanding at December 31, 2008, and an additional $3.4 million was committed as security for various letters of credit. The amounts borrowed under the revolving credit facility bear interest, payable
monthly, at a floating rate that, at our option, is either (1) Silicon Valley Banks prime rate, or (2) the sum of LIBOR plus 2.9%: provided that in either case, the minimum interest rate is 4.0%. The interest rate was 4.0% at
December 31, 2008.

Our obligations under the SVB Facilities are secured by substantially all of our personal property
assets and those of our subsidiaries, including our intellectual property. The SVB Facilities contain certain financial covenants, and customary affirmative covenants and negative covenants. If we do not comply with the various covenants and other
requirements under the SVB Facilities, Silicon Valley Bank is entitled to, among other things, require the immediate repayment of all outstanding amounts and sell our assets to satisfy the obligations under the SVB Facilities. As of
December 31, 2008, we were in compliance with these covenants.

For fiscal year 2008, we sold $10.2 million of
customer trade receivables to Silicon Valley Bank on a non-recourse basis in exchange for cash. The sale of the receivables did not represent a securitization, and there was no continuing involvement or interests in the receivables by us after the
sale.

In January 2009, we repaid the $15.0 million outstanding under the SVB Facilities. In March 2009, the SVB Facilities
were replaced when we entered into a new $20.0 million secured revolving credit arrangement with Silicon Valley Bank as discussed in Note 15 to the consolidated financial statements.

Future Requirements and Funding Sources

Our fixed commitments for cash expenditures
consist primarily of payments under operating leases, inventory purchase commitments, and payments of principal and interest for debt obligations. As a result of the Paradyne acquisition in 2005, we assumed a lease commitment for facilities in
Largo, Florida. The term of the lease expires in June 2012 and had an estimated remaining obligation of approximately $15.2 million as of December 31, 2008. We intend to continue to occupy only a portion of these facilities. We have recorded a
liability of $5.6 million as of December 31, 2008, which we believe is adequate to cover costs incurred to exit the excess portion of these facilities, net of estimated sublease income.

As a result of the financial demands of major network deployments and the difficulty in accessing capital markets, network service
providers continue to request financing assistance from their suppliers. From time to time, we may provide or commit to extend credit or credit support to our customers. This financing may include extending the terms for product payments to
customers. Depending upon market conditions, we may seek to factor these arrangements to financial institutions and investors to reduce the amount of our financial commitments associated with such arrangements. For example, during the year ended
December 31, 2008, we sold $10.2 million of customer trade receivables to Silicon Valley Bank on a non-recourse basis in exchange for cash. The sale of the receivables did not represent a securitization, and there was no continuing involvement
or interests in the receivables by us after the sale. Our ability to provide customer financing is limited and depends upon a number of factors, including our capital structure, the level of our available credit and our ability to factor commitments
to third parties. Any extension of financing to our customers will limit the capital that we have available for other uses.



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Our accounts receivable, while not considered a primary source of liquidity, represents a
concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of large balances due from a relatively small number of customer account balances. As of December 31, 2008,
two customers accounted for 13% and 10% of accounts receivable, and receivables from customers in territories outside of the United States of America represented 69% of accounts receivable. We do not currently have any material commitments for
capital expenditures, or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt.

We expect that operating losses and negative cash flows from operations will continue. In order to meet our liquidity needs and finance our capital expenditures and working capital needs for our business, we may need
to raise additional capital through the issuance of debt or equity financing or the sale of assets. Continued uncertainty in credit markets may negatively impact our ability to access debt financing or to refinance existing indebtedness in the
future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict our ability to
operate our business. Likewise, any equity financing could result in additional dilution of our stockholders. If we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be
required to reduce the scope of our planned product development and sales and marketing efforts beyond the reductions we have previously taken. Based on our current plans and business conditions, we believe that our existing cash, cash equivalents
and short-term investments and available credit facilities will be sufficient to satisfy our anticipated cash requirements for the foreseeable future.

Contractual Commitments and Off-Balance Sheet Arrangements

At December 31, 2008, our estimated future
contractual commitments by fiscal year were as follows (in thousands):



|                               |  |       |        |      |   |        |  |      |       |      |   |        |  |   |       |  |   |  
|------------------------------ |  | ----- | ------ | ---- | - | ------ |  | ---- | ----- | ---- | - | ------ |  | - | ----- |  | - | -
|                               |  | Total |        | 2009 |   | 2010   |  | 2011 |       | 2012 |   | 2013  
|Operating leases               |  | $     | 16,036 |      | $ | 4,773  |  | $    | 4,506 |      | $ | 4,478  |  | $ | 2,279 |  | $ | 
|Line of credit                 |  |       | 15,000 |      |   | 15,000 |  |      |      |      |   |       |  |   |      |  |   | 
|Debt                           |  |       | 19,078 |      |   | 380    |  |      | 408   |      |   | 18,290 |  |   |      |  |   | 
|Inventory purchase commitments |  |       | 43     |      |   | 43     |  |      |      |      |   |       |  |   |      |  |   | 
|                               |  |       |        |      |   |        |  |      |       |      |   |        |  |   |       |  |   |  
|Total                          |  | $     | 50,157 |      | $ | 20,196 |  | $    | 4,914 |      | $ | 22,768 |  | $ | 2,279 |  | $ | 
|                               |  |       |        |      |   |        |  |      |       |      |   |        |  |   |       |  |   |  

Operating Leases

The operating lease amounts shown above represent primarily off-balance sheet arrangements. For operating lease commitments, a liability is generally not recorded on our balance sheet unless the
facility represents an excess facility for which an estimate of the facility exit costs has been recorded on our balance sheet. For operating leases that include contractual commitments for operating expenses and maintenance, estimates of such
amounts are included based on current rates. Payments made under operating leases will be treated as rent expense for the facilities currently being utilized. Of the total $16.0 million operating lease amount, $5.6 million has been recorded as a
liability on our balance sheet as of December 31, 2008.

Line of Credit and Debt

The debt and line of credit obligations have been recorded as liabilities on our balance sheet. The debt obligation amounts shown above
represent the scheduled principal repayments, but not the associated interest payments which may vary based on changes in market interest rates. At December 31, 2008, the interest rate on our outstanding debt obligations ranged from 4% to 6.9%.

As of December 31, 2008, we had $15.0 million outstanding under our line of credit and an additional
$3.4 million committed as security for various letters of credit, as discussed in Note 6 to the consolidated financial statements.



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Inventory Purchase Commitments

Inventory purchase commitments represent the amount of excess inventory purchase commitments that have been recorded as a liability on our balance sheet at December 31, 2008.

Recent Accounting Pronouncements

SFAS 157  Fair Value
Measurements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards (SFAS) No. 157 (SFAS 157), Fair Value Measurements, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any
new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities. In
February 2008, the FASB issued FASB FSP 157-2 which delays the effective date of SFAS 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at
least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. We adopted the provisions of SFAS 157 with respect to our financial assets and liabilities beginning in the first quarter of
fiscal year 2008. The adoption of SFAS 157 did not have a material effect on our consolidated financial condition or results of operations or cash flows. We are still in the process of evaluating this standard with respect to its effect on
non-financial assets and liabilities and therefore have not yet determined the impact it will have on our consolidated financial statements upon full adoption in our 2009 fiscal year. Non-financial assets and liabilities for which we have not
applied the provisions of SFAS 157 include those measured at fair value in impairment testing.

SFAS 159  Fair Value Option for Financial Assets
and Financial Liabilities

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for
Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which
the fair value option has been elected be reported in earnings. We were required to adopt SFAS 159 beginning in the first quarter of fiscal year 2008. We did not elect the fair value option, therefore the adoption of SFAS 159 did not have any impact
on our consolidated financial statements.

SFAS 141R  Business Combinations

In December 2007, the FASB issued SFAS No. 141 (revised 2007),Business Combinations (SFAS 141R), which replaces SFAS
No. 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non controlling interest in the acquiree and the
goodwill acquired. This statement also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for business combinations which close in fiscal years
beginning after December 15, 2008. We will be required to adopt SFAS 141R in our 2009 fiscal year.

FSP APB 14-1  Accounting for Convertible
Debt Instruments

In May 2008, the FASB issued FASB Staff Position No. APB 14-1, Accounting for Convertible Debt
Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement),(FSP APB 14-1), which requires issuers of convertible debt that may be settled wholly or partly in cash when converted to account for the debt and
equity components separately. This statement is effective for fiscal years beginning after December 15, 2008 and must be applied retrospectively to all periods. We are currently evaluating the impact, if any, that the adoption of FSP ABP 14-1
will have on our consolidated financial statements.



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##### Table of Contents

|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

Cash, Cash Equivalents and Investments

We consider all cash and highly liquid investments purchased with an
original maturity of less than three months to be cash equivalents.

Cash, cash equivalents and short-term investments
consisted of the following as of December 31, 2008 and 2007 (in thousands):



|                          |  |                  |        |                  |   |       
|------------------------- |  | ---------------- | ------ | ---------------- | - | ------
|                          |  | December 31,2008 |        | December 31,2007
|Cash and cash equivalents |  | $                | 33,251 |                  | $ | 37,804
|Short-term investment     |  |                  | 2,992  |                  |   | 12,361
|                          |  |                  |        |                  |   |       
|                          |  | $                | 36,243 |                  | $ | 50,165
|                          |  |                  |        |                  |   |       

Concentration of Credit Risk

Financial instruments which potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable. Cash and cash
equivalents and short-term investments consist principally of demand deposit and money market accounts, commercial paper and corporate debentures and bonds with credit ratings of AA or better. Cash and cash equivalents and short-term investments are
principally held with various domestic financial institutions with high credit standing. As of December 31, 2008 and 2007, receivables from customers in international territories represented 69% and 63%, respectively, of accounts receivable.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt. We do not use derivative financial instruments in our investment portfolio. We do not hold financial instruments for
trading or speculative purposes. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. Our cash and cash equivalents and
short-term investments are not subject to material interest rate risk due to their short maturities. Under our investment policy, short-term investments have a maximum maturity of one year from the date of acquisition, and the average maturity of
the portfolio cannot exceed six months. Due to the relatively short maturity of the portfolio, a 10% increase in market interest rates at December 31, 2008 would decrease the fair value of the portfolio by less than $0.1 million.

As of December 31, 2008, our outstanding debt balance was $19.1 million. Interest on our long-term debt accrues on the unpaid
principal balance at a variable interest rate (which adjusts every six months) equal to the sum of the LIBOR rate plus 3.0% per annum; provided that in no event will the variable interest rate (a) exceed 14.2488% per annum,
(b) be less than 6.5% per annum, or (c) be adjusted by more than 1.0% at any adjustment date. Assuming the outstanding balance on our variable rate long-term debt remains constant over a year, a 2% increase in the interest rate would
decrease pre-tax income and cash flow by approximately $0.4 million.

Foreign Currency Risk

We transact business in various foreign countries. Substantially all of our assets are located in the United States. We have sales
operations throughout Europe, Asia, the Middle East and Latin America. We are exposed to foreign currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily intercompany receivables and payables.
Accordingly, our operating results are exposed to changes in

exchange rates between the U.S. dollar and those currencies. During 2008 and
2007, we did not hedge any of our foreign currency exposure. During both 2008 and 2007, we recorded $0.1 million of foreign exchange loss in other income (expense) on our statements of operations.



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##### Table of Contents

We have performed sensitivity analyses as of December 31, 2008 and 2007, using a
modeling technique that measures the change in the fair values arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The sensitivity
analyses indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of $0.1 million for both 2008 and 2007. This sensitivity analysis assumes a parallel adverse shift in foreign
currency exchange rates, which do not always move in the same direction. Actual results may differ materially.



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##### Table of Contents

|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                         |  |     
|-------------------------------------------------------- |  | ----
|                                                         |  | Page
|Reports of Independent Registered Public Accounting Firm |  | 50  
|Consolidated Balance Sheets                              |  | 52  
|Consolidated Statements of Operations                    |  | 53  
|Consolidated Statements of Stockholders Equity          |  | 54  
|Consolidated Statements of Cash Flows                    |  | 56  
|Notes to Consolidated Financial Statements               |  | 57  



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Zhone Technologies, Inc.:

We have audited the accompanying consolidated balance sheets of Zhone Technologies,
Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders equity and cash flows for each of the years in the three-year period ended
December 31, 2008. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Zhone Technologies, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year
period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

We also have
audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Zhone Technologies, Inc.s 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), and our report dated March 16, 2009 expressed an unqualified opinion on the effectiveness of the Companys
internal control over financial reporting.



|                         
|-------------------------
|/s/ KPMG LLP             
|                         
|Mountain View, California
|March 16, 2009           



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Zhone Technologies, Inc.:

We have audited Zhone Technologies, Inc.s 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). Zhone Technologies, Inc.s management is
responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Report on Internal Control over
Financial Reporting. Our responsibility is to express an opinion on the Companys internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether effective internal control over financial reporting was maintained in all material respects. Our audit 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 audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinion.

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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2) 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 (3) 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.

In our opinion, Zhone Technologies, Inc. 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.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheets of Zhone Technologies, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders equity and cash flows for each of the
years in the three-year period ended December 31, 2008, and our report dated March 16, 2009 expressed an unqualified opinion on those consolidated financial statements.



|                         
|-------------------------
|/s/ KPMG LLP             
|                         
|Mountain View, California
|March 16, 2009           



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##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2008 and 2007

(In thousands, except par value)



|                                                                                                                                                            |  |      |            |   |      |   |           |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ---------- | - | ---- | - | --------- | -
|                                                                                                                                                            |  | 2008 |            |   | 2007 |  
|Assets                                                                                                                                                      |  |      |            |   |      |   |           |  
|Current assets:                                                                                                                                             |  |      |            |   |      |   |           |  
|Cash and cash equivalents                                                                                                                                   |  | $    | 33,251     |   |      | $ | 37,804    |  
|Short-term investments                                                                                                                                      |  |      | 2,992      |   |      |   | 12,361    |  
|Accounts receivable, net of allowances for sales returns and doubtful accounts of $5,155 in 2008 and $5,941 in 2007                                         |  |      | 23,665     |   |      |   | 33,258    |  
|Inventories                                                                                                                                                 |  |      | 40,706     |   |      |   | 44,698    |  
|Prepaid expenses and other current assets                                                                                                                   |  |      | 2,654      |   |      |   | 3,804     |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total current assets                                                                                                                                        |  |      | 103,268    |   |      |   | 131,925   |  
|Property and equipment, net                                                                                                                                 |  |      | 20,003     |   |      |   | 20,818    |  
|Goodwill                                                                                                                                                    |  |      |           |   |      |   | 70,401    |  
|Restricted cash                                                                                                                                             |  |      | 123        |   |      |   | 186       |  
|Other assets                                                                                                                                                |  |      | 55         |   |      |   | 76        |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total assets                                                                                                                                                |  | $    | 123,449    |   |      | $ | 223,406   |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|                                                                                                                                                            |  |     
|Liabilities and Stockholders Equity                                                                                                                        |  |      |            |   |      |   |           |  
|Current liabilities:                                                                                                                                        |  |      |            |   |      |   |           |  
|Accounts payable                                                                                                                                            |  | $    | 12,719     |   |      | $ | 21,276    |  
|Line of credit                                                                                                                                              |  |      | 15,000     |   |      |   | 15,000    |  
|Current portion of long-term debt                                                                                                                           |  |      | 380        |   |      |   | 265       |  
|Accrued and other liabilities                                                                                                                               |  |      | 13,162     |   |      |   | 17,888    |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total current liabilities                                                                                                                                   |  |      | 41,261     |   |      |   | 54,429    |  
|Long-term debt, less current portion                                                                                                                        |  |      | 18,698     |   |      |   | 19,140    |  
|Other long-term liabilities                                                                                                                                 |  |      | 4,193      |   |      |   | 290       |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total liabilities                                                                                                                                           |  |      | 64,152     |   |      |   | 73,859    |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Stockholders equity:                                                                                                                                       |  |      |            |   |      |   |           |  
|Common stock, $0.001 par value. Authorized 900,000 shares; issued and outstanding 150,683 and 150,024 shares as of December 31, 2008 and
2007, respectively |  |      | 151        |   |      |   | 150       |  
|Additional paid-in capital                                                                                                                                  |  |      | 1,064,493  |   |      |   | 1,061,849 |  
|Other comprehensive income                                                                                                                                  |  |      | 250        |   |      |   | 610       |  
|Accumulated deficit                                                                                                                                         |  |      | (1,005,597 | ) |      |   | (913,062  | )
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total stockholders equity                                                                                                                                  |  |      | 59,297     |   |      |   | 149,547   |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  
|Total liabilities and stockholders equity                                                                                                                  |  | $    | 123,449    |   |      | $ | 223,406   |  
|                                                                                                                                                            |  |      |            |   |      |   |           |  



See accompanying notes to consolidated financial statements.

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

Years ended December 31, 2008, 2007 and 2006

(In thousands, except per share data)



|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|---------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                         |  | 2008 |         |   | 2007 |   |         | 2006 | 
|Net revenue                                                                              |  | $    | 146,160 |   |      | $ | 175,448 |      |  | $ | 194,344  |  
|Cost of revenue (1)                                                                      |  |      | 101,096 |   |      |   | 116,370 |      |  |   | 131,749  |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Gross profit                                                                             |  |      | 45,064  |   |      |   | 59,078  |      |  |   | 62,595   |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Operating expenses:                                                                      |  |      |         |   |      |   |         |      |  |   |          |  
|Research and product development (1)                                                     |  |      | 27,063  |   |      |   | 32,720  |      |  |   | 36,099   |  
|Sales and marketing (1)                                                                  |  |      | 28,269  |   |      |   | 33,192  |      |  |   | 38,225   |  
|General and administrative (1)                                                           |  |      | 15,609  |   |      |   | 10,170  |      |  |   | 14,036   |  
|Gain on sale of fixed assets                                                             |  |      | (455    | ) |      |   | (659    | )    |  |   |         |  
|Gain on sale of intangible assets                                                        |  |      | (4,397  | ) |      |   | (5,000  | )    |  |   |         |  
|Amortization of intangible assets                                                        |  |      |        |   |      |   |        |      |  |   | 2,764    |  
|Impairment of intangible assets and goodwill                                             |  |      | 70,401  |   |      |   |        |      |  |   | 113,666  |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Total operating expenses                                                                 |  |      | 136,490 |   |      |   | 70,423  |      |  |   | 204,790  |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Operating loss                                                                           |  |      | (91,426 | ) |      |   | (11,345 | )    |  |   | (142,195 | )
|Interest expense                                                                         |  |      | (1,625  | ) |      |   | (2,213  | )    |  |   | (2,774   | )
|Interest income                                                                          |  |      | 708     |   |      |   | 1,813   |      |  |   | 2,328    |  
|Other income                                                                             |  |      | 78      |   |      |   | 37      |      |  |   | 239      |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Loss before income taxes                                                                 |  |      | (92,265 | ) |      |   | (11,708 | )    |  |   | (142,402 | )
|Income tax provision                                                                     |  |      | 270     |   |      |   | 394     |      |  |   | 264      |  
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Net loss                                                                                 |  | $    | (92,535 | ) |      | $ | (12,102 | )    |  | $ | (142,666 | )
|                                                                                         |  |      |         |   |      |   |         |      |  |   |          |  
|Basic and diluted net loss per share                                                     |  | $    | (0.62   | ) |      | $ | (0.08   | )    |  | $ | (0.96    | )
|Weighted average shares outstanding used to compute basic and diluted net loss per share |  |      | 150,342 |   |      |   | 149,623 |      |  |   | 148,727  |  
|                                                                                         |  |      |        
|(1) Amounts include stock-based compensation cost as follows:                            |  |      |         |   |      |   |         |      |  |   |          |  
|Cost of revenue                                                                          |  |      | 158     |   |      |   | 296     |      |  |   | 892      |  
|Research and product development                                                         |  |      | 479     |   |      |   | 717     |      |  |   | 1,632    |  
|Sales and marketing                                                                      |  |      | 511     |   |      |   | 603     |      |  |   | 1,380    |  
|General and administrative                                                               |  |      | 1,203   |   |      |   | 1,250   |      |  |   | 1,601    |  



See accompanying notes to consolidated financial statements.

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##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders Equity

Years ended December 31, 2008, 2007 and 2006 (In thousands)



|                                                                         |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|------------------------------------------------------------------------ |  | ------------ |  | ------------------------ | --- |  | ------------------------------- | --------- | - | ------------------------------- | - | ---- | ------------------------------- |  | - | ------------------ | - |  | ------------------------ | --- | - |  | - | -------- | - |  | - | -------- | -
|                                                                         |  | Common stock |  | Additionalpaid-incapital |     |  | Notesreceivablefromstockholders |           |   | Deferredstock-basedcompensation |   |      | Othercomprehensiveincome (loss) |  |   | Accumulateddeficit |   |  | Totalstockholdersequity |    
|                                                                         |  | Shares       |  | Amount                   |     |  |                                 |           |   |                                
|Balances as of December 31, 2005                                         |  | 147,759      |  | $                        | 148 |  | $                               | 1,051,320 |   |                                 | $ | (550 | )                               |  | $ | (818               | ) |  | $                        | (17 | ) |  | $ | (758,294 | ) |  | $ | 291,789  |  
|Exercise of stock options for cash                                       |  | 913          |  |                          | 1   |  |                                 | 1,393     |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 1,394    |  
|Issuance of common stock in connection with employee stock purchase plan |  | 581          |  |                          |    |  |                                 | 867       |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 867      |  
|Issuance of common stock for services                                    |  | 24           |  |                          |    |  |                                 | 50        |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 50       |  
|Reversal of unamortized deferred stock-based compensation                |  |             |  |                          |    |  |                                 | (818      | ) |                                 |   |     |                                 |  |   | 818                |   |  |                          |    |   |  |   |         |   |  |   |         |  
|Stock-based compensation under SFAS 123R                                 |  |             |  |                          |    |  |                                 | 5,505     |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 5,505    |  
|Proceeds from repayment of officer loans                                 |  |             |  |                          |    |  |                                 |          |   |                                 |   | 550  |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 550      |  
|Comprehensive loss:                                                      |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|Net loss                                                                 |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   | (142,666 | ) |  |   | (142,666 | )
|Foreign currency translation adjustment                                  |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          | 84  |   |  |   |         |   |  |   | 84       |  
|Unrealized gain on available for sale securities                         |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          | 31  |   |  |   |         |   |  |   | 31       |  
|                                                                         |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|Total comprehensive loss                                                 |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   | (142,551 | )
|                                                                         |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|Balances as of December 31, 2006                                         |  | 149,277      |  |                          | 149 |  |                                 | 1,058,317 |   |                                 |   |     |                                 |  |   |                   |   |  |                          | 98  |   |  |   | (900,960 | ) |  |   | 157,604  |  
|Exercise of stock options for cash                                       |  | 68           |  |                          |    |  |                                 | 14        |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 14       |  
|Issuance of common stock in connection with employee stock purchase plan |  | 641          |  |                          | 1   |  |                                 | 652       |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 653      |  
|Issuance of common stock for services                                    |  | 38           |  |                          |    |  |                                 | 49        |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 49       |  
|Stock-based compensation under SFAS 123R                                 |  |             |  |                          |    |  |                                 | 2,817     |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   |         |   |  |   | 2,817    |  
|Comprehensive loss:                                                      |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|Net loss                                                                 |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          |    |   |  |   | (12,102  | ) |  |   | (12,102  | )
|Foreign currency translation adjustment                                  |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          | 505 |   |  |   |         |   |  |   | 505      |  
|Unrealized gain on available for sale securities                         |  |             |  |                          |    |  |                                 |          |   |                                 |   |     |                                 |  |   |                   |   |  |                          | 7   |   |  |   |         |   |  |   | 7        |  
|                                                                         |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  
|Total comprehensive loss                                                 |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   | (11,590  | )
|                                                                         |  |              |  |                          |     |  |                                 |           |   |                                 |   |      |                                 |  |   |                    |   |  |                          |     |   |  |   |          |   |  |   |          |  



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|                                                                         |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   |         |  
|------------------------------------------------------------------------ |  | ------------ |  | ------------------------ | --- | ------------------------------- | - | ------------------------------- |  | ------------------------------- | - |  | ------------------ | - |  | ------------------------ | ---- | - |  | - | ---------- | - |  | - | ------- | -
|                                                                         |  | Common stock |  | Additionalpaid-incapital |     | Notesreceivablefromstockholders |   | Deferredstock-basedcompensation |  | Othercomprehensiveincome (loss) |   |  | Accumulateddeficit |   |  | Totalstockholdersequity |     
|                                                                         |  | Shares       |  | Amount                   |     |                                 |   |                                 |  |                                
|Balances as of December 31, 2007                                         |  | 150,024      |  |                          | 150 |                                 |   | 1,061,849                       |  |                                 |  |  |                    |  |  |                          | 610  |   |  |   | (913,062   | ) |  |   | 149,547 |  
|Exercise of stock options for cash                                       |  | 28           |  |                          |    |                                 |   | 6                               |  |                                 |  |  |                    |  |  |                          |     |   |  |   |           |   |  |   | 6       |  
|Issuance of common stock in connection with employee stock purchase plan |  | 557          |  |                          | 1   |                                 |   | 287                             |  |                                 |  |  |                    |  |  |                          |     |   |  |   |           |   |  |   | 288     |  
|Issuance of common stock for services                                    |  | 74           |  |                          |    |                                 |   | 81                              |  |                                 |  |  |                    |  |  |                          |     |   |  |   |           |   |  |   | 81      |  
|Stock-based compensation under SFAS 123R                                 |  |             |  |                          |    |                                 |   | 2,270                           |  |                                 |  |  |                    |  |  |                          |     |   |  |   |           |   |  |   | 2,270   |  
|Comprehensive loss:                                                      |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   |         |  
|Net loss                                                                 |  |             |  |                          |    |                                 |   |                                |  |                                 |  |  |                    |  |  |                          |     |   |  |   | (92,535    | ) |  |   | (92,535 | )
|Foreign currency translation adjustment                                  |  |             |  |                          |    |                                 |   |                                |  |                                 |  |  |                    |  |  |                          | (355 | ) |  |   |           |   |  |   | (355    | )
|Unrealized loss on available for sale securities                         |  |             |  |                          |    |                                 |   |                                |  |                                 |  |  |                    |  |  |                          | (5   | ) |  |   |           |   |  |   | (5      | )
|                                                                         |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   |         |  
|Total comprehensive loss                                                 |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   | (92,895 | )
|                                                                         |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   |         |  
|Balances as of December 31, 2008                                         |  | 150,683      |  | $                        | 151 |                                 | $ | 1,064,493                       |  | $                               |  |  | $                  |  |  | $                        | 250  |   |  | $ | (1,005,597 | ) |  | $ | 59,297  |  
|                                                                         |  |              |  |                          |     |                                 |   |                                 |  |                                 |   |  |                    |   |  |                          |      |   |  |   |            |   |  |   |         |  



See accompanying notes to
consolidated financial statements.



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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2008, 2007 and 2006

(In thousands)



|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|--------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                            |  | 2008 |         |   | 2007 |   |         | 2006 | 
|Cash flows from operating activities:                                       |  |      |         |   |      |   |         |      |  |   |          |  
|Net loss                                                                    |  | $    | (92,535 | ) |      | $ | (12,102 | )    |  | $ | (142,666 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |      |         |   |      |   |         |      |  |   |          |  
|Depreciation and amortization                                               |  |      | 2,204   |   |      |   | 2,660   |      |  |   | 5,383    |  
|Stock-based compensation                                                    |  |      | 2,351   |   |      |   | 2,866   |      |  |   | 5,505    |  
|Impairment of goodwill and intangible assets                                |  |      | 70,401  |   |      |   |        |      |  |   | 113,666  |  
|Gain on sale of intangible assets                                           |  |      | (4,397  | ) |      |   | (5,000  | )    |  |   |         |  
|Gain on sale of fixed assets                                                |  |      | (455    | ) |      |   | (659    | )    |  |   | (301     | )
|(Accretion) or impairment of investments                                    |  |      | (169    | ) |      |   | (462    | )    |  |   | (527     | )
|Provision for sales returns and doubtful accounts                           |  |      | 3,143   |   |      |   | 3,305   |      |  |   | 6,638    |  
|Changes in operating assets and liabilities:                                |  |      |         |   |      |   |         |      |  |   |          |  
|Accounts receivable                                                         |  |      | 6,450   |   |      |   | (4,735  | )    |  |   | (3,074   | )
|Inventories                                                                 |  |      | 3,992   |   |      |   | 338     |      |  |   | 3,334    |  
|Prepaid expenses and other current assets                                   |  |      | 1,150   |   |      |   | 585     |      |  |   | 239      |  
|Other assets                                                                |  |      | 21      |   |      |   | 3       |      |  |   | 30       |  
|Accounts payable                                                            |  |      | (8,557  | ) |      |   | 2,383   |      |  |   | 771      |  
|Accrued and other liabilities                                               |  |      | (823    | ) |      |   | (3,958  | )    |  |   | (5,236   | )
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Net cash used in operating activities                                       |  |      | (17,224 | ) |      |   | (14,776 | )    |  |   | (16,238  | )
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Cash flows from investing activities:                                       |  |      |         |   |      |   |         |      |  |   |          |  
|Tax refund related to acquisition of Sorrento                               |  |      |        |   |      |   | 336     |      |  |   |         |  
|Proceeds from sale of intangible assets                                     |  |      | 4,397   |   |      |   | 5,000   |      |  |   | 9,000    |  
|Proceeds from sale of assets                                                |  |      | 502     |   |      |   | 2,250   |      |  |   | 1,716    |  
|Purchases of property and equipment                                         |  |      | (1,436  | ) |      |   | (1,365  | )    |  |   | (2,004   | )
|Purchases of short-term investments                                         |  |      | (10,879 | ) |      |   | (26,992 | )    |  |   | (37,905  | )
|Proceeds from maturity of short-term investments                            |  |      | 20,412  |   |      |   | 32,437  |      |  |   | 40,100   |  
|Changes in restricted cash                                                  |  |      | 63      |   |      |   | (87     | )    |  |   | (89      | )
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Net cash provided by investing activities                                   |  |      | 13,059  |   |      |   | 11,579  |      |  |   | 10,818   |  
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Cash flows from financing activities:                                       |  |      |         |   |      |   |         |      |  |   |          |  
|Proceeds from issuance of common stock and warrants                         |  |      | 294     |   |      |   | 667     |      |  |   | 2,311    |  
|Proceeds from repayment of officer loans                                    |  |      |        |   |      |   |        |      |  |   | 550      |  
|Borrowings under credit facilities                                          |  |      |        |   |      |   | 500     |      |  |   |         |  
|Repayment of debt                                                           |  |      | (327    | ) |      |   | (7,644  | )    |  |   | (2,718   | )
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Net cash provided by (used in) financing activities                         |  |      | (33     | ) |      |   | (6,477  | )    |  |   | 143      |  
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Effect of exchange rate changes on cash                                     |  |      | (355    | ) |      |   | 505     |      |  |   | 84       |  
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Net decrease in cash and cash equivalents                                   |  |      | (4,553  | ) |      |   | (9,169  | )    |  |   | (5,193   | )
|Cash and cash equivalents at beginning of year                              |  |      | 37,804  |   |      |   | 46,973  |      |  |   | 52,166   |  
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Cash and cash equivalents at end of year                                    |  | $    | 33,251  |   |      | $ | 37,804  |      |  | $ | 46,973   |  
|                                                                            |  |      |         |   |      |   |         |      |  |   |          |  
|Supplemental disclosures of cash flow information:                          |  |      |         |   |      |   |         |      |  |   |          |  
|Cash paid during period for:                                                |  |      |         |   |      |   |         |      |  |   |          |  
|Taxes                                                                       |  | $    | 371     |   |      | $ | 349     |      |  | $ | 740      |  
|Interest                                                                    |  |      | 1,639   |   |      |   | 2,226   |      |  |   | 2,635    |  
|Noncash investing and financing activities:                                 |  |      |         |   |      |   |         |      |  |   |          |  
|Purchase price allocation adjustment                                        |  |      |        |   |      |   |        |      |  |   | 1,206    |  
|Reclassification of restricted cash                                         |  |      |        |   |      |   | 537     |      |  |   |         |  



See accompanying notes to consolidated financial statements.

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(1)
Organization and Summary of Significant Accounting Policies

(a) Description of Business

Zhone Technologies, Inc. (sometimes referred to, collectively with its subsidiaries, as Zhone or the
Company) designs, develops and manufactures communications network equipment for telephone companies and cable operators worldwide. The Companys products allow network service providers to deliver video and interactive
entertainment services in addition to their existing voice and data service offerings. The Company was incorporated under the laws of the state of Delaware in June 1999. The Company began operations in September 1999 and is headquartered in Oakland,
California.

(b) Basis of Presentation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All
significant inter-company transactions and balances have been eliminated in consolidation.

(c) Risks and Uncertainties

The accompanying consolidated financial statements have been prepared assuming that the Company
will continue as a going concern. The Companys continued losses reduced cash, cash equivalents and short-term investments in 2007 and 2008. As of December 31, 2008, the Company had approximately $36.2 million in cash, cash equivalents and
short-term investments and $15.0 million outstanding under its bank lending facility. Continued uncertainty in the credit markets may negatively impact the Companys ability to access debt financing or to refinance existing indebtedness in the
future on favorable terms, or at all. In order to meet liquidity needs and finance capital expenditures and working capital, the Company may be required to sell assets, or to borrow on potentially unfavorable terms. The Company may be unable to sell
assets or access additional indebtedness to meet these needs. As a result, the Company may become unable to pay its ordinary expenses, including its debt service, on a timely basis. The Companys current lack of liquidity could harm it by:



| |  |  | increasing its vulnerability to adverse economic conditions in its industry or the economy in general;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | limiting its ability to plan for, or react to, changes in its business and industry; and
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | influencing investor and customer perceptions about its financial stability and limiting its ability to obtain financing or acquire customers.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------

The global unfavorable economic and market conditions and the financial crisis could
impact the Companys business in a number of ways, including:



| |  |  | Potential deferment of purchases and orders by customers;
| | - |  | ---------------------------------------------------------



| |  |  | Customers inability to obtain financing to make purchases from the Company and/or maintain their business;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | Negative impact from increased financial pressures on third-party dealers, distributors and retailers; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | Negative impact from increased financial pressures on key suppliers.
| | - |  | --------------------------------------------------------------------



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If the economic, market and geopolitical conditions in the United States
and the rest of the world do not improve, or if they continue to deteriorate, the Company may experience material adverse impacts on its business, operating results and financial condition.

During 2008, the Company implemented several activities intended to reduce costs, improve operating efficiencies and
change its operations to more closely align them with its key strategic focus, including the sale of legacy product lines and headcount reductions.

The Company expects that operating losses and negative cash flows from operations will continue. In order to meet the Companys liquidity needs and finance its capital expenditures and
working capital needs for the business, the Company may need to raise additional capital through the issuance of debt or equity financing or the sale of assets. Continued uncertainty in credit markets may negatively impact the Companys ability
to access debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include
covenants, restrictions and financial ratios that may restrict the Companys ability to operate its business. Likewise, any equity financing could result in additional dilution of the Companys stockholders. If the Company is unable to
obtain additional capital or is required to obtain additional capital on terms that are not favorable, it may be required to reduce the scope of its planned product development and sales and marketing efforts beyond the reductions it has previously
taken. Based on the Companys current plans and business conditions, it believes that its existing cash, cash equivalents and short-term investments and available credit facilities will be sufficient to satisfy its anticipated cash requirements
for the foreseeable future.

(d) Use of Estimates

The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the
United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

(e) Revenue Recognition

The Company recognizes revenue when the earnings process is
complete. The Company recognizes product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, net of estimated sales returns and allowances at the time of shipment.
Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue
is deferred until such obligations are fulfilled. The Companys arrangements generally do not have any significant post-delivery obligations. The Company offers products and services such as support, education and training, hardware upgrades
and post-warranty support. For multiple element revenue arrangements, the Company establishes the fair value of these products and services based primarily on sales prices when the products and services are sold separately. If fair value cannot be
established for undelivered elements, all of the revenue under the arrangement is deferred until those elements have been delivered. When collectibility is not reasonably assured, revenue is recognized when cash is collected. Revenue from education
services and support services is recognized over the contract term or as the service is performed. The Company makes certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. Return
privileges generally allow distributors to return inventory based on a percent of purchases made within a specific period of time. The Company recognizes revenue on sales to distributors that have contractual return rights when the products have
been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. In those instances when revenue is recognized upon shipment to distributors, the Company uses
historical rates of return from the distributors to provide



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for estimated products return in accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When
Right of Return Exists. The Company accrues for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs. In accordance with the provisions of Emerging Issues Task Force
Issue No. 06-3 (EITF 06-3), How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation), the Company nets sales taxes against revenue.

(f) Allowances for Sales Returns and Doubtful Accounts

The Company records an allowance for sales returns for estimated future product returns related to current period product
revenue. The allowance is recorded as a reduction of revenues in the Companys consolidated financial statements. The Company bases its allowance on periodic assessments of historical trends in product return rates and current approved returned
products. If the actual future returns were to deviate from the historical data on which the reserve had been established, the Companys revenue could be adversely affected.

The Company records an allowance for doubtful accounts for estimated losses resulting from the inability of customers to
make payments. The allowance is recorded as a general and administrative expense in the Companys consolidated financial statements. The Company bases its allowance on periodic assessments of its customers liquidity and financial
condition through analysis of information obtained from credit rating agencies, financial statement review and historical collection trends. Additional allowances may be required if the liquidity or financial condition of its customers were to
deteriorate.

Activity under the Companys allowance for sales returns and doubtful accounts was
comprised as follows (in thousands):



|                             |  |                         |        |   |      |   |        |      |  |   |        |  
|---------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                             |  | Year ended December 31, |       
|                             |  | 2008                    |        |   | 2007 |   |        | 2006 | 
|Balance at beginning of year |  | $                       | 5,941  |   |      | $ | 6,939  |      |  | $ | 5,643  |  
|Charged to revenue           |  |                         | 2,356  |   |      |   | 2,728  |      |  |   | 5,574  |  
|Charged to expenses          |  |                         | 787    |   |      |   | 577    |      |  |   | 1,064  |  
|Utilization                  |  |                         | (3,929 | ) |      |   | (4,303 | )    |  |   | (5,342 | )
|                             |  |                         |        |   |      |   |        |      |  |   |        |  
|Balance at end of year       |  | $                       | 5,155  |   |      | $ | 5,941  |      |  | $ | 6,939  |  
|                             |  |                         |        |   |      |   |        |      |  |   |        |  

The allowance for doubtful accounts was $3.9 million and $4.3
million as of December 31, 2008 and 2007, respectively.

(g) Inventories

Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO)
method. In assessing the net realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its
estimated net realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory
obsolescence due to rapidly changing technology and customer requirements, the Company may incur significant charges for excess inventory.

h) Operating Lease Liabilities

As a result of the acquisition of Paradyne in
September 2005, the Company assumed certain lease liabilities for facilities in Largo, Florida. In accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination
(EITF 95-3), the Company



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accrued a liability for the excess portion of these facilities. The computation of the estimated liability includes a number of assumptions and subjective
variables. These variables include the level and timing of future sublease income, amount of contractual variable costs, future market rental rates, discount rate, and other estimated expenses. If circumstances change, and the Company employs
different assumptions in future periods, the future lease liability may differ significantly from what the Company has recorded in the current period and could materially affect its net loss and net loss per share.

(i) Foreign Currency Translation

For operations outside the United States, the Company translates assets and liabilities of foreign subsidiaries, whose functional currency is the local currency, at end of period exchange rates.
Revenues and expenses are translated at monthly average rates of exchange prevailing during the year. The adjustment resulting from translating the financial statements of such foreign subsidiaries, is included in accumulated other comprehensive
income (loss), which is reflected as a separate component of stockholders equity. Realized gains and losses on foreign currency transactions are included in other income (expense) in the accompanying consolidated statement of operations.
During 2008 and 2007, the Company recorded a $0.1 million realized foreign exchange loss for each period in other income (expense) on its statements of operations.

(j) Cash and Cash Equivalents, and Short-Term Investments

The
Company considers all cash and highly liquid investments purchased with an original maturity of less than three months to be cash equivalents.

Short-term investments include securities with original maturities greater than three months and less than one year and are available for use in current operations or other activities. Short-term
investments consist principally of commercial paper, corporate debentures and bonds. Short-term investments have been classified as available for sale. Under this classification, the investments are reported at fair value, with unrealized gains and
losses excluded from results of operations and reported, net of tax, as a component of other comprehensive loss in stockholders equity. Realized gains and losses and declines in value judged to be other than temporary are included in results
of operations. Gains and losses from the sale of securities are based on the specific-identification method.

Cash, cash equivalents, and short-term investments consisted of the following as of December 31, 2008 (in thousands):



|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|-------------------------- |  | ---- | ------ | -------------- | - | -------------- |  | - | ---------- | - |  | - | ------
|                           |  | Cost |        | UnrealizedGain |   | UnrealizedLoss |  |   | Fair Value
|Cash and Cash Equivalents: |  |      |        |                |   |                |  |   |            |   |  |   |       
|Cash                       |  | $    | 26,607 |                | $ |               |  | $ |           |   |  | $ | 26,607
|Money Market Funds         |  |      | 6,644  |                |   |               |  |   |           |   |  |   | 6,644 
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|                           |  | $    | 33,251 |                | $ |               |  | $ |           |   |  | $ | 33,251
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|Short-term investments:    |  |      |        |                |   |                |  |   |            |   |  |   |       
|Commercial Paper           |  | $    | 896    |                | $ | 2              |  | $ |           |   |  | $ | 898   
|Corporate Securities       |  |      | 2,091  |                |   | 5              |  |   | (2         | ) |  |   | 2,094 
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|                           |  | $    | 2,987  |                | $ | 7              |  | $ | (2         | ) |  | $ | 2,992 
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       



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Cash, cash equivalents, and short-term investments consisted of the
following as of December 31, 2007 (in thousands):



|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|-------------------------- |  | ---- | ------ | -------------- | - | -------------- |  | - | ---------- | - |  | - | ------
|                           |  | Cost |        | UnrealizedGain |   | UnrealizedLoss |  |   | Fair Value
|Cash and Cash Equivalents: |  |      |        |                |   |                |  |   |            |   |  |   |       
|Cash                       |  | $    | 13,674 |                | $ |               |  | $ |           |   |  | $ | 13,674
|Money Market Funds         |  |      | 20,491 |                |   |               |  |   |           |   |  |   | 20,491
|Commercial Paper           |  |      | 3,638  |                |   | 1              |  |   |           |   |  |   | 3,639 
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|                           |  | $    | 37,803 |                | $ | 1              |  | $ |           |   |  | $ | 37,804
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|Short-term investments:    |  |      |        |                |   |                |  |   |            |   |  |   |       
|Commercial Paper           |  | $    | 6,082  |                | $ | 4              |  | $ |           |   |  | $ | 6,086 
|US Agency Securities       |  |      | 900    |                |   |               |  |   |           |   |  |   | 900   
|Corporate Securities       |  |      | 5,370  |                |   | 6              |  |   | (1         | ) |  |   | 5,375 
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       
|                           |  | $    | 12,352 |                | $ | 10             |  | $ | (1         | ) |  | $ | 12,361
|                           |  |      |        |                |   |                |  |   |            |   |  |   |       

(k) Fair Value of Financial Instruments

The carrying amounts of the Companys consolidated financial instruments which include cash and cash equivalents,
accounts receivable, accounts payable and accrued liabilities approximate their fair values as of December 31, 2008 and 2007 due to the relatively short maturities of these instruments. The carrying value of the Companys debt obligations
at December 31, 2008 and 2007 approximate their fair value.

(l) Concentration of Risk

Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and
cash equivalents and accounts receivable. Cash and cash equivalents consist principally of demand deposits and money market accounts, commercial paper and debt securities of domestic municipalities with credit ratings of AA or better. Cash and cash
equivalents are principally held with various domestic financial institutions with high credit standing. The Companys customers include competitive and incumbent local exchange carriers, competitive access providers, internet service
providers, wireless carriers, and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. The
Companys accounts receivable represents a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of large balances due from a relatively small number of customer
account balances. As of December 31, 2008, two customers accounted for 13% and 10% of accounts receivable. In addition, as of December 31, 2008 and 2007, receivables from customers in international territories represented 69% and 63%,
respectively, of accounts receivable.

The Company may provide or commit to extend credit or credit support
to certain customers. During the years ended December 31, 2008 and 2007, the Company sold $10.2 million and $2.0 million, respectively, of customer trade receivables to financial institutions on a non-recourse basis in exchange for cash. The
sale of the receivables did not represent a securitization, and there was no continuing involvement or interests in the receivables by the Company after the sale. As of December 31, 2008, the Company did not have any significant customer
financing commitments or guarantees.

The Companys products are concentrated in the communications
equipment market, which is highly competitive and subject to rapid change. Significant technological changes in the industry could adversely affect operating results. The Companys inventories include components that may be specialized in
nature, and subject to rapid technological obsolescence. The Company actively manages inventory levels, and the



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Company considers technological obsolescence and potential changes in product demand based on macroeconomic conditions when estimating required allowances to
reduce recorded inventory amounts to market value. Such estimates could change in the future.

The
Companys growth and ability to meet customer demands are also dependent on its ability to obtain timely deliveries of components from suppliers and contract manufacturers. The Company depends on contract manufacturers and sole or limited
source suppliers for several key components. If the Company were unable to obtain these components on a timely basis, the Company would be unable to meet its customers product delivery requirements which could adversely impact operating
results. While the Company is not solely dependent on one contract manufacturer, it expects to continue to rely on contract manufacturers to fulfill a portion of its product manufacturing requirements.

(m) Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over their estimated useful lives. Useful life for buildings is 30 years. Useful lives for laboratory and manufacturing
equipment range from 10 to 30 years. Useful lives of all other property and equipment range from 3 to 5 years. Leasehold improvements are generally amortized over the shorter of their useful lives or the remaining lease term.

(n) Goodwill

Costs in excess of the fair value of tangible and identifiable intangible assets acquired and liabilities assumed in a purchase business combination are recorded as goodwill. SFAS No. 142, Goodwill and Other
Intangible Assets, requires that companies test for goodwill impairment at least annually using a two-step approach. The Company evaluates goodwill on an annual basis in November, at a minimum, and whenever events and changes in circumstances
suggest that the carrying amount may not be recoverable. Impairment of goodwill is tested at the reporting unit level by comparing the reporting units carrying amount, including goodwill, to the fair value of the reporting unit. The Company
has determined that it operates in a single segment with one operating unit. The Company performs the annual goodwill impairment test using the market approach. If the carrying amount of the reporting unit exceeds its fair value, indication of
goodwill impairment exists and a second step is performed to measure the amount of impairment loss, if any. During the years ended December 31, 2008 and 2006, the Company recorded non-cash goodwill impairment charges of $70.4 million, and
$110.5 million, respectively, as discussed in Note 3.

(o) Purchased Intangibles and Other Long-Lived Assets

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company
reviews long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable based on expected undiscounted cash
flows attributable to that asset. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If the carrying amount of an
asset exceeds its estimated future net undiscounted cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Any assets to be disposed of would be separately
presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented
separately in the appropriate asset and liability sections of the balance sheet.

During the year ended
December 31, 2006, the Company recorded non-cash impairment charges of $3.2 million related to the impairment of purchased technology, customer relationships and other amortizable intangibles as discussed in Note 3.



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(p) Research and Product Development Expenditures

Costs related to research, design, and development of products are charged to research and product development expense as
incurred.

(q) Accounting for Stock-Based Compensation

SFAS No. 123 (revised 2004), Share-Based Payment(SFAS 123R), requires companies to estimate the fair value of
share-based payment awards on the date of grant using an option pricing model. The Company adopted the Black Scholes model to estimate the fair value of options. The value of the portion of the award that is ultimately expected to vest is recognized
as expense over the requisite service periods in the Companys Consolidated Statement of Operations.

Awards of stock options granted to consultants under the Companys share-based compensation plans are accounted for at fair value determined by using the Black Scholes option pricing model in accordance with Emerging Issues Task Force
Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or In Conjunction with Selling, Goods or Services(EITF 96-18). These options are generally immediately exercisable and expire
seven to ten years from the date of grant. The Company values non-employee options using the Black Scholes model. Non-employee options subject to vesting are valued as they become vested.

Fair value stock-based compensation expense under SFAS 123R for the year ended December 31, 2008 includes
compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and compensation expense for
the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In conjunction with the provisions of SFAS 123R, the Company changed its
method of attributing the value of stock-based compensation to expense from the accelerated method to the straight line method. Compensation expense for all employee share-based payment awards granted on or prior to December 31, 2005 will
continue to be recognized using the accelerated method while compensation expense for all share-based payment awards granted subsequent to December 31, 2005 is recognized using the straight line method.

(r) Income Taxes

The Company uses the asset and liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and the income
tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established, when necessary, to
reduce deferred tax assets to the amount expected to be realized. The Company has recorded a full valuation allowance against its net deferred tax assets at December 31, 2008 and 2007 due to the significant uncertainty regarding whether the
deferred tax assets will be realized.

(s) Net Loss per Common Share

Basic net loss per share is computed by dividing the net loss applicable to holders of common stock for the period by the
weighted average number of shares of common stock outstanding during the period. The calculation of diluted net loss per share gives effect to common stock equivalents; however, potential common equivalent shares are excluded if their effect is
antidilutive. Potential common equivalent shares are composed of common stock subject to repurchase rights and incremental shares of common equivalent shares issuable upon the exercise of stock options and warrants, and the conversion of convertible
debt.



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(t) Other Comprehensive Income (Loss)

Other comprehensive income (loss) is recorded directly to stockholders equity and includes unrealized gains and
losses which have been excluded from the consolidated statements of operations. These unrealized gains and losses consist of foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities.

(u) Recent Accounting Pronouncements

SFAS 157  Fair Value Measurements

In September 2006, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157 (SFAS 157), Fair Value Measurements, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding
fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after
November 15, 2007 for financial assets and liabilities. In February 2008, the FASB issued FASB FSP 157-2 which delays the effective date of SFAS 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at
fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Company adopted the provisions of SFAS 157 with respect to
its financial assets and liabilities beginning in the first quarter of fiscal year 2008. The adoption of SFAS 157 did not have a material effect on the Companys consolidated financial condition or results of operations or cash flows. The
Company is still in the process of evaluating this standard with respect to its effect on non-financial assets and liabilities and therefore has not yet determined the impact it will have on its consolidated financial statements upon full adoption
in fiscal year 2009. Non-financial assets and liabilities for which the Company has not applied the provisions of SFAS 157 include those measured at fair value in impairment testing.

SFAS 159  Fair Value Option for Financial Assets and Financial Liabilities

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial
Liabilities (SFAS 159). SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been
elected be reported in earnings. The Company was required to adopt SFAS 159 beginning in the first quarter of fiscal year 2008. The Company did not elect the fair value option, therefore the adoption of SFAS 159 did not have any impact on its
consolidated financial statements.

SFAS 141R  Business Combinations

In December 2007, the FASB issued SFAS No. 141 (revised 2007),Business Combinations (SFAS 141R), which
replaces SFAS No. 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non controlling interest in the
acquiree and the goodwill acquired. This statement also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for business combinations which
close in fiscal years beginning after December 15, 2008. The Company will be required to adopt SFAS 141R in its 2009 fiscal year.

FSP APB 14-1  Accounting for Convertible Debt Instruments

In May 2008, the FASB
issued FASB Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement),(FSP APB 14-1), which requires issuers of convertible debt that may be
settled wholly or partly in cash when converted to account for the debt and equity components separately. This statement is effective for fiscal years beginning after December 15, 2008 and must be applied retrospectively to all periods. The
Company is currently evaluating the impact, if any, that the adoption of FSP ABP 14-1 will have on its consolidated financial statements.



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(v) Reclassifications

Certain reclassifications have been made to prior period balances in order to conform to the current periods
presentation. These include the reclassification of stock-based compensation expense to the associated operating expense line items in the consolidated statement of operations; and, commencing with the first quarter of 2007, the reclassification of
prior period balances relating to the Companys historical optical transport business as part of its balances relating to its legacy, services and other product category.

(2) Operating Lease Liabilities

As a result of the acquisition of Paradyne Networks,
Inc. (Paradyne) in September 2005, the Company assumed a lease commitment for facilities in Largo, Florida. In accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase
Business Combination (EITF 95-3), the Company accrued a liability for the excess portion of these facilities. The term of the lease expires in June 2012 and had an estimated remaining obligation of approximately $15.2 million as of
December 31, 2008, of which $5.6 million was accrued for excess facilities, net of estimated sublease income. The computation of the estimated liability includes a number of assumptions and subjective variables. These variables include the
level and timing of future sublease income, amount of contractual variable costs, future market rental rates, discount rate, and other estimated expenses. If circumstances change, and the Company employs different assumptions in future periods, the
lease liability may differ significantly from what the Company has recorded in the current period and could materially affect its net loss and net loss per share. During the second quarter of 2008, the Company significantly reduced its assumptions
regarding estimated future sublease income primarily as a result of the deteriorating real estate market. Accordingly, during the second quarter of 2008, the Company increased its excess lease liability balance by $3.3 million with a corresponding
charge to general and administrative expenses. A summary of current period activity related to excess lease liabilities accrued is as follows (in thousands):



|                             |  |            |        |  
|---------------------------- |  | ---------- | ------ | -
|                             |  | Exit Costs |       
|Balance at December 31, 2007 |  | $          | 3,695  |  
|Cash payments, net           |  |            | (1,403 | )
|Change in estimate           |  |            | 3,305  |  
|                             |  |            |        |  
|Balance at December 31, 2008 |  | $          | 5,597  |  
|                             |  |            |        |  

A summary of the assumed lease liabilities related to excess
facilities at their net present value is as follows (in thousands):



|                                  |  |            |        |  
|--------------------------------- |  | ---------- | ------ | -
|                                  |  | Exit Costs |       
|Future lease payments             |  | $          | 8,250  |  
|Less: contractual sublease income |  |            | (2,079 | )
|Less: estimated sublease income   |  |            | (599   | )
|Other sublease expenses           |  |            | 25     |  
|                                  |  |            |        |  
|Balance at December 31, 2008      |  | $          | 5,597  |  
|                                  |  |            |        |  

The current portion of the excess lease liability as of December 31, 2008 of
$1.7 million is classified in Accrued and other liabilities and the long-term portion of $3.9 million is classified in Other long-term liabilities in the accompanying consolidated balance sheet.

(3) Long-lived Assets, Goodwill and Other Acquisition-Related Intangible Assets

The Company tests goodwill for impairment using a two step approach on an annual basis in November, or when certain indicators of impairment exist in accordance with SFAS No. 142,
Goodwill and Other Intangible



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Assets. Impairment of goodwill is tested at the reporting unit level by comparing the reporting units carrying amount, including goodwill, to
the fair value of the reporting unit using the market approach. The Company has determined that it operates in a single segment with one reporting unit. If the carrying amount of the reporting unit exceeds its fair value, a second step is performed
to measure the amount of impairment loss, if any. In 2008 and 2006, the Company determined that the reporting units carrying value exceeded its fair value and the second step was performed, resulting in a goodwill impairment loss of $70.4
million and $110.5 million, respectively.

Changes in the carrying amount of goodwill were as follows (in thousands):



|                       |  |                        |         |   |      |   |        |  
|---------------------- |  | ---------------------- | ------- | - | ---- | - | ------ | -
|                       |  | Year endedDecember 31, |        
|                       |  | 2008                   |         |   | 2007 |  
|Beginning balance      |  | $                      | 70,401  |   |      | $ | 70,737 |  
|Impairment of goodwill |  |                        | (70,401 | ) |      |   |       |  
|Other adjustments      |  |                        |        |   |      |   | (336   | )
|                       |  |                        |         |   |      |   |        |  
|Ending balance         |  | $                      |        |   |      | $ | 70,401 |  
|                       |  |                        |         |   |      |   |        |  

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal
of Long Lived Assets, the Company reviews long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on
expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.

The Company estimates the fair value of its long-lived assets based on a combination of the market, income and replacement cost
approaches. In the application of the impairment testing, the Company is required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed
variables could differ from these estimates. During the third quarter of 2006, the Company determined that indicators of impairment existed and an impairment analysis was performed, resulting in an impairment loss to amortizable intangibles of $3.2
million. The Companys amortizable intangibles at December 31, 2008 and 2007 were zero.

Sale of Intangible Assets

During 2008 and 2007, the Company sold some of its non-strategic patents for $1.1 million and $5.0 million, respectively.
The resulting $1.1 million and $5.0 million gain were recorded within operating expenses as gain on sale of intangible assets. During the second quarter of 2006, the Company sold some of its non-strategic patents for $9.0 million, resulting in a
gain of $0.3 million, which was recorded within general and administrative operating expenses.

Sale of Legacy
Inventory and Other Assets

In January 2008, the Company sold its GigaMux legacy product line to a third party.
The sale of the GigaMux legacy product line was not treated as a discontinued operation since it did not represent a component of the Company that had operations and cash flows that were clearly distinguishable, operationally and for financial
reporting purposes, from the rest of the entity. The Company allocated the proceeds received to receivables, inventory, fixed assets and intangible assets based on the relative fair value of the assets sold. The Company recognized a gain of $1.3
million on the sale of the inventory related to this product line in the first quarter of 2008 that was recorded in cost of revenue. The Company also recognized a gain of $0.5 million and $3.2 million on the sale of fixed assets and intangible
assets, respectively, in the first quarter of 2008 that was recorded as a component of operating expenses. The Company is entitled to additional contingent consideration

for the sale of the GigaMux legacy product line upon the buyers usage of inventory and/or attainment of certain



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performance targets through December 2010. Additional contingent consideration, if any, will be recorded upon receipt of cash as an additional gain in cost
of revenue. In the second, third and fourth quarters of 2008, the Company received contingent consideration of $0.6 million, $0.4 million and $0.1 million, respectively, related to the buyers usage of inventory related to the GigaMux legacy
product line.

In December 2007, the Company sold its Access Node legacy product line to a third party. In addition to sale
of inventory, the Company also sold fixed assets related to the Access Node legacy product line. Upon sale of the fixed assets, the Company recorded a gain of $0.7 million, which was recorded as a component of operating expenses.

Sale of Land

During the second quarter of 2007, the Company completed the sale of approximately 3.625 acres of undeveloped land at a price of $1.5 million to the Redevelopment Agency of the City of Oakland pursuant to a repurchase option exercised by
it. No gain or loss was recorded on the sale.

(4) Fair Value Measurement

The Company adopted SFAS 157 during the first fiscal quarter of 2008, which requires enhanced disclosures about assets and liabilities measured at fair value. The Companys adoption of SFAS
157 was limited to financial assets and liabilities, which primarily relate to its fixed income securities.

The Company
utilizes the market approach to measure fair value of its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

SFAS 157 includes a fair value hierarchy that is intended to increase consistency and comparability in fair value
measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would
use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entitys pricing based upon their own market assumptions. The fair value hierarchy consists of the
following three levels:



|        |  |   |  |                                                                                                                                                                                                                                                                                                                                              
|------- |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Level 1 |  | - |  | Inputs are quoted prices in active markets for identical assets or liabilities.                                                                                                                                                                                                                                                              
|        |  |  
|Level 2 |  | - |  | Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active,
inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.
|        |  |  
|Level 3 |  | - |  | Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.                                                                                                                                                                                                                      



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The following table represents the Companys financial assets and liabilities at fair value on a
recurring basis as of December 31, 2008 and the basis for that measurement:



|                                               |  |                                                                |        |                                                 |   |                                  |  |                               |       |  |   |  
|---------------------------------------------- |  | -------------------------------------------------------------- | ------ | ----------------------------------------------- | - | -------------------------------- |  | ----------------------------- | ----- |  | - | -
|                                               |  | Fair Value Measurements at Reporting Date Using (In Thousands)
|                                               |  |                                                                |        | QuotedPrices inActiveMarkets forIdenticalAssets |   | SignificantOtherObservableInputs |  | SignificantUnobservableInputs
|                                               |  | Total                                                          |        | (Level 1)                                       |   | (Level 2)                        |  | (Level 3)                    
|Money market funds and overnight deposits (1)  |  | $                                                              | 21,639 |                                                 | $ | 21,639                           |  | $                             |      |  | $ | 
|Fixed income available-for-sale securities (2) |  |                                                                | 2,992  |                                                 |   |                                 |  |                               | 2,992 |  |   | 
|                                               |  |                                                                |        |                                                 |   |                                  |  |                               |       |  |   |  
|Total                                          |  | $                                                              | 24,631 |                                                 | $ | 21,639                           |  | $                             | 2,992 |  | $ | 
|                                               |  |                                                                |        |                                                 |   |                                  |  |                               |       |  |   |  



|(1) | Included in cash and cash equivalents on the Companys consolidated balance sheet.
|--- | ----------------------------------------------------------------------------------

|(2) | Included in short-term investments on the Companys consolidated balance sheet.
|--- | -------------------------------------------------------------------------------

(5) Balance Sheet Detail

Balance
sheet detail as of December 31, 2008 and 2007 is as follows (in thousands):



|                                               |  |      |         |   |      |   |        |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | -
|                                               |  | 2008 |         |   | 2007 |  
|Inventories:                                   |  |      |         |   |      |   |        |  
|Raw materials                                  |  | $    | 26,720  |   |      | $ | 33,479 |  
|Work in process                                |  |      | 5,160   |   |      |   | 5,194  |  
|Finished goods                                 |  |      | 8,826   |   |      |   | 6,025  |  
|                                               |  |      |         |   |      |   |        |  
|                                               |  | $    | 40,706  |   |      | $ | 44,698 |  
|                                               |  |      |         |   |      |   |        |  
|Property and equipment:                        |  |      |         |   |      |   |        |  
|Land                                           |  | $    | 4,821   |   |      | $ | 4,821  |  
|Buildings                                      |  |      | 14,007  |   |      |   | 14,007 |  
|Machinery and equipment                        |  |      | 8,682   |   |      |   | 7,729  |  
|Computers and acquired software                |  |      | 3,536   |   |      |   | 3,401  |  
|Furniture and fixtures                         |  |      | 513     |   |      |   | 389    |  
|Leasehold improvements                         |  |      | 381     |   |      |   | 378    |  
|                                               |  |      |         |   |      |   |        |  
|                                               |  |      | 31,940  |   |      |   | 30,725 |  
|Less accumulated depreciation and amortization |  |      | (11,937 | ) |      |   | (9,907 | )
|                                               |  |      |         |   |      |   |        |  
|                                               |  | $    | 20,003  |   |      | $ | 20,818 |  
|                                               |  |      |         |   |      |   |        |  

Depreciation and amortization expense associated with property and equipment
amounted to $2.2 million, $2.7 million and $2.6 million for the years ended December 31, 2008, 2007 and 2006, respectively.



|                                              |  |      |        |      |   |       
|--------------------------------------------- |  | ---- | ------ | ---- | - | ------
|                                              |  | 2008 |        | 2007
|Accrued and other liabilities (in thousands): |  |      |        |      |   |       
|Accrued warranty                              |  | $    | 1,979  |      | $ | 2,487 
|Accrued compensation                          |  |      | 2,765  |      |   | 3,051 
|Accrued exit costs                            |  |      | 1,718  |      |   | 3,695 
|Deferred revenue                              |  |      | 683    |      |   | 656   
|Other                                         |  |      | 6,017  |      |   | 7,999 
|                                              |  |      |        |      |   |       
|                                              |  | $    | 13,162 |      | $ | 17,888
|                                              |  |      |        |      |   |       



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The Company accrues for warranty costs based on historical trends for the expected
material and labor costs to provide warranty services. Warranty periods are generally one year from the date of shipment. The following table summarizes the activity related to the product warranty liability during the years ended December 31,
2008 and 2007 (in thousands):



|                             |  |   |        |  
|---------------------------- |  | - | ------ | -
|Balance at December 31, 2006 |  | $ | 3,128  |  
|Charged to operations        |  |   | 2,410  |  
|Claims/settlements           |  |   | (3,051 | )
|                             |  |   |        |  
|Balance at December 31, 2007 |  | $ | 2,487  |  
|Charged to operations        |  |   | 1,625  |  
|Claims/settlements           |  |   | (2,133 | )
|                             |  |   |        |  
|Balance at December 31, 2008 |  | $ | 1,979  |  
|                             |  |   |        |  

(6) Debt

Secured Real Estate Loan

Long-term debt as of December 31, 2008 and 2007
consisted of a secured real estate loan as follows (in thousands):



|                                        |  |      |        |   |      |   |        |  
|--------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                        |  | 2008 |        |   | 2007 |  
|Secured real estate loan due April 2011 |  | $    | 19,078 |   |      | $ | 19,405 |  
|Less current portion of long-term debt  |  |      | (380   | ) |      |   | (265   | )
|                                        |  |      |        |   |      |   |        |  
|                                        |  | $    | 18,698 |   |      | $ | 19,140 |  
|                                        |  |      |        |   |      |   |        |  

Aggregate debt maturities as of December 31, 2008 are $0.4 million in each of
fiscal 2009 and 2010 and $18.3 million in fiscal 2011.

In December 2005, the Company entered into an amendment to an
existing loan with a financial institution relating to the financing of its Oakland, California campus (the Amended Loan). Under the Amended Loan, (a) the outstanding principal balance was paid down from approximately $31.1 million
to approximately $20.0 million, (b) the maturity date was extended five years to April 1, 2011, (c) the floor rate was reduced from 8.0% per annum to 6.5% per annum, (d) the variable rate margin was reduced from
3.5% per annum to 3.0% per annum, (e) the amortization period for purposes of calculating monthly principal payments was amended to a period of 25 years commencing on January 1, 2006, and (f) the financial institution
cancelled the Companys $6.0 million letter of credit. Interest accrues on the unpaid principal balance at a variable interest rate (which adjusts every six months) equal to the sum of the LIBOR rate plus 3.0% per annum; provided that in
no event will the variable interest rate (a) exceed 14.2488% per annum, (b) be less than 6.5% per annum, or (c) be adjusted by more than 1.0% at any adjustment date. The Company is obligated to make monthly payments of
principal and interest in an amount which fully amortizes the then unpaid principal balance of the loan and interest accruing thereon at the interest rate in effect in equal monthly installments over the remaining term of the amortization period.
The interest rate on this debt was 6.9% as of December 31, 2008. The Companys obligations under the Amended Loan remain secured by a security interest in the Companys campus. As of December 31, 2008 and 2007, the debt was
collateralized by land and buildings with a net book value of $16.1 million and $16.5 million, respectively.

Convertible Debentures

In July 2004, the Company assumed convertible debentures of $11.7 million in connection with the acquisition of
Sorrento, with an interest rate of 7.5%. During 2006, the Company made a voluntary repayment of



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$1.5 million relating to the convertible debenture debt. On August 2, 2007, the convertible debentures matured and the Company repaid the outstanding
principal amount of $7.4 million plus accrued interest. The debentures were convertible into common stock at the option of the holder at a conversion price of $6.02 per share. No holders elected to convert their debentures into common stock.

Credit Facility

The Company has a revolving line of credit and letter of credit facility and an accounts receivable purchase facility with Silicon Valley Bank (the SVB Facilities). Under the facilities, the Company has
the option of borrowing funds at agreed upon rates of interest, so long as the aggregate amount of outstanding borrowings does not exceed $25.0 million. In addition, the Company may sell specific accounts receivables to Silicon Valley Bank, on a non
recourse basis, at agreed upon discounts to the face amount of those accounts receivables, so long as the aggregate amount of outstanding accounts receivables does not exceed $10.0 million.

Under the SVB Facilities, $15.0 million was outstanding at December 31, 2008 and 2007, and an additional $3.4 million was committed
as security for various letters of credit as of December 31, 2008. The amounts borrowed under the revolving credit facility bear interest, payable monthly, at a floating rate that, at the Companys option, is either (1) Silicon Valley
Banks prime rate, or (2) the sum of the LIBOR rate plus 2.9%; provided that in either case, the minimum interest rate is 4.0%. The interest rate was 4.0% at December 31, 2008.

The Companys obligations under the SVB Facilities are secured by substantially all of the Companys personal property assets
and those of its subsidiaries, including their intellectual property. The SVB Facilities contain certain financial covenants, and customary affirmative covenants and negative covenants. If the Company does not comply with the various covenants and
other requirements under the SVB Facilities, Silicon Valley Bank is entitled to, among other things, require the immediate repayment of all outstanding amounts and sell the Companys assets to satisfy the obligations under the SVB Facilities.
As of December 31, 2008, the Company was in compliance with these covenants.

In January 2009, the Company repaid the
$15.0 million outstanding under the SVB Facilities. In March 2009, the Company replaced the SVB Facilities when it entered into a new $20.0 million secured revolving credit arrangement with Silicon Valley Bank as discussed in Note 15 to the
consolidated financial statements.

(7) Stockholders Equity

(a) Overview

As of December 31, 2008 and 2007, the Companys equity
capitalization consisted of 900 million authorized shares of common stock, of which 150.7 million and 150.0 million, respectively, were outstanding.

(b) Warrants

At December 31, 2008, the Company had a total of
1.39 million warrants to purchase common stock outstanding at a weighted average exercise price of $4.67 per share. Of these, 1.35 million fully vested warrants were assumed through the Companys acquisition of Sorrento Networks
Corporation (Sorrento) in July 2004 at a weighted average exercise price of $3.88 per share. These warrants were valued using the Black-Scholes option pricing model and the resulting fair value of $7.1 million was included in the
purchase price for the acquisition. Warrants to purchase 0.8 million shares of common stock expired unexercised in 2008 with an aggregate exercise price of $2.7 million. The remaining warrants will expire in the years 2009 through 2014. No
warrants were exercised in 2008, 2007 or 2006.



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(c) Stock-Based Compensation

As of December 31, 2008, the Company had two types of share-based compensation plans related to stock options and employee stock
purchases. The compensation cost that has been charged as an expense in the statement of operations for those plans was $2.4 million, $2.9 million and $5.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.

The following table summarizes stock-based compensation expense for the years ended December 31, 2008, 2007 and 2006 (in
thousands):



|                                                              |  |                         |       |      |   |       |  |   |      
|------------------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | -----
|                                                              |  | Year ended December 31,
|                                                              |  | 2008                    |       | 2007 |   | 2006 
|Stock-based compensation under SFAS 123R                      |  | $                       | 2,140 |      | $ | 2,603 |  | $ | 5,180
|Compensation expense relating to non-employees                |  |                         | 81    |      |   | 49    |  |   | 10   
|Compensation expense relating to Employee Stock Purchase Plan |  |                         | 130   |      |   | 214   |  |   | 315  
|                                                              |  |                         |       |      |   |       |  |   |      
|Stock-based compensation expense                              |  | $                       | 2,351 |      | $ | 2,866 |  | $ | 5,505
|                                                              |  |                         |       |      |   |       |  |   |      

Stock Options

The share-based compensation plans are designed to attract, motivate, retain and reward talented employees, directors and consultants and
align stockholder and employee interests. The Company has two active plans, the Amended and Restated Special 2001 Stock Incentive Plan and the Amended and Restated 2001 Stock Incentive Plan. Stock options are primarily issued from the Amended and
Restated 2001 Stock Incentive Plan. This plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards and other stock-based awards to officers, employees, directors and consultants of the Company.
Options may be granted at an exercise price less than, equal to or greater than the fair market value on the date of grant, except that any options granted to a 10% stockholder must have an exercise price equal to at least 110% of the fair market
value of the Companys common stock on the date of grant. The Board of Directors determines the term of each option, the option exercise price and the vesting terms. Stock options are generally granted at an exercise price equal to the fair
market value on the date of grant, expiring seven to ten years from the date of grant and vesting over a period of four years. On January 1 of each year, if the number of shares available for grant under the Amended and Restated 2001 Stock
Incentive Plan is less than 5% of the total number of shares of common stock outstanding as of that date, the shares available for grant under the plan are automatically increased by the amount necessary to make the total number of shares available
for grant equal to 5% of the total number of shares of common stock outstanding, or by a lesser amount as determined by the Board of Directors. As of December 31, 2008, 2.1 million shares were available for grant under these plans.

Through the acquisition of Paradyne in September 2005 and Sorrento in July 2004, the Company assumed several stock option
plans, including the Amended and Restated 1996 Equity Incentive Plan, the 1999 Non-Employee Directors Stock Option Plan, the 2000 Broad-Based Stock Plan, the Amended and Restated Osicom Technologies, Inc. 1997 Incentive and Non-Qualified Stock
Option Plan, Sorrento Networks Corporation 2000 Stock Incentive Plan and the 2003 Equity Incentive Plan. In February 2006, the Company amended and froze these plans as well as the Zhone Technologies, Inc. 1999 Stock Option Plan and the 2002 Stock
Incentive Plan to provide that no further awards be made under these plans. As a result of this amendment, approximately 12.4 million shares were no longer available for grant. During the year ended December 31, 2008 and 2007, there were
cancelled shares relating to plans which were frozen and therefore unavailable for grant of 3.5 million and 1.7 million, respectively.

The Company has estimated the fair value of stock-based payment awards on the date of grant using the Black Scholes pricing model, which is affected by the Companys stock price as well as assumptions regarding a
number of complex and subjective variables. These variables include the Companys expected stock price



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volatility over the term of the awards, actual and projected employee option exercise behaviors, risk free interest rate and expected dividends. The
estimated expected term of options granted was determined based on historical option exercise trends. Estimated volatility was based on historical volatility and the risk free interest rate was based on U.S. Treasury yield in effect at the time of
grant for the expected life of the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore used an expected dividend yield of zero in the option valuation model. The Company is also required to
estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. Historical data was used to estimate pre-vesting forfeitures and record stock-based compensation expense
only for those awards that are expected to vest.

The assumptions used to value option grants for the years ended
December 31, 2008, 2007 and 2006 are as follows:



|                        |  |                         |   |  |           |   |  |           |  
|----------------------- |  | ----------------------- | - |  | --------- | - |  | --------- | -
|                        |  | Year ended December 31, |  
|                        |  | 2008                    |   |  | 2007      |   |  | 2006      |  
|Expected term           |  | 4.7 years               |   |  | 4.7 years |   |  | 4.9 years |  
|Expected volatility     |  | 75                      | % |  | 60        | % |  | 73        | %
|Risk free interest rate |  | 1.86                    | % |  | 4.13      | % |  | 4.7       | %

The weighted average grant date fair value of options granted during the years
ended December 31, 2008, 2007 and 2006 was $0.09, $0.68 and $1.10 per share, respectively. The intrinsic value of options exercised for the years ended December 31, 2008, 2007 and 2006 was $0.02 million, $0.08 million and
$0.8 million, respectively. For the years ended December 31, 2008, 2007 and 2006, the Company received $0.01 million, $0.01 million and $1.4 million in proceeds from stock option exercises, respectively.

The following table sets forth the summary of option activity under the stock option program for the year ended December 31, 2008
(in thousands, except per share data):



|                                                 |  |                    |   |  |                                |      |                                           |      |                         |   |    
|------------------------------------------------ |  | ------------------ | - |  | ------------------------------ | ---- | ----------------------------------------- | ---- | ----------------------- | - | ---
|                                                 |  | OptionsOutstanding |   |  | Weighted AverageExercise Price |      | Weighted AverageRemainingContractual Term |      | AggregateIntrinsicValue
|Outstanding as of December 31, 2007              |  | 24,939             |   |  | $                              | 4.21 |                                           | 4.92 |                         | $ | 406
|Granted (1)                                      |  | 18,181             |   |  | $                              | 0.16 |                                           |      |                         |   |    
|Canceled/Forfeited (1)                           |  | (16,592            | ) |  | $                              | 2.81 |                                           |      |                         |   |    
|Exercised                                        |  | (28                | ) |  | $                              | 0.21 |                                           |      |                         |   |    
|                                                 |  |                    |   |  |                                |      |                                           |      |                         |   |    
|Outstanding as of December 31, 2008              |  | 26,500             |   |  | $                              | 2.29 |                                           | 5.00 |                         | $ |   
|                                                 |  |                    |   |  |                                |      |                                           |      |                         |   |    
|Vested and expected to vest at December 31, 2008 |  | 24,117             |   |  | $                              | 2.64 |                                           | 4.69 |                         | $ |   
|                                                 |  |                    |   |  |                                |      |                                           |      |                         |   |    
|Vested and exercisable at December 31, 2008      |  | 9,443              |   |  | $                              | 6.19 |                                           | 1.82 |                         | $ |   
|                                                 |  |                    |   |  |                                |      |                                           |      |                         |   |    

| | 
| | 

| | (1) | Includes options of 14.5 million shares exchanged in the Exchange Offer.
| | --- | ------------------------------------------------------------------------

The aggregate intrinsic value represents the total pretax intrinsic value, based on the Companys closing stock price as of
December 31, 2008 of $0.08, which would have been received by the option holders had the option holders exercised their options as of that date.

As of December 31, 2008, there was $4.3 million of unrecognized compensation costs, adjusted for estimated forfeitures related to unvested stock-based payments granted which are expected to be recognized over a
weighted average period of 2 years.



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In October 2008, the Companys stockholders approved an amendment to the
Companys restated certificate of incorporation that would effect a reverse stock split, pursuant to which the existing shares of Zhones common stock would be combined into new shares of common stock at an exchange ratio ranging from
one-for-five to one-for-ten, with the exchange ratio to be determined by Zhone. In addition, the Companys stockholders approved amendments to certain of its equity incentive compensation plans to permit the repricing of stock options and to
increase the number of shares reserved for issuance under the Zhone Technologies, Inc. Amended and Restated 2001 Stock Incentive Plan.

In November 2008, the Company completed an offer (the Exchange Offer) to exchange certain stock options issued to eligible employees, officers and directors of Zhone under Zhones equity incentive
compensation plans. Stock options previously granted that had an exercise price per share of equal to or greater than $0.35 per share were eligible to be exchanged on a one-for-one basis for new stock options with an exercise price equal to the last
reported sale price of Zhone common stock on The Nasdaq Global Market on the date of grant. Options for an aggregate of 14.5 million shares of common stock were exchanged. The new stock options issued pursuant to the Exchange Offer have an
exercise price of $0.10, will vest over a four-year period with no credit for past vesting and have a seven-year term. The Exchange Offer will result in incremental stock-based compensation of approximately $0.7 million to be recognized over the
four-year vesting period. The remaining unrecognized compensation expense of the original grant will be amortized over the original requisite service period.

Employee Stock Purchase Plan

The Companys 2002 Employee Stock Purchase Plan (ESPP)
allows eligible employee participants to purchase shares of the Companys common stock at a price equal to 85% of the lower of the fair market value of the common stock at the beginning or the end of each offering period. Participation is
limited to 10% of an employees eligible compensation, not to exceed amounts allowed by the Internal Revenue Code. During the second quarter of 2006, the number of available shares under the ESPP was increased by 2.0 million. At
September 1, 2005, the Company changed from a six month offering period to a three month offering period under the ESPP. The following table summarizes shares purchased, weighted average purchase price, cash received and the aggregate intrinsic
value for ESPP purchases during the years ended December 31, 2008, 2007 and 2006 (in thousands, except per share data):



|                                |  |                         |      |      |   |      |  |   |     
|------------------------------- |  | ----------------------- | ---- | ---- | - | ---- |  | - | ----
|                                |  | Year ended December 31,
|                                |  | 2008                    |      | 2007 |   | 2006
|Shares purchased                |  |                         | 557  |      |   | 641  |  |   | 581 
|Weighted average purchase price |  | $                       | 0.52 |      | $ | 1.02 |  | $ | 1.49
|Cash received                   |  | $                       | 288  |      | $ | 653  |  | $ | 867 
|Aggregate intrinsic value       |  | $                       | 50   |      | $ | 182  |  | $ | 351 

The assumptions used to value stock purchases under the Companys ESPP for
the years ended December 31, 2008, 2007 and 2006 are as follows:



|                                      |  |                         |   |  |          |   |  |          |  
|------------------------------------- |  | ----------------------- | - |  | -------- | - |  | -------- | -
|                                      |  | Year ended December 31, |  
|                                      |  | 2008                    |   |  | 2007     |   |  | 2006     |  
|Expected term                         |  | 3 months                |   |  | 3 months |   |  | 3 months |  
|Volatility                            |  | 68                      | % |  | 60       | % |  | 57       | %
|Risk free interest rate               |  | 2.0                     | % |  | 4.7      | % |  | 4.7      | %
|Weighted average fair value per share |  | $0.24                   |   |  | $0.35    |   |  | $0.54    |  



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(8) Net Loss Per Share

The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share data):



|                                          |  |                         |         |   |      |   |         |      |  |   |          |  
|----------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                          |  | Year ended December 31, |        
|                                          |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|Numerator:                                |  |                         |         |   |      |   |         |      |  |   |          |  
|Net loss                                  |  | $                       | (92,535 | ) |      | $ | (12,102 | )    |  | $ | (142,666 | )
|                                          |  |                         |         |   |      |   |         |      |  |   |          |  
|Denominator:                              |  |                         |         |   |      |   |         |      |  |   |          |  
|Weighted average common stock outstanding |  |                         | 150,342 |   |      |   | 149,623 |      |  |   | 148,727  |  
|                                          |  |                         |         |   |      |   |         |      |  |   |          |  
|Basic and diluted net loss per share      |  | $                       | (0.62   | ) |      | $ | (0.08   | )    |  | $ | (0.96    | )
|                                          |  |                         |         |   |      |   |         |      |  |   |          |  

The following table sets forth potential common stock that is not included in the
diluted net loss per share calculation above because their effect would be anti-dilutive for the periods indicated (in thousands, except exercise price per share data):



|                                                         |  |        |  |                                |     
|-------------------------------------------------------- |  | ------ |  | ------------------------------ | ----
|                                                         |  | 2008   |  | Weighted AverageExercise price
|Warrants                                                 |  | 1,389  |  | $                              | 4.67
|Outstanding stock options and unvested restricted shares |  | 26,548 |  | $                              | 2.29
|                                                         |  |        |  |                                |     
|                                                         |  | 27,937 |  |                                |     
|                                                         |  |        |  |                                |     
|                                                         |  |       
|                                                         |  | 2007   |  | Weighted AverageExercise price
|Warrants                                                 |  | 2,185  |  | $                              | 4.20
|Outstanding stock options and unvested restricted shares |  | 24,977 |  | $                              | 4.21
|                                                         |  |        |  |                                |     
|                                                         |  | 27,162 |  |                                |     
|                                                         |  |        |  |                                |     
|                                                         |  |       
|                                                         |  | 2006   |  | Weighted AverageExercise price
|Warrants                                                 |  | 2,716  |  | $                              | 4.68
|Convertible debentures                                   |  | 1,231  |  | $                              | 6.02
|Outstanding stock options                                |  | 25,141 |  | $                              | 4.56
|                                                         |  |        |  |                                |     
|                                                         |  | 29,088 |  |                                |     
|                                                         |  |        |  |                                |     

As of December 31, 2008 and 2007, there were zero shares of issued common
stock subject to repurchase.



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(9) Income Taxes

The following is a summary of the components of income tax expense applicable to net loss before income taxes (in thousands):



|          |  |                         |     |      |   |      |  |   |    
|--------- |  | ----------------------- | --- | ---- | - | ---- |  | - | ---
|          |  | Year ended December 31,
|          |  | 2008                    |     | 2007 |   | 2006
|Current:  |  |                         |     |      |   |      |  |   |    
|Federal   |  | $                       |    |      | $ |     |  | $ |   
|State     |  |                         | 104 |      |   | 150  |  |   | 117
|Foreign   |  |                         | 166 |      |   | 244  |  |   | 147
|          |  |                         |     |      |   |      |  |   |    
|          |  |                         | 270 |      |   | 394  |  |   | 264
|Deferred: |  |                         |     |      |   |      |  |   |    
|Federal   |  |                         |    |      |   |     |  |   |   
|State     |  |                         |    |      |   |     |  |   |   
|Foreign   |  |                         |    |      |   |     |  |   |   
|          |  |                         |     |      |   |      |  |   |    
|          |  | $                       | 270 |      | $ | 394  |  | $ | 264
|          |  |                         |     |      |   |      |  |   |    

A reconciliation of the expected tax expense (benefit) to the actual tax expense
is as follows (in thousands):



|                                             |  |                         |         |   |      |   |        |      |  |   |         |  
|-------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                             |  | Year ended December 31, |        
|                                             |  | 2008                    |         |   | 2007 |   |        | 2006 | 
|Expected tax benefit at statutory rate (35%) |  | $                       | (32,292 | ) |      | $ | (4,098 | )    |  | $ | (49,841 | )
|State taxes, net of Federal effect           |  |                         | 68      |   |      |   | 98     |      |  |   | 76      |  
|Goodwill amortization and impairment         |  |                         | 24,640  |   |      |   |       |      |  |   | 38,665  |  
|Foreign rate differential                    |  |                         | (759    | ) |      |   | (1,474 | )    |  |   | 5,833   |  
|Valuation allowance                          |  |                         | 7,764   |   |      |   | 4,886  |      |  |   | 3,834   |  
|Stock-based compensation                     |  |                         | 810     |   |      |   | 948    |      |  |   | 1,615   |  
|Other                                        |  |                         | 39      |   |      |   | 34     |      |  |   | 82      |  
|                                             |  |                         |         |   |      |   |        |      |  |   |         |  
|                                             |  | $                       | 270     |   |      | $ | 394    |      |  | $ | 264     |  
|                                             |  |                         |         |   |      |   |        |      |  |   |         |  

Deferred income taxes reflect the net tax effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Companys deferred tax assets and liabilities as of December 31, 2008 and 2007 are as follows (in thousands):



|                                                               |  |      |          |   |      |   |          |  
|-------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                               |  | 2008 |          |   | 2007 |  
|Deferred assets:                                               |  |      |          |   |      |   |          |  
|Net operating loss, capital loss, and tax credit carryforwards |  | $    | 493,534  |   |      | $ | 478,835  |  
|Fixed assets and intangible assets                             |  |      | 50,687   |   |      |   | 59,542   |  
|Inventory and other reserves                                   |  |      | 12,056   |   |      |   | 14,321   |  
|Other                                                          |  |      | 126      |   |      |   | 120      |  
|                                                               |  |      |          |   |      |   |          |  
|Gross deferred tax assets                                      |  |      | 556,403  |   |      |   | 552,818  |  
|Less valuation allowance                                       |  |      | (556,403 | ) |      |   | (552,818 | )
|                                                               |  |      |          |   |      |   |          |  
|Total deferred tax assets                                      |  | $    |         |   |      | $ |         |  
|                                                               |  |      |          |   |      |   |          |  

For the years ended December 31, 2008 and 2007, the net changes in the
valuation allowance were an increase of $3.6 million and a decrease of $0.1 million, respectively. The Company recorded a full valuation allowance against the net deferred tax assets at December 31, 2008 and 2007 since it is more likely than
not that



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the net deferred tax assets will not be realized due to the lack of previously paid taxes and anticipated taxable income. Approximately $359.0 million of the
valuation allowance for deferred tax assets relates to various acquisitions.

As of December 31, 2008, the Company had
net operating loss carryforwards for federal and California income tax purposes of approximately $1,275.3 million and $389.2 million, respectively, which are available to offset future taxable income, if any, in years through 2028. Approximately
$3.1 million and $2.0 million net operating loss carryforwards for federal and California income tax purposes, respectively, are attributable to employee stock option deductions, the benefit from which will be allocated to paid-in-capital rather
than current income when subsequently recognized. Federal and state laws impose substantial restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an ownership change for tax purposes, as defined in
Section 382 of the Internal Revenue Code. As a result of such ownership changes, the Companys ability to realize the potential future benefit of tax losses and tax credits that existed at the time of the ownership change will be
significantly reduced. The Companys deferred tax asset and related valuation allowance would be reduced as a result. The Company has not yet performed a Section 382 study to determine the amount of reduction, if any.

As of December 31, 2008, the Company also had research credit carryforwards for federal and state income tax purposes of
approximately $20.8 million and $7.7 million, respectively, which are available to reduce future income taxes, if any, in years through 2028 and over an indefinite period, respectively. Additionally, the Company had alternative minimum tax credit
carryforwards for federal income tax purposes of approximately $0.1 million which are available to reduce future income taxes, if any, over an indefinite period. The Company also had enterprise zone credit carryforwards for state income tax purposes
of approximately $0.2 million which are available to reduce future state income taxes, if any, over an indefinite period.

The Company may have unrecognized tax benefits included in its deferred tax assets which are subject to a full valuation allowance as of December 31, 2008 and 2007. However, the Company has not yet performed a study to determine the
amount of such unrecognized tax benefits.

Interest and penalties, to the extent accrued on unrecognized tax benefits in
the future, will be included in tax expense.

The Company or one of its subsidiaries files income tax returns in the U.S.
federal jurisdiction, and various state and foreign jurisdictions. The open tax years for the major jurisdictions are as follows:



|                                   |  |            
|---------------------------------- |  | -----------
|       Federal                    |  | 2005  2008
|       California and Canada      |  | 2004  2008
|       Brazil                     |  | 2001  2008
|       Germany and United Kingdom |  | 2005  2008

However, due to the fact the Company had net operating losses and credits carried
forward in most jurisdictions, certain items attributable to technically closed years are still subject to adjustment by the relevant taxing authority through an adjustment to tax attributes carried forward to open years.

In addition, to the extent the Company is deemed to have a sufficient connection to a particular taxing jurisdiction to enable that
jurisdiction to tax the Company but the Company has not filed an income tax return in that jurisdiction for the year(s) at issue, the jurisdiction would typically be able to assert a tax liability for such years without limitation on the number of
years it may examine.

The Company is not currently under examination for income taxes in any material jurisdiction.



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(10) Related-Party Transactions

In the ordinary course of business, the Companys executive officers and non-employee directors are reimbursed for travel related expenses when incurred for business purposes. The Company
reimburses its Chairman, President and Chief Executive Officer, Morteza Ejabat, for the direct operating expenses incurred in the use of his private aircraft when used for business purposes. The amount reimbursed for these expenses was $0.5 million,
$0.6 million and $0.7 million during the years ended December 31, 2008, 2007 and 2006, respectively.

(11) Commitments and Contingencies

Operating Leases

The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options.

Estimated future lease payments under all non-cancelable operating leases with terms in excess of one year, including taxes and services fees, are as follows (in thousands):



|                             |  |                  |       
|---------------------------- |  | ---------------- | ------
|                             |  | Operating leases
|Year ending December 31:     |  |                  |       
|2009                         |  |                  | 4,773 
|2010                         |  |                  | 4,506 
|2011                         |  |                  | 4,478 
|2012                         |  |                  | 2,279 
|2013                         |  |                  |      
|                             |  |                  |       
|Total minimum lease payments |  | $                | 16,036
|                             |  |                  |       

The total minimum lease payments shown above include projected payments and
obligations for leases, some of which relate to excess facilities obtained through acquisitions. At December 31, 2008, the Company had estimated commitments of $15.2 million related to facilities assumed as a result of the Paradyne acquisition,
of which $5.6 million was accrued for excess facilities in accrued liabilities as of December 31, 2008. For operating leases that include contractual commitments for operating expenses and maintenance, estimates of such amounts are included
based on current rates. Rent expense under operating leases, excluding rent relating to excess facilities previously accrued, totaled $4.0 million, $4.9 million and $4.0 million for the years ended December 31, 2008, 2007 and 2006,
respectively. Sublease rental income totaled $1.3 million, $1.5 million and $1.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.

Other Commitments

The Company has agreements with various contract
manufacturers which include inventory repurchase commitments for excess material based on the Companys sales forecasts. The Company has recorded a liability for estimated charges of $0.04 million and $0.01 million related to these arrangements
as of December 31, 2008 and 2007, respectively.

The Company is currently under audit examination by several state
taxing authorities for non income based taxes. The Company has reserved an estimated amount which the Company believes is sufficient to cover potential claims. However, there are certain examinations including those related to acquired entities, for
which an amount cannot be reasonably estimated. In these instances, the examinations are still in the information gathering stage and no formal assessment has been made.



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Performance Bonds

In the normal course of operations, the Company arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company
guarantees that the Company will perform in accordance with contractual or legal obligations. If the Company fails to perform under its obligations, the maximum potential payment under these surety bonds would have been $0.8 million as of
December 31, 2008.

Royalties

The Company has certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage
of the underlying revenue.

(12) Litigation

Paradyne Matters

As a result of the acquisition of Paradyne, the Company became involved in various
legal proceedings, claims and litigation, including those identified below, relating to the operations of Paradyne prior to the acquisition of Paradyne.

A purported stockholder class action complaint was filed in December 2001 in the United States District Court in the Southern District of New York against Paradyne, Paradynes then-current directors and executive
officers, and each of the underwriters (the Underwriter Defendants) who participated in Paradynes initial public offering and follow-on offering (collectively, the Paradyne Offerings). The complaint alleges that, in
connection with the Paradyne Offerings, the Underwriter Defendants charged excessive commissions, inflated transaction fees not disclosed in the applicable registration statements and allocated shares of the Paradyne Offerings to favored customers
in exchange for purported promises by such customers to purchase additional shares in the aftermarket, thereby allegedly inflating the market price for the Paradyne Offerings. The complaint seeks damages in an unspecified amount for the purported
class for the losses suffered during the class period. This action has been consolidated with hundreds of other securities class actions commenced against more than 300 companies (collectively, the Issuer Defendants) and approximately 40
investment banks in which the plaintiffs make substantially similar allegations as those made against Paradyne with respect to the initial public offerings and/or follow-on offerings at issue in those other cases. All of these actions have been
consolidated before Judge Shira Scheindlin under the caption In re: Initial Public Offering Securities Litigation(the IPO Actions).

In 2003, the Issuer Defendants participated in a global settlement among the plaintiffs and the insurance companies that provided directors and officers insurance coverage to the Issuer Defendants (the
Issuer Settlement). The Issuer Settlement agreements provided for the Issuer Defendants (including Paradyne) to be fully released and dismissed from the IPO Actions. Under the terms of the Issuer Settlement agreements, Paradyne would not
have been required to make any cash payment to the plaintiffs. Although the District Court preliminarily approved the Issuer Settlement, the preliminary approval remained subject to a future final settlement order, after notice of settlement had
been provided to class members and they had been afforded the opportunity to oppose or opt out of the settlement. However, before the District Court could conduct its final settlement hearing, on December 5, 2006, the United States Court of
Appeals for the Second Circuit (the Second Circuit) reversed an October 13, 2004 order of the District Court in which Judge Scheindlin had granted class certification for six test cases in the IPO Actions. On
April 4, 2007, the Second Circuit denied the plaintiffs petition for rehearing of the December 5, 2006 ruling. The District Court has since made clear that the Issuer Settlement cannot be approved  in its current form  as
a class action settlement in light of the Second Circuits December 5, 2006 ruling and has declined to schedule a final approval hearing with respect to the Issuer Settlement for that reason. Counsel for the plaintiffs, for the Issuer
Defendants and for the insurance companies



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that provided directors and officers insurance to the Issuer Defendants are currently engaged in discussions to restructure and salvage the
Issuer Settlement. There can be no assurance that a restructured Issuer Settlement will be reached by the parties or that any such future settlement will meet the conditions for final approval by the District Court.

Other Matters

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to
resolve these matters will have a material adverse effect on its consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were
to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

(13) Employee Benefit Plan

The Company maintains a 401(k) plan for its employees whereby eligible
employees may contribute up to a specified percentage of their earnings, on a pretax basis, subject to the maximum amount permitted by the Internal Revenue Code. Under the 401(k) plan, the Company may make discretionary contributions. The Company
made no discretionary contributions to the plan during the three years ended December 31, 2008.

Through the
acquisition of Paradyne in September 2005, the Company assumed the Paradyne Corporation Retirement Savings Plan 401K Plan. In December 2005, the plan was amended thereby freezing all future contributions and eliminating any Company contributions. In
March 2006, the plans assets were merged into the Zhone Technologies, Inc. 401(k) Plan.

(14) Enterprise Wide Information

The Company designs, develops and markets communications products for network service providers. The Company derives substantially all of
its revenues from the sales of the Zhone product family. The Companys chief operating decision maker is the Companys Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis
accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company has determined that it has operated within one discrete reportable business
segment since inception. The following summarizes required disclosures about geographic concentrations and revenue by products and services (in thousands).



|                            |  |                         |         |      |   |         |  |   |        
|--------------------------- |  | ----------------------- | ------- | ---- | - | ------- |  | - | -------
|                            |  | Year ended December 31,
|                            |  | 2008                    |         | 2007 |   | 2006   
|Revenue by Geography:       |  |                         |         |      |   |         |  |   |        
|United States               |  | $                       | 60,830  |      | $ | 79,453  |  | $ | 105,098
|Canada                      |  |                         | 5,391   |      |   | 10,497  |  |   | 10,611 
|                            |  |                         |         |      |   |         |  |   |        
|Total North America         |  |                         | 66,221  |      |   | 89,950  |  |   | 115,709
|                            |  |                         |         |      |   |         |  |   |        
|Latin America               |  |                         | 32,197  |      |   | 37,808  |  |   | 25,154 
|Europe, Middle East, Africa |  |                         | 43,820  |      |   | 42,208  |  |   | 45,441 
|Asia Pacific                |  |                         | 3,922   |      |   | 5,482   |  |   | 8,040  
|                            |  |                         |         |      |   |         |  |   |        
|Total International         |  |                         | 79,939  |      |   | 85,498  |  |   | 78,635 
|                            |  |                         |         |      |   |         |  |   |        
|                            |  | $                       | 146,160 |      | $ | 175,448 |  | $ | 194,344
|                            |  |                         |         |      |   |         |  |   |        



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|                                  |  |                         |         |      |   |         |  |   |        
|--------------------------------- |  | ----------------------- | ------- | ---- | - | ------- |  | - | -------
|                                  |  | Year ended December 31,
|                                  |  | 2008                    |         | 2007 |   | 2006   
|Revenue by products and services: |  |                         |         |      |   |         |  |   |        
|Products                          |  | $                       | 141,916 |      | $ | 164,570 |  | $ | 181,988
|Services                          |  |                         | 4,244   |      |   | 10,878  |  |   | 12,356 
|                                  |  |                         |         |      |   |         |  |   |        
|                                  |  | $                       | 146,160 |      | $ | 175,448 |  | $ | 194,344
|                                  |  |                         |         |      |   |         |  |   |        

(15) Subsequent Event

On March 16, 2009, the Company entered into a secured revolving credit arrangement (SVB Facility) with Silicon Valley Bank (SVB) to provide liquidity and working
capital through March 15, 2010. The SVB Facility replaced the existing SVB Facilities.

Under the SVB Facility,
the Company has the option of borrowing funds at agreed upon interest rates as long as the aggregate amount outstanding does not exceed $20.0 million. The amount that the Company is able to borrow under the SVB Facility will vary based on the
eligible accounts receivable, as defined in the agreement. Also, under the SVB Facility, the Company is able to utilize up to $7.0 million of the facility as security for letters of credit.

The amounts borrowed under the revolving credit facility will bear interest, payable monthly, at a floating rate that is SVBs prime
rate plus 2.5%. The minimum interest rate is 4.0%. The Companys obligations under the SVB Facility are secured by substantially all of its personal property assets and those of its subsidiaries, including their intellectual property. The SVB
Facility contains certain new financial covenants, and customary affirmative and negative covenants. If Zhone does not comply with the various covenants and other requirements under the SVB Facility, SVB is entitled, among other things, to require
the immediate repayment of all outstanding amounts and to sell Zhones assets to satisfy the obligations under the SVB Facility.



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(16) Quarterly Information (unaudited)



|                                                                                         |  |                                       |         |   |    |   |         |    |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------- |  | ------------------------------------- | ------- | - | -- | - | ------- | -- |  | - | ------- | - |  | - | ------- | -
|                                                                                         |  | Year ended December 31, 2008          |        
|                                                                                         |  | Q1                                    |         |   | Q2 |   |         | Q3 |  |   | Q4      |  
|                                                                                         |  | (in thousands, except per share data) |        
|Net revenue                                                                              |  | $                                     | 43,033  |   |    | $ | 40,069  |    |  | $ | 32,020  |   |  | $ | 31,038  |  
|Gross profit                                                                             |  |                                       | 13,806  |   |    |   | 11,616  |    |  |   | 9,644   |   |  |   | 9,998   |  
|Gain on sale of intangible assets                                                        |  |                                       | (3,204  | ) |    |   | (93     | )  |  |   |        |   |  |   | (1,100  | )
|Impairment of intangible assets and goodwill                                             |  |                                       |        |   |    |   | 70,401  |    |  |   |        |   |  |   |        |  
|Operating loss (a)                                                                       |  |                                       | (888    | ) |    |   | (80,091 | )  |  |   | (6,153  | ) |  |   | (4,294  | )
|Net loss                                                                                 |  |                                       | (941    | ) |    |   | (80,334 | )  |  |   | (6,529  | ) |  |   | (4,731  | )
|Basic and diluted net loss per share                                                     |  | $                                     | (0.01   | ) |    | $ | (0.53   | )  |  | $ | (0.04   | ) |  | $ | (0.03   | )
|Weighted-average shares outstanding used to compute basic and diluted net loss per share |  |                                       | 150,072 |   |    |   | 150,260 |    |  |   | 150,443 |   |  |   | 150,595 |  
|                                                                                         | 
|                                                                                         |  | Year ended December 31, 2007          |        
|                                                                                         |  | Q1                                    |         |   | Q2 |   |         | Q3 |  |   | Q4      |  
|                                                                                         |  | (in thousands, except per share data) |        
|Net revenue                                                                              |  | $                                     | 43,146  |   |    | $ | 44,085  |    |  | $ | 41,604  |   |  | $ | 46,613  |  
|Gross profit                                                                             |  |                                       | 15,539  |   |    |   | 14,976  |    |  |   | 12,471  |   |  |   | 16,092  |  
|Gain on sale of intangible assets                                                        |  |                                       |        |   |    |   |        |    |  |   | (5,000  | ) |  |   |        |  
|Operating loss (b)                                                                       |  |                                       | (4,569  | ) |    |   | (4,403  | )  |  |   | (1,389  | ) |  |   | (984    | )
|Net loss                                                                                 |  |                                       | (4,786  | ) |    |   | (4,554  | )  |  |   | (1,530  | ) |  |   | (1,232  | )
|Basic and diluted net loss per share                                                     |  | $                                     | (0.03   | ) |    | $ | (0.03   | )  |  | $ | (0.01   | ) |  | $ | (0.01   | )
|Weighted-average shares outstanding used to compute basic and diluted net loss per share |  |                                       | 149,338 |   |    |   | 149,533 |    |  |   | 149,715 |   |  |   | 149,907 |  



|(a) | Operating loss included a $1.1 million gain on sale of patents during the fourth quarter ended December 31, 2008, a $3.2 million and $0.1 million gain on
sale of intangible assets related to the GigaMux legacy product line during the first and second quarters ended March 31, 2008 and June 30, 2008, respectively, and $70.4 million of goodwill impairment during the second quarter ended
June 30, 2008.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) | Operating loss included a $5.0 million gain on sale of patents during the third quarter ended September 30, 2007.
|--- | -----------------------------------------------------------------------------------------------------------------



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|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------

None.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------

Disclosure Controls and Procedures

We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of
the end of the period covered by this report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer. Based upon this evaluation, our
Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted in this Part II, Item 9A, as of the end of the period covered by this report, our disclosure controls and procedures were effective to
provide reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material
information relating to Zhone and its consolidated subsidiaries is made known to management, including our Chief Executive Officer and Chief Financial Officer, particularly during the period when our periodic reports are being prepared.

Managements Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial
reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management assessed the effectiveness of our internal control over financial reporting as of December 31,
2008, the end of our fiscal year. In making this assessment, management used the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the report entitled Internal Control-Integrated
Framework. Based on our assessment of internal control over financial reporting, management has concluded that, as of December 31, 2008, our internal control over financial reporting was effective to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles. Our independent registered public accounting firm, KPMG LLP, has issued
an attestation report on our internal control over financial reporting. Such report appears at page 51.

Changes in Internal Control Over Financial
Reporting

There were no changes in our internal control over financial reporting that occurred during our last fiscal
quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent
Limitations on Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial
Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error 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. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their
costs. Further, 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 have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the
individual acts of some persons, by collusion of two or more people, or



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by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may
become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

On
March 16, 2009, we entered into a secured revolving credit arrangement (SVB Facility) with Silicon Valley Bank (SVB) to provide liquidity and working capital. The SVB Facility replaced the existing SVB Facilities.

Under the SVB Facility, we have the option of borrowing funds at agreed upon interest rates as long as the aggregate
amount outstanding does not exceed $20.0 million. The amount that we are able to borrow under the SVB Facility will vary based on the eligible accounts receivable, as defined in the agreement. Also, under the SVB Facility, we are able to utilize up
to $7.0 million of the facility as security for letters of credit.

The amounts borrowed under the revolving credit
facility will bear interest, payable monthly, at a floating rate that is SVBs prime rate plus 2.5%. The minimum interest rate is 4.0%. Our obligations under the SVB Facility are secured by substantially all of our personal property assets and
those of our subsidiaries, including our intellectual property. The SVB Facility contains certain new financial covenants, and customary affirmative and negative covenants. If we do not comply with the various covenants and other requirements under
the SVB Facility, SVB is entitled, among other things, to require the immediate repayment of all outstanding amounts and to sell our assets to satisfy the obligations under the SVB Facility.

The foregoing description of the SVB Facility does not purport to be complete and is qualified in its entirety by reference to the Second
Amended and Restated Loan and Security Agreement and the Loan and Security Agreement (EXIM Facility) with SVB, which are filed as Exhibits 10.19 and 10.20 to this report and incorporated herein by reference.



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PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
|-------- | ------------------------------------------------------

The information required by this item relating to our directors and nominees, and compliance with Section 16(a) of the Securities Exchange Act of 1934 is included under the captions Corporate Governance
Principles and Board Matters, Ownership of Securities and Proposal 1: Election of Directors in our definitive Proxy Statement for the 2009 Annual Meeting of Stockholders and is incorporated herein by reference.

The information required by this item relating to our executive officers is included under the caption Executive
Officers in Part I of this Form 10-K and is incorporated by reference into this section.

We have adopted a Code of
Conduct and Ethics applicable to all of our employees, directors and officers (including our principal executive officer, principal financial officer, principal accounting officer and controller). The Code of Conduct and Ethics is designed to deter
wrongdoing and to promote honest and ethical conduct and compliance with applicable laws and regulations. The full text of our Code of Conduct and Ethics is published on our website at www.zhone.com. We intend to disclose future amendments to
certain provisions of our Code of Conduct and Ethics, or waivers of such provisions granted to executive officers and directors, on our website within four business days following the date of such amendment or waiver.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

The
information required by this item is included under the captions Executive Compensation and Compensation Committee Report in our definitive Proxy Statement for the 2009 Annual Meeting of Stockholders and is incorporated
herein by reference.



|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
|-------- | ----------------------------------------------------------------------------------------------

The information required by this item relating to security ownership of certain beneficial owners and management, and securities
authorized for issuance under equity compensation plans is included under the captions Ownership of Securities and Executive Compensation in our definitive Proxy Statement for the 2009 Annual Meeting of Stockholders and is
incorporated herein by reference.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
|-------- | -------------------------------------------------------------------------

The information required by this item is included under the captions Certain Relationships and Related Transactions and Corporate Governance Principles and Board Matters
in our definitive Proxy Statement for the 2009 Annual Meeting of Stockholders and is incorporated herein by reference.



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

The information required by this item is included under the caption Proposal 2: Ratification of Appointment of Independent Registered Public Accounting Firm in our definitive Proxy Statement for the 2009 Annual Meeting of
Stockholders and is incorporated herein by reference.



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PART IV



|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES
|-------- | ---------------------------------------



| | 1. | Financial Statements
| | -- | --------------------

The Index to Consolidated Financial Statements on page 49 is incorporated herein by reference as the list of financial statements required as part of this report.



| | 2. | Exhibits
| | -- | --------

The Exhibit Index on page 87 is incorporated herein by reference as the list of exhibits required as part of this report.



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SIGNATURES

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



|                     |  |                          |  |                        
|-------------------- |  | ------------------------ |  | -----------------------
|                     |  | ZHONE TECHNOLOGIES, INC.
|                     |  |                         
|Date: March 16, 2009 |  | By:                      |  | /S/    MORTEZA
EJABAT  
|                     |  |                          |  | Morteza Ejabat         
|                     |  |                          |  | Chief Executive Officer

Know all persons by these presents, that each person whose signature appears below
constitutes and appoints Morteza Ejabat and Kirk Misaka, jointly and severally, his attorneys-in-fact, each with the full power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to
file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or
cause to be done by virtue hereof. 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 and on the dates indicated.



|                            |  |                                                                      |  |               
|--------------------------- |  | -------------------------------------------------------------------- |  | --------------
|Signature                   |  | Title                                                                |  | Date          
|                            |  |                                                                     
|/S/    MORTEZA
EJABAT       |  | Chairman of the Board of Directors,                                  |  | March 16, 2009
|Morteza Ejabat              |  | President, and Chief Executive Officer (Principal Executive Officer) |  |               
|                            |  |                                                                     
|/S/    KIRK
MISAKA          |  | Chief Financial Officer,                                             |  | March 16, 2009
|Kirk Misaka                 |  | Treasurer and Secretary (Principal Financial and Accounting Officer) |  |               
|                            |  |                                                                     
|/S/    MICHAEL
CONNORS      |  | Director                                                             |  | March 16, 2009
|Michael Connors             |  |                                                                      |  |               
|                            |  |                                                                     
|/S/    ROBERT
DAHL          |  | Director                                                             |  | March 16, 2009
|Robert Dahl                 |  |                                                                      |  |               
|                            |  |                                                                     
|/S/    JAMES H. GREENE,
JR. |  | Director                                                             |  | March 16, 2009
|James H. Greene, Jr.        |  |                                                                      |  |               
|                            |  |                                                                     
|/S/    C. RICHARD
KRAMLICH  |  | Director                                                             |  | March 16, 2009
|C. Richard Kramlich         |  |                                                                      |  |               
|                            |  |                                                                     
|/S/    STEVEN
LEVY          |  | Director                                                             |  | March 16, 2009
|Steven Levy                 |  |                                                                      |  |               
|                            |  |                                                                     
|/S/    JAMES
TIMMINS        |  | Director                                                             |  | March 16, 2009
|James Timmins               |  |                                                                      |  |               



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EXHIBIT INDEX



|               |  |                                                                                                                                   |  |                           |  |                |  |             |  |                   |  | 
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ----------------- |  | 
|Exhibit Number |  | Exhibit Description                                                                                                               |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                              |  | File Number               |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                   |  |                           |  |               
|3.1            |  | Restated Certificate of Incorporation dated February 16, 2005                                                                     |  | 10-K                      |  | 000-32743      |  | 3.1         |  | March 16, 2005    |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|3.2            |  | Amended and Restated Bylaws                                                                                                       |  | 10-K                      |  | 000-32743      |  | 3.2         |  | March 16, 2005    |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|4.1            |  | Form of Second Restated Rights Agreement dated November 13, 2003                                                                  |  | 10-Q                      |  | 000-32743      |  | 4.1         |  | May 14, 2004      |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.1           |  | Zhone Technologies, Inc. 1999 Stock Option Plan                                                                                   |  | 10                        |  | 000-50263      |  | 10.2        |  | April 30, 2003    |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.2           |  | Zhone Technologies, Inc. Amended and Restated 2001 Stock Incentive Plan                                                           |  | 8-K                       |  | 000-32743      |  | 10.1        |  | May 17, 2007      |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.3           |  | Form of Stock Option Agreement for the Zhone Technologies, Inc. Amended and Restated 2001 Stock Incentive Plan                    |  | 8-K                       |  | 000-32743      |  | 10.1        |  | September 1, 2006 |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.4           |  | Zhone Technologies, Inc. Amended and Restated Special 2001 Stock Incentive Plan                                                   |  | 10-Q                      |  | 000-32743      |  | 10.28       |  | August 15, 2002   |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.5           |  | Form of Restricted Stock Award Agreement for the Zhone Technologies, Inc. Amended and Restated 2001 Stock Incentive Plan          |  | 8-K                       |  | 000-32743      |  | 10.2        |  | May 17, 2007      |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.6           |  | Zhone Technologies, Inc. 2002 Employee Stock Purchase Plan                                                                        |  | 8-K                       |  | 000-32743      |  | 10.1        |  | May 17, 2006      |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.7           |  | Incentive Awards Program Summary                                                                                                  |  | 8-K                       |  | 000-32743      |  | 10.2        |  | March 15, 2006    |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.8           |  | Form of Indemnity Agreement between Zhone Technologies, Inc. and its directors and officers                                       |  | 10-Q                      |  | 000-32743      |  | 10.20       |  | May 14, 2004      |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.9           |  | Letter Agreement dated November 13, 2003 between Zhone Technologies, Inc. and KKRZT, L.L.C.                                      |  | Schedule 13D              |  | 005-61973      |  | 4           |  | November 24, 2003 |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.10          |  | Letter Agreement dated May 24, 2006 between Zhone Technologies, Inc. and KKRZT, L.L.C.                                           |  | 10-K                      |  | 000-32743      |  | 10.10       |  | March 8, 2007     |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.11          |  | Letter Agreement dated November 13, 2003 between Zhone Technologies, Inc. and New Enterprise Associates VIII, Limited Partnership |  | Schedule 13D              |  | 005-61973      |  | 5           |  | November 24, 2003 |  | 
|               |  |                                                                                                                                   |  |                           |  |               
|10.12          |  | Letter Agreement dated November 13, 2003 between Zhone Technologies, Inc. and TPG Zhone, L.L.C.                                   |  | Schedule 13D              |  | 005-61973      |  | 2           |  | November 25, 2003 |  | 



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|               |  |                                                                                                                                                                                          |  |                           |  |                |  |             |  |                   |  |  
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ----------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                                                                      |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                                                                     |  | File Number               |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.13          |  | Loan and Security Agreement dated March 30, 2001 between Zhone Technologies, Inc. and Fremont Investment and Loan                                                                        |  | 10                        |  | 000-50263      |  | 10.21       |  | April 30, 2003    |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.14          |  | Pledge and Assignment of Cash Collateral Account dated March 30, 2001 between Zhone Technologies, Inc. and Fremont Investment and Loan                                                   |  | 10                        |  | 000-50263      |  | 10.22       |  | April 30, 2003    |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.15          |  | Secured Promissory Note dated March 30, 2001 between Zhone Technologies, Inc. and Fremont Investment and Loan                                                                            |  | 10                        |  | 000-50263      |  | 10.23       |  | April 30, 2003    |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.16          |  | Second Amendment to Deed of Trust and Other Loan Documents dated December 27, 2005 between Zhone Technologies, Inc., Zhone Technologies Campus, LLC, and Fremont Investment &
Loan       |  | 8-K                       |  | 000-32743      |  | 10.1        |  | December 27, 2005 |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.17          |  | Purchase and Sale Agreement with Repurchase Options dated January 20, 2000 between Zhone Technologies, Inc. and the Redevelopment Agency of the City of Oakland                          |  | 10                        |  | 000-50263      |  | 10.28       |  | April 30, 2003    |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.18          |  | Amended and Restated Employment Agreement dated November 8, 2007 by and between Zhone Technologies, Inc. and Morteza Ejabat                                                              |  | 10-K                      |  | 000-32743      |  | 10.27       |  | March 6, 2008     |  |  
|               |  |                                                                                                                                                                                          |  |                           |  |               
|10.19          |  | Second Amended and Restated Loan and Security Agreement with an effective date of March 16, 2009 among Zhone Technologies, Inc., ZTI Merger Subsidiary III, Inc. and Silicon Valley
Bank |  |                           |  |                |  |             |  |                   |  | X



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##### Table of Contents

|               |  |                                                                                                                                                                              |  |                           |  |                |  |             |  |               |  |  
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                                                          |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                                                         |  | File Number               |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                                              |  |                           |  |               
|10.20          |  | Loan and Security Agreement (EXIM Facility) with an effective date of March 16, 2009 among Zhone Technologies, Inc., ZTI Merger Subsidiary III, Inc. and Silicon Valley Bank |  |                           |  |                |  |             |  |               |  | X
|               |  |                                                                                                                                                                              |  |                           |  |               
|21.1           |  | List of Subsidiaries                                                                                                                                                         |  | 10-K                      |  | 000-32743      |  | 21.1        |  | March 6, 2008 |  |  
|               |  |                                                                                                                                                                              |  |                           |  |               
|23.1           |  | Consent of Independent Registered Public Accounting Firm                                                                                                                     |  |                           |  |                |  |             |  |               |  | X
|               |  |                                                                                                                                                                              |  |                           |  |               
|24.1           |  | Power of Attorney (see signature page)                                                                                                                                       |  |                           |  |                |  |             |  |               |  | X
|               |  |                                                                                                                                                                              |  |                           |  |               
|31.1           |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                |  |                           |  |                |  |             |  |               |  | X
|               |  |                                                                                                                                                                              |  |                           |  |               
|31.2           |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                |  |                           |  |                |  |             |  |               |  | X
|               |  |                                                                                                                                                                              |  |                           |  |               
|32.1           |  | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer                                                                                            |  |                           |  |                |  |             |  |               |  | X



89