**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

# **Washington, D.C. 20549**

# ** **

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**FORM 10-K**

 

| **ý**                                                                                                                                                                                                                                                                          |   | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT  OF 1934**        |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                |   |                                                                                                    |
| **for the fiscal year ended January 31,  2004**                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                |
| **OR**                                                                                                                                                                                                                                                                              |
|                                                                                                                                                                                                                                                                                |
| **o**                                                                                                                                                                                                                                                                               |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                |   |                                                                                                    |
| **for the transition period  from                      to                     ** |
|                                                                                                                                                                                                                                                                                |
| **Commission File No. 000-31257**                                                                                                                                                                                                                                              |

 

**McDATACorporation**

(Exact name of registrant as specified in itscharter)

 

| **A Delaware Corporation**                                      |   | **84-1421844**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **380 Interlocken Crescent, Broomfield,  Colorado 80021**       |
| **Telephone Number (720) 558-8000**                        |

 

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Securities registered pursuant toSection 12(b) of the Act:

 
| **Title of each class**                                    |   | **Name of Each Exchange on  Which Registered** |
|-----------------------------------------------------------------|--------|------------------------------------------------|
| McDATA Class B Common  Stock  ($0.01 per share, par value) |   | Nasdaq National Market                         |

 

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Securities registered pursuant toSection 12(g) of the Act:

 

**McDATA Class A Common Stock**

**($0.01 per share, par value)**

**Nasdaq National Market**

 

At April 2, 2004, approximately 81,000,000 shares of theregistrant’s Class A Common Stock were outstanding and approximately36,468,048 shares of the registrant’s Class B Common Stock wereoutstanding. At July 31, 2003, the aggregate market value of theregistrant’s Class A Common Stock held by non-affiliates was approximately$871 million and the aggregate market value of the registrant’s Class BCommon Stock held by non-affiliates was approximately $285 million.

 

**Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes **ý  No o

** **

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes  ý  No  o

 

 

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**McDATA Corporation**

**Form 10-K**

 

**TABLE OF CONTENTS**

 
| **Item**     |   | **Description**                                                                             |   | **Page** |
|--------------|--------|---------------------------------------------------------------------------------------------|--------|----------|
|         |   |                                                                                        |
| **PART I**   |   |                                                                                        |
|         |   |                                                                                        |
| 1.           |   | Business                                                                                    |   | 2        |
| 2.           |   | Properties                                                                                  |   | 22       |
| 3.           |   | Legal  Proceedings                                                                          |   | 23       |
| 4.           |   | Submission  of Matters to a Vote of Security Holders                                        |   | 23       |
|         |   |                                                                                        |   |     |
| **PART II**  |   |                                                                                        |
|         |   |                                                                                        |
| 5.           |   | Market  for Registrant’s Common Equity and Related Stockholder Matters                 |   | 23       |
| 6.           |   | Selected  Financial Data                                                                    |   | 24       |
| 7.           |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 25       |
| 7A.          |   | Quantitative and Qualitative Disclosures about  Market Risk                                 |   | 37       |
| 8.           |   | Consolidated Financial Statements and  Supplementary Data                                   |   | 37       |
| 9.           |   | Changes in and Disagreements with Accountants on Accounting and  Financial Disclosure       |   | 37       |
| 9A.          |   | Controls and Procedures                                                                     |   | 38       |
|         |   |                                                                                        |   |     |
| **PART III** |   |                                                                                        |
| 10.          |   | Directors and Executive Officers of the Registrant                                          |   | 39       |
| 11.          |   | Executive Compensation                                                                      |   | 45       |
| 12.          |   | Security Ownership of Certain Beneficial Owners and Management                              |   | 58       |
| 13.          |   | Certain Relationships and Related Transactions                                              |   | 60       |
| 14.          |   | Principal Accountant Fees and Services                                                      |   | 61       |
|         |   |                                                                                        |   |     |
| **PART IV**  |   |                                                                                        |
| 15.          |   | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                           |   | 63       |

 

 

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**McDATA Corporation**

# **FORM 10-K**

# ** **

**Special Note Regarding Forward-LookingStatements**

 

Someof the information presented in this Annual Report on Form 10-K contains“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995 (the “Reform Act”). Although McDATA Corporation(“McDATA” or the “Company,” which may also be referred to as “we,” “us” or“our”) believes that its expectations are based on reasonable assumptionswithin the bounds of its knowledge of its businesses and operations; there canbe no assurance that actual results will not differ materially from ourexpectations. Factors that could cause actual results to differ materially fromexpectations include:

 

•                  changes in our relationship with EMCCorporation, or EMC, International Business Machines Corporation, or IBM, andHitachi Data Systems, or HDS, and the level of their orders;

 

•                  our ability to successfully increase sales ofMcDATA’s multi-protocol network switches and management software, includingSANavigator®;

 

•                  competition in the multi-protocol (FibreChannel and IP) network market, including competitive pricing pressures andproduct give-aways, by our competitors such as Brocade Communication Systems,Inc., or Brocade, QLogic Corp, or QLogic, Computer Network TechnologyCorporation, or CNT, Cisco Systems, Inc., or Cisco, and other IP andmulti-protocol switch and software suppliers;

 

•                  additional manufacturing and component costsand production delays that we may experience as we continue the transition tonew products;

 

•                  a loss of any of our key customers (and ourOEMs’ key customers), distributors, resellers, suppliers or our manufacturers;

 

•                  our ability to expand our product offeringsand any transition to new products (including higher port density,multi-protocol and intelligent network products);

 

•                  any change inbusiness conditions, our business and sales strategy or product developmentplans, and our ability to attract and retain highly skilled individuals;

 

•                  any industry or technology changes that causeobsolescence of our products or components of those products;

 

•                  one-time events and other important risks andfactors disclosed previously and from time to time in our filings with the U.S.Securities and Exchange Commission, or SEC, including the risk factorsdiscussed in this Annual Report; and

 

•                  the impact of any acquisitions by us ofbusinesses, products, or technologies, including difficulties in integratingany acquisitions.

 

Youshould not construe these cautionary statements as an exhaustive list or as anyadmission by us regarding the adequacy of the disclosures made by us. We cannotalways predict or determine after the fact what factors would cause actualresults to differ materially from those indicated by our forward-lookingstatements or other statements. In addition, you are urged to considerstatements that include the terms “believes,” “belief,” “expects,” “plans,”“objectives,” “anticipates,” “intends,” or the like to be uncertain and forward-looking.All cautionary statements should be read as being applicable to allforward-looking statements wherever they appear. We do not undertake anyobligation to publicly update or revise any forward-looking statements.

 

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**Part I**

 

**ITEM1. Business**

 

#### **Who We Are**

#### ** **

McDATACorporation provides Multi-Capable Storage Network SolutionsTM (integrating multiple platforms, networks, protocols and locations)that enable end-customers around the world to better consolidate and utilizetheir storage infrastructure, easily manage the storage network, and implementbest-in-class business continuance solutions. McDATA solutions are an integralpart of data services infrastructures sold by many major storage and systemvendors, including Dell Products L.P. (Dell), EMC Corporation (EMC),Hewlett-Packard (HP), Hitachi Data Systems (HDS), International BusinessMachines Corporation (IBM), StorageTechnology Corporation (STK) and SunMicrosystems, Inc. (Sun).  The Companywas reorganized and incorporated in the state of Delaware in October of1997.

 

McDATA provides storage area networking (SAN)solutions, including hardware and software, for connecting servers and storagedevices from the core to the edge of an enterprise’s data infrastructure, andheterogenous SANs via our SAN Routing capabilities.  Our solutions include hardware and software products, professionalservices and education that enable businesses to scale their operationsglobally through a comprehensive, manageable, flexible data infrastructure thatis optimized for rapid deployment and responsiveness to customer needs. Wecombine experience in designing, developing and manufacturing high performanceSAN solutions with knowledge of business critical applications, service andsupport to solve data infrastructure challenges facing enterprises of varyingsizes.

 

**Recent Developments**

 

***Acquisitions***

 

OnSeptember 19, 2003, we completed our acquisition of Nishan Systems, Inc.(Nishan), a provider of native IP storage switching solutions that builds openstorage networking products based on IP and Ethernet, both internationalnetworking standards. The Nishan transaction accelerates our delivery ofmulti-protocol inter-networking capabilities that scale data center storagenetworks and extend storage network benefits across the campus, the enterpriseand geographies. On September 30, 2003, we completed our acquisition ofSanera Systems, Inc. (Sanera), a producer of intelligent Director classswitching platform technologies.  Theacquisition of Sanera, when combined with McDATA technologies, extends ourmulti-capable storage-networking director platform and accelerates our visionof delivering a real-time storage services infrastructure.  On August 25, 2003, we also made anequity investment in Aarohi Communications, Inc.

 

**Hardware Products**

 

###### ***SAN Fibre ChannelDirectors***

###### *** ***

We are a leading provider of high availability SANdirectors with our IntrepidTM 6140 Director (140 ports) and IntrepidTM 6064Director (64 ports). The IntrepidTM 6140 Director provides high-availability andhigh-port density within 12u (“u” equals 1.75 inches in height) of verticalspace, enabling 420 ports to reside in a single McDATA Fabricenter® Cabinet orany other industry standard rack.  Thefull line of IntrepidTM Directors are flexible building blocks for storagenetworks with hundreds and even thousands of connections.

 

The distinction between a director-class environmentand a simple combined or clustered switching solution environment issignificant at the core of the data center. Our directors offer fullredundancy, “five-nines” (99.999%) of availability, ultra-high predictive performanceprovided by a non-blocking architecture, security and highly integratedcentralized management provided through software management tools. McDATA’sdirectors provide customers with high performance, high availability solutionsto network storage. Both the IntrepidTM

 

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6140 Director and IntrepidTM 6064 Directorprovide optimal port granularity with 4 ports per card module, with 35swappable port card modules per chassis for a total of 140 ports, and 16 swappableport card modules per chassis for a total of 64 ports, respectively. In therare event of a single port failure, only one port module in a director wouldbe affected and can be replaced without network disruption.  Therefore, the McDATA IntrepidTM Directorprovides very low disruption to the network, with only 4 ports being affectedin the rare event of a port failure, unlike a similar failure with a combinedor clustered switching solution that has sixteen ports per module. In addition,the extensibility and openness of our architecture provides customers withinvestment protection by providing a platform that can be upgraded to newperformance levels and protocols including FICON, or mainframe multi-speeds,such as 1 Gb and 2 Gb; and has a passive backplane allowing for multi-protocoltransmission in the future. As a result of our acquisition of Sanera, we planto introduce the IntrepidTM 10000 Director, which will be fully interoperablewith McDATA’s current products, after qualification testing with our saleschannels is completed.

 

###### ***SAN Fibre Channel FabricSwitches***

###### *** ***

For small and mid-sized enterprises that want highperformance features at a cost effective “pay as you grow” upgrade price, weoffer the SphereonTM Family of Fabric Switches with flexport technology.  The SphereonTM  4500  delivers“connectivity-on-demand” in 8 port increments (8, 16 and 24 ports) and theSphereonTM 4300 Fabric Switch delivers “connectivity-on-demand” in 4 portincrements (4, 8 and 12 ports). When upgrading a switch from 8 ports to 12ports, for example, the end-customer simply purchases a flexport upgrade, andimplements the upgrade using a simple software feature enablement key whichupgrades the switch non-disruptively. With each SphereonTM Fabric Switch weoffer web-based management software known as SANPilotTM. SANPilotTM provides thefeatures necessary to easily manage small SAN fabrics. The SphereonTM4000-Series (4500 and 4300) Fabric Switches also offer non-disruptive softwarecode load and activation (HotCAT Technology), hot-plug capable transceivers,fibre channel loop connectivity for storage consolidation (directly attachingdisk or tape and maximizing storage utilization) and other industry leadingfeatures.

 

For larger departments within a data center,we offer the SphereonTM 3232 Fabric Switch. The SphereonTM 3232 Fabric Switch is also available for FICONenvironments and offers HotCAT Technology (non-disruptive code load andactivation), redundant power and cooling, hot-plug capable transceivers andother industry leading features. With each SphereonTM 3232 Fabric Switch we alsoinclude our web-based management software, SANPilotTM at no additional cost.

 

##### ***Multi-Protocol IP Storage Switches and InternetworkingSwitches***

##### *** ***

Forenterprises that want to leverage their fibre channel storage networkinfrastructure and their IP networks to consolidate storage infrastructuresacross the campus, the enterprise and geographies, we offer the Eclipse®IPS 4300 multi-protocol IP Storage Switch (16 multi-service ports), the Eclipse® IPS 3300multi-protocol IP Storage Switch (8 multi-service ports) and the Eclipse® 1620 SANInter-networking Switch.  These switch solutions allow for integrateddisaster recovery architectures, and cost effective integration of low-endservers and applications into the storage network.****The Eclipse® IPS 4300 and 3300 switchesalso provide SAN routing capabilities, allowing end-customers to consolidateheterogeneous SANs and share data between heterogeneous storage environments,while at the same time isolating faults from propagating between SANs withfault isolation technology. With the Eclipse® line of switchproducts we offer our SANvergenceâManager software.

 

***Cabinets***

 

Our Fabricenter® Cabinet supports internal cable management for 512Fibre Channel cables and provides 36u of vertical space while occupying onlyone tile width (24”) of valuable data center floor space. Its sleek, industrialdesign provides maximum airflow, security and visibility of equipment. TheFabricenter® Cabinet can house our IntrepidTM , SphereonTM  and Eclipse® lineof products.  These cabinets, whenpopulated with our director, switch and software products, represent ourconfigured products.

 

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**Software Products**

 

Through our Extendable Open Network (EON) software architecture, weoffer open, end-to-end SAN management through a layered software approach. OurSANavigatorâsoftware provides complete SAN monitoring, management, visualization andcontrol of heterogeneous fabric environments. Our Enterprise FabricConnectivity Manager (EFCM) software systematically simplifies the setup andconfiguration of a SAN with our SAN directors and fibre channel fabric switches, and provides fabric level SANmanagement and administration. Both SANavigator® and EFCM softwarecan be run locally on the server platform or remotely on any network-attachedworkstation in the enterprise. We recently integrated certain features of ourSANavigator® software into EFCM, providing end-customers and oursales channels the flexibility to purchase only those modules that fit theirbusiness strategies.

 

Our Element Manager (EM) software (formerly known as Product Managersoftware) provides device level management and administration of our SAN fibrechannel directors and fabric switches. Our Enterprise Operating SystemTM (E/OS)operating system software is embedded in our directors and switches and formsthe foundation for our Enterprise Architecture providing a myriad of advancedservices to upper layers of software applications including HotCATTM Technology.Our SAN Internetworking Operating System******(SIOS) software is embedded in our Eclipse®line of switch products and our SANvergence® Manager is a collectionof software tools for managing an IP storage fabric consisting of Eclipse®switches and gateways.  Our FICONManagement Server software is available with our IntrepidTM Directors and theSphereonTM 3232 Fibre Channel Fabric Switch to provide mainframe customers withsingle-console management of FICON storage networks from the mainframeconsole.  Our web-based managementsoftware known as SANPilot® is available in our SphereonTM line ofswitch products. Our SANtegrity® Security Suite software applieslayers of security to individual storage network ports, switches and entirefabrics, limiting exposure to intentional security threats and accidentalchanges to the storage network.

 

**Professional Services and Solutions**

** **

**Our Professional Services group provides our customers withsome of the most experienced and comprehensive storage network consultingservices and solutions in the industry. Our full line of service offerings and state-of-the-art tools such asProSADATM and SANavigator® allow customers to efficiently plan,implement, and manage complex storage networks worldwide. We provide customerswith complete solutions that solve critical customer problems such asconsolidation and data protection allowing the customers to focus on theirbusiness mission with the assurance of high availability and functionality. Wealso provide technology-centric, vendor-neutral storage network training to ITprofessionals through our Learning Services group.  Our training emphasizes system-level solutions by providing ITprofessionals the skills necessary to be effective in today’s multi-vendor,heterogeneous storage networking environments.**

** **

**Technology**

 

We have developed ASIC (Application SpecificIntegrated Circuit) technology that serves as the foundation for thedevelopment of our complete family of SAN products. These ASICs combine anumber of Fibre Channel functions in a single chip, reducing the number ofcomponents needed in our fibre channel directors and switches.  Our ASICs are used in our current fibrechannel directors and fibre channel fabric switch products and we intend to usevariations of such ASICs in our future products.

 

The implementation of our Fibre Channel directors and switcharchitecture is based on a common hardware and software design. Thearchitecture enables product designs that span from the high-end data center tolow-end workgroup storage computing environments with gigabit performance and24x7 operation.

 

Our technology/architecture allows us to offerdirector-class products with a higher number of data transmission ports in lessspace than similarly sized competitive products. This architecture allowsend-customers to maximize space in their data centers.  Our IntrepidTM 6140 and IntrepidTM 6064Directors utilize a durable serial crossbar non-blocking architecture, whichallows for the maximization of usable ports because none of our director

 

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ports needs to be diverted to other networkswitches – unlike developed architectures based upon small port-count switchesin a meshed switch environment. Our current architecture enables us to addresslarge enterprise core-to-edge customer fabrics with thousands of ports.  The architecture supports transmission of upto 2 gigabits per second and is designed to support transmission of up to 10gigabits per second in the future. The flexibility of our architecture providescustomers with investment protection by allowing the director platform to beupgraded from 1 gigabite, to 2 gigabits and to 10 gigabits, when generallyavailable, as well as future technology protocols like IP, iSCSI and Infiniband(IB).

 

Our current director products include, and we expect our futureproducts will include, many of the following characteristics:

 

•                  system statusmonitoring;

 

•                  ability toreplace faulty internal component parts without interruption of datatransmission;

 

•                  non-disruptiveserviceability;

 

•                  automatedcomponent failure detection and reporting;

 

•                  user friendlyoperation;

 

•                  automated callhome features;

 

•                  networkmanagement that supports both in-band and out-of-band systems; and

 

•                  networkmanagement via our SANavigator®, EFCM, Element Manager, E/OS,  SANPilot®, and SANvergence®Manager software products.

 

#### **Customers**

#### ** **

Three major customers, EMC, IBM and HDS, are significant providers ofenterprise storage systems. For the fiscal year ending January 31, 2004,EMC accounted for approximately 56% (54% in 2002), IBM accounted forapproximately 21% (down from 25% in 2002), and HDS accounted for approximately10% (up from 9% in 2002) of our total revenue. McDATA solutions areoffered and sold by other major storage and system vendors, including Dell, HP,STK and Sun. In addition to our storage and system vendors, we haverelationships with resellers, distributors and systems integratorsworldwide.  Expanding our reseller,distributor and system integrator channels into Small Medium Enterprise (SME)and vertical markets will be a strategic focus for us as we continue to expandour business.

 

**Backlog**

** **

We manufacture our products on the basis of ourforecast of near-term demand and maintain inventory in advance of receipt offirm orders from customers. Some of our products are configured to customerspecifications and are generally shipped by us, via our contract manufacturers,shortly after receipt of the order. For this reason, our backlog at anyparticular time is not meaningful to our business because it is not necessarilyindicative of future sales levels.

 

**Sales and Marketing**

 

Our sales and marketing approach is focused on an indirect sales modelexecuted through OEMs and large resellers, such as EMC, IBM, HDS, HP, STK,Sun and Dell, and our distributors and system integrators. We support thesedistribution customers in a direct-assist sales model with our field sales andservice personnel. In order to be competitive, we may need to increase ourfield sales team and we may need to enhance our direct-assist model and

 

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contact with end-user customers to create product pull through ourchannels. With regard to our Eclipse® line ofInternetworking Switch products and our SANavigator® software, wesell primarily through reseller, systems integrator and distributor channels,and directly to end-user customers as necessary.  We also offer our Professional Services directly and indirectlythrough a number of our channels and other service providers. Our ProfessionalServices group is recognized within the industry as technical experts withproven system design and deployment methodologies and comprehensivemulti-protocol education curricula.

 

Our OEMs and several of our large resellercustomers incorporate our directors and switches into their end-user customerproducts that are installed and field-serviced by the partner’s technicalsupport organizations.  IBM GlobalServices provides our first level of field support for all products that aresold through IBM and IBM Global Services and Anacomp provide first level fieldsupport for products sold through our indirect channel partners (generally,system integrators, smaller resellers and distributors).  The sales cycle used in selling to an OEMand large reseller customer can vary significantly in terms of its length andcomplexity. Often, it involves the use of our testing labs or those of ourstrategic partner to qualify the products through substantial testing. It alsooften involves the submission of proposal documentation and presentations tosuch customers. This sales process generally involves the combined efforts ofour sales and marketing, engineering and management teams and can take fromseveral weeks to more than one year.

 

In December of 1999, we entered into adistribution agreement with HDS that governs HDS’ resale of our products.  In May of 2000, we entered into afive-year agreement for EMC to remarket, or rebrand, and resell our products toend-user customers or for EMC to purchase our products for internal use. Underthe terms of this agreement, we provide varying degrees of support to EMC forthose products. We also entered into a resale agreement with IBM inFebruary of 2000 and another resale agreement in August of 2003 thatgoverns IBM’s purchases of our products and appoints IBM as a non-exclusiveauthorized reseller of our products and services to IBM resellers and end-usercustomers.  In August 2002,January 2003 and February of 2003, we entered into purchase agreementswith Dell, STK, and Sun, respectively. None of these agreements provide for the purchase of a guaranteedminimum amount of product.

 

As of January 31, 2004, our sales organizationwas located in several major cities in the United States, Canada, Germany, theUnited Kingdom, Japan, Austria, France, Italy, Norway, Australia, Hong Kong,Korea, Switzerland, Singapore and China. Our sales and marketing organizationincludes field sales personnel, systems engineers, channel sales professionals,educational services providers and sales operations professionals.

 

For financial information about geographic areas andsegments, see Note 14 “Segment Information,” of the Notes to ConsolidatedFinancial Statements

 

**Customer Service, Support and Solutions**

 

We provide technical support to our OEM and resellercustomers and to systems integrators, enabling them to provide technicalsupport to their end-user customers. We do this by providing training anddocumentation together with 24x7 support. When a customer issue originates from our call center, we typicallyremain in contact with the customer until the issue is resolved.  Our customer support includes acomprehensive array of full-service support elements, including: 24x7 call homemonitoring; spare parts depots; direct support through IBM Global Services andAnacomp; field engineers, manufacturer-based technical support specialists andregional support specialists available to handle on-site requirements. We havebeen certified to ISO9001 standards since 1994 and we are now certified toISO9001:2000 standards.

 

**Manufacturing**

 

Our leased manufacturing facility, located inLouisville, Colorado, is currently 91,000 square feet. In May 2004, uponrenewal of the operating lease, we plan to reduce the size of this leasedfacility to approximately half of its current size given the manufacturingoutsourcing efforts we have implemented. We perform customer service repair andlogistics in this facility. We currently anticipate that this facility will beadequate for our activities for the foreseeable future.  Since

 

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November of 2001, we have beentransitioning to a more outsourced manufacturing model by moving a number ofmanufacturing tasks to our contract manufacturers. Please see Note 13“Commitments” of the Notes to Consolidated Financial Statements for a furtherdiscussion of our outsourcing activities.

 

We subcontract a majority of our production activities, including themanufacture, assembly and testing of a substantial portion of our products.Sanmina–SCI, Inc. (SSCI) is the contract manufacturer for our printedcircuit boards, and they perform assembly, testing, box build and cabinetintegration for our directors.  SSCIalso manufactures our SphereonTM 3232 Fabric Switch. SSCI manufactures theseproducts in Fountain, Colorado. Solectron Corporation (Solectron) is the contract manufacturer for ourSphereonTM 4500 and 4300 Fabric Switches and for our Eclipse® 1620Switch. Solectron manufactures these products in Austin, Texas and Guadalajara,Mexico.  SSCI and Solectron havemultiple sites in multiple countries that can be used to significantly expandtheir manufacturing capacity.  PyconIncorporated (Pycon) manufactures the Eclipse® 3300and 4300 Switch products in San Jose, California.  We currently depend upon LSI Logic and IBM for the production ofall of our custom ASICs.

 

We depend on SSCI, Solectron, Pycon, IBM, LSI Logicand our other subcontractors to deliver high-quality products in a timelymanner, but we cannot be assured that they will be able to do so.  We do not have long-term supply contractswith any of our subcontractors and we are subject to component supplyshortages.

 

We design test processes for all of our products toidentify the causes and measure the frequency of product failures. We and ourmajor suppliers use these test processes in connection with the manufacture ofour products. For certain of our high reliability products, our tests includeenvironmental stress screening, which seeks to ensure product performance andreduce premature product failures, and other test processes, designed toidentify product defects prior to shipping. In addition to qualifying ourproducts, we also qualify our component suppliers based on their ability tomanufacture components within defined specifications.

 

**Research and Development**

 

The SAN and other information infrastructure marketsare characterized by rapid technological change, including changes in customerrequirements, frequent new product introductions and enhancements, and evolvingindustry standards. We believe that continued research and development effortsare an important factor in our ability to maintain technologicalcompetitiveness. We employ individuals in engineering and development effortsthat are focused on the development, enhancement and testing of directors andswitches, ASICs and the associated software offerings that address the needs ofthe SAN market. We intend to dedicate resources to the continued development ofthe Fibre Channel and other protocol standards, and to achieve interoperabilitywith the storage networking devices of other companies.  Finally, our Systems Integration Lab locatedin Broomfield, Colorado is the industry’s premiere fibre channel switchedfabric interoperability lab and is staffed by fibre channel and open systemsexperts.

 

Our research and development expenditures wereapproximately $89 million in fiscal year 2003, $59 million in fiscal year2002, and $49 million in fiscal year 2001.

 

**Competition**

 

Themarket for our multi-protocol SAN switching hardware and software products ishighly competitive, especially with the entrance of competitors from the IPbased switch market. Our competitors are providing SAN switching hardware andsoftware that is multi-protocol capable such as Fibre Channel over IP (FCIP),SCSI over Internet (iSCSI), Internet Fibre Channel (iFCP) and InfiniBand(IB).Our competitors in the this market include Brocade, CNT, Cisco, QLogic Corp.,Emulex Corporation (which recently acquired Vixel Corporation), BroadcomCorporation (which acquired the assets of Gadzoox Networks), Veritas SoftwareCorporation, Fujitsu Softech and others, including storage hardware deviceproviders. Given the recent market share gain by Cisco, other IP-basedswitching companies such as Juniper, Extreme, and Foundry may enter the marketfor multi-protocol SAN products. A number of our current and potentialcompetitors have longer operating histories, greater name recognition, accessto larger customer bases, more established distribution channels andsubstantially greater financial and managerial resources. Given the highlycompetitive market, we

 

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anticipate continuedelongated sales cycles and continued pricing pressures.  To remain competitive, we may have tosubstantially increase headcount in our direct-assist sales model to enhancedirect end-user customer touch.

 

#### **Intellectual Property**

#### ** **

Our success depends on our ability to protect ourproprietary technology and to operate without infringing the proprietary rightsof third parties. We rely on a combination of patents, copyrights, trademarksand trade secrets, as well as confidentiality agreements and other contractualrestrictions with employees and third parties, to establish and protect ourproprietary rights. We cannot be assured that the steps we take to protect ourintellectual property will adequately protect our proprietary rights; thatothers will not copy or otherwise obtain and use our products and technologywithout authorization, independently develop or otherwise acquire equivalent orsuperior technology; or that we can maintain such technology as tradesecrets.  In addition, the laws of someof the countries in which our products are or may be sold may not protect ourproprietary rights as fully as do the laws of the United States.

 

Currently, we hold 37 U.S. patents and have 50additional U.S. patents pending (including 13 pending for SANavigator®).We are seeking additional patent protection for certain additional aspects ofour technology. However, it is possible that patents may not be issued forthese applications. It is possible that litigation may be necessary in thefuture to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of the proprietary rights ofothers. Litigation could result in substantial costs and diversion of ourresources and could materially harm our business. From time to time, we havereceived, and may receive in the future, notice of claims of infringement ofother parties’ proprietary rights. Infringement or other claims could beasserted or prosecuted against us in the future, and it is possible that pastor future assertions or prosecutions could harm our business. Any such claims,with or without merit, could be time-consuming, result in costly litigation anddiversion of technical and management personnel, cause delays in thedevelopment and release of our products, or require us to develop alternativenon-infringing technology or enter into royalty or licensing arrangements. Suchroyalty arrangements, if required, may not be available on terms acceptable tous, or at all. For these reasons, infringement claims could materially harm ourbusiness.

 

Under the terms of the May 2000 Master ConfidentialDisclosure and License Agreement between EMC and us, EMC has granted us alicense to then existing EMC patents and we granted EMC a license under thenexisting McDATA patents.  If we areacquired, our acquirer will retain this license as long as our acquirer grantsto EMC a license under all of the acquirer’s patents for those productslicensed under the agreement under the same terms as the license we havegranted to EMC under the agreement. The potential for a loss of the licensefrom EMC after an acquisition may make an acquisition of us by a third partyunlikely.

 

EMC and IBM entered into a cross-license agreementon March 19, 1999, and amended that agreement on May 12, 2000, underwhich each party, on behalf of itself and its subsidiaries, granted the other alicense under patents issued or issuing on applications entitled to aneffective filing date through December 31, 2005. Under the terms of thiscross-license agreement, patents held by us were licensed to IBM and patentsheld by IBM were sublicensed to us by EMC. Each party released the other andits subsidiaries from claims of patent infringement committed prior to the dateof the cross-license. Effective as of the February 7, 2001 distribution ofour Class A common stock by EMC, IBM, pursuant to the cross-licenseagreement, retained the benefit of a license to our patents with an effectivefiling date through the date of such distribution, but the sublicense to usunder IBM patents terminated upon such date in accordance with the terms of thecross license agreement. We believe that the termination of the sublicense doesnot materially affect our business.

 

**Employees**

 

At January 31, 2004, we had 1022 full-timeemployees. Of these employees, 412 were engaged in engineering and development,352 in sales and marketing, 105 in manufacturing and customer support, and 153in finance and administration. None of our employees are represented by a laborunion. We have not experienced any

 

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work stoppages and consider ourrelations with our employees to be good. In January 2004, we announced a9% reduction in force (RIF) of our employee base (See Note 4 to our Notes tothe Consolidated Financial Statements). We currently anticipate that we willonly need to hire additional employees for sales and certain other criticalpositions in 2004 to meet the expected growth of our business.

 

**Available Information**

 

Our company web site is located at *www.mcdata.com*.Our web site contains a link to a third party SEC filings web site that makesour filings with the SEC available free of charge as soon as reasonablypracticable after they are electronically filed with the SEC. Our filings withthe SEC are available free of charge by contacting:

 

McDATA Corporation

Attn: Investor Relations

380 Interlocken Crescent

Broomfield, Colorado 80021

(720) 558-8000

 

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**Risk Factors**

 

***Risks Relating toOur Business***

 

**ChangingMarket Conditions and Increased Competitive Risks.**

 

Themarket for our multi-protocol storage area networking (SAN) products andsolutions has grown and will continue to become more competitive with (a) theentrance of new competitors from the IP based switching market into our market,(b) pricing pressures resulting from this increase in competitive SAN networkingproducts and solutions, (c) challenges to our direct-assist sales model withdistribution through channels when our competitors engage end-user customersdirectly or otherwise have the ability to drive end-user customer preferencefor SAN equipment through their traditional IP networking presence andrelationships, and (d) anticipated competition from our own storage OEMpartners through their recent acquisitions of, or alliances with, competitivesoftware management products and/or application providers that would utilizethe intelligence in the network. As a result of these market changes, weanticipate continued lengthened sales cycles and price erosion in anenvironment where storage OEM certification of our products may still berequired for end-user customer acceptance. Given our direct-assist sales modelwith distribution through our channel partners, we are highly dependent uponour channel partners’ relationships with end-user customers to promote thevalue of our products. If our channel partners do not promote the value of ourproducts or competitors begin to control end-user customer preference, we maylose sales in key enterprise accounts that would materially adversely affectour revenues.

 

**We are highly dependent on our OEM sellers,especially EMC, and efforts by them to reduce the prices of their suppliers maydecrease our revenue and gross margins.**

 

Weare highly dependent on our OEM partners, especially EMC, and efforts by themto reduce the prices of their suppliers may decrease our revenue and grossmargins.  For example, given ourconcentration of sales with EMC, the revenue shortfall with EMC experienced inthe fiscal quarter ending October 31, 2003 and EMC’s public statementsthat they will further reduce their suppliers’ prices, we may experienceunanticipated decreases in sales revenue and gross margins that may lead us tobe unprofitable. The above-mentioned factors may also strain businessrelationships with our storage OEM partners and may adversely affect thequalification and certification of our products. Moreover, the introduction ofsuch new products and any pending qualification and certification by ourpartners may stall sales of our existing products with end user customers.  Given the dependencies on our limited numberof OEM resellers combined with an increasingly competitive environment, we mayexperience continued adverse price pressures at critical times near the end ofthe fiscal quarters.

 

**Newcompetitors have entered this market and we may not be able to successfullycompete against existing or potential competitors.**

 

The market for our multi-protocol SAN switching hardware and softwareproducts is highly competitive, especially with the entrance of competitorsfrom the IP based switch market. Our competitors are providing or plan toprovide SAN switching hardware and software that is multi-protocol capable(such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), InternetFibre Channel (iFCP) and InfiniBand). Our competitors in the this marketinclude Brocade, CNT, Cisco, QLogic Corp., Emulex Corporation (which recentlyacquired Vixel Corporation), Broadcom Corporation (which acquired the assets ofGadzoox Networks), Veritas Software Corporation, Fujitsu Softech and others,including storage hardware device providers. Given the market share gain byCisco, other IP based switching companies such as Juniper, Extreme, Foundry andothers may enter the market for multi-protocol SAN products. Many of ourcompetitors and potential competitors have longer operating histories, greatername recognition, access to larger customer bases, more establisheddistribution channels and substantially greater financial and managerialresources than McDATA. Given the highly competitive market, we anticipatecontinued lengthened sales cycles and continued downward pricingpressures.  To be competitive, we mayhave to substantially increase headcount in our direct-assist sales model andmigrate to a direct end-user customers touch and possibly to direct sales,which we may not be able to do successfully and

 

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which, in anycase, will increase expenses. Continued or increased competition couldresult in pricing pressures, reduced sales, reduced margins, reduced profits,reduced market share, further elongating of sales cycles, or the failure of ourproducts to achieve or maintain market acceptance.

 

**We incurreda substantial loss for the fiscal years ended January 31, 2004,December 31, 2002 and December 31, 2001 and may not be profitable inthe future.**

 

Weincurred losses of $43.1 million, $10.0 million and $8.7 million, respectively,for the fiscal years ended January 31, 2004, December 31, 2002 andDecember 31, 2001.  Our futureoperating results will depend on many factors, including the growth of themulti-protocol (Fibre Channel and IP) market, market acceptance of new productswe introduce, demand for our products, levels of product and price competitionand our reaching and maintaining targeted costs for our products. In addition,we expect to incur continued significant product development, sales andmarketing, and general and administrative expenses. We cannot provide assurancethat we will generate sufficient revenue to achieve or sustain profitability.

 

**The pricesand gross margins of our products may decline, which would reduce our revenuesand profitability.**

 

Inresponse to changes in product mix, competitive pricing pressures, increasedsales discounts, introductions of new competitive products, productenhancements by our competitors, increases in manufacturing or labor costs orother operating expenses, we may experience declines in the prices, grossmargins and profitability. To maintain our gross margins we must maintain orincrease current shipment volumes, develop and introduce new products andproduct enhancements and reduce the costs to produce our products. Moreover,most of our expenses are fixed in the short-term or incurred in advance ofreceipt of corresponding revenue. As a result, we may not be able to decrease ourspending to offset any unexpected shortfall in revenues. If this occurs, wecould incur losses, and our revenue, gross margins and operating results may bebelow our expectations and those of investors and stock market analysts.

 

**We dependon two key distribution relationships for most of our revenue and the loss ofeither of them could significantly reduce our revenues.**

 

Wedepend on EMC and IBM, for a significant portion of our total revenue. Sales toEMC and IBM represented approximately 56% and 21%, respectively, of our revenuefor the fiscal year ended January 31, 2004. We anticipate that our futureoperating results will continue to depend heavily on sales to EMC and IBM. EMCand IBM resell products offered by our competitors, and nothing restricts EMCand IBM from expanding those relationships in a manner that could be adverse tous. Therefore, the loss of either EMC and IBM as a customer, or a significantreduction in sales to either EMC and IBM could significantly reduce ourrevenue. While we are aware that Dell sources some of our switch productthrough EMC, it is unclear whether this mitigates our dependency on EMC. Ourproduct sales agreements with sales partners do not provide for the purchase ofa guaranteed minimum amount of product.

 

**We currentlyhave limited product offerings and must successfully introduce new products andproduct enhancements that respond to rapid technological changes and evolvingindustry standards.**

 

Forthe fiscal year ended January 31, 2004, we derived a significant portionof our revenue from sales of our director-class IntrepidTM switchproducts. We expect that revenue from our director-class IntrepidTMswitch products will continue to account for a substantial portion of ourrevenue for the foreseeable future. Factors such as performance, marketpositioning, the availability and price of competing products, the introductionof new technologies and the success of our OEM, reseller and systems integratorcustomers will affect the market acceptance of our products.  Therefore, continued market acceptance ofthese products and their successor products, along with our SphereonTMand Eclipse® switches, are critical to our future success.

 

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Inaddition, our future success depends upon our ability to address the changingneeds of customers and to transition to new technologies and industrystandards. The introduction of competing products embodying new technologies orthe emergence of new industry standards could render our productsnon-competitive, obsolete or unmarketable and seriously harm our market share,revenue and gross margin. Risks inherent in transitions to new technology,industry standards and new protocols include the inability to expand productioncapacity to meet demand for new products, write-downs of our existing inventorydue to obsolescence, the impact of customer demand for new products or productsbeing replaced, and delays in the introduction or initial shipment of newproducts. There can be no assurance that we will successfully manage thesetransitions.

 

Weare currently developing products that contain untested devices andsubassemblies. As with any development, there are inherent risks should suchdevices or subassemblies require redesign or rework. In particular, inconjunction with the transition of our products from fibre channel tomulti-protocol, 2 Gb to 4Gb to 10 Gb transmission speed technology, higher portdensities, and advanced management capabilities, we will be introducingproducts with new features and functionality, such as our next generationdirector-class switch product, the IntrepidTM 10000 Director. We face risks relating to this producttransition, including risks relating to getting storage and system OEMs toqualify such products, forecasting of demand, as well as possible product andsoftware defects and a potentially different sales and support environment dueto the complexity of these new systems. Finally, if we fail to introduce newproducts timely, or to add new features and functions to existing products tocompete against new entrants in the market, or if there is no demand for theseor our current products, our business could be seriously harmed.

 

**Risksrelated to recent acquisitions.**

 

InSeptember 2003, we closed our acquisitions of Nishan Systems, Inc.(Nishan) and Sanera Systems, Inc. (Sanera). While management believes that suchacquisitions are an integral part of their long-term strategy, there are risksand uncertainties related to acquiring companies that have limited or noproduct sales to date. Our success depends upon integrating Nishan and Sanerawith McDATA, finalizing the development of such products, retaining criticalemployees from the acquired companies, qualifying such products with our OEMand reseller partners and ramping sales of those products with such partners.

 

**Ourbusiness is subject to risks from global operations.**

 

Weconduct significant sales and customer support operations in countries outsideof the United States and also depend on non-U.S. operations of our contractmanufacturers, and our distribution partners. Further, we utilize an Indiabased firm to provide certain software engineering services, and ourvirtualization chip supplier, Aarohi Communications, is also reliant onoffshore engineering. We derived approximately 33% of our revenue for thefiscal year ended January 31, 2004, from customers located outside of theUnited States. We believe that our continued growth and profitability willrequire us to continue to expand marketing and selling efforts internationally.We have limited experience in marketing, distributing and supporting ourproducts internationally and may not be able to maintain or increaseinternational market demand for our products. In addition, our internationaloperations are generally subject to inherent risks and challenges that couldharm our operating results, including:

 

•                  expensesassociated with developing and customizing our products for foreign countries;

•                  difficulties instaffing and managing international operations, including reliance on thirdparties to manage certain aspects of our foreign operations, including hubinventory locations;

•                  multiple,conflicting and changing governmental laws and regulations;

•                  tariffs, quotasand other import or export restrictions, trade protection measures and otherregulatory requirements on computer peripheral equipment;

•                  longer salescycles for our products;

•                  reduced orlimited protections of intellectual property rights;

•                  adverse taxconsequences, including imposition of withholding or other taxes on payments bysubsidiaries and customers;

 

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•                  compliance withinternational standards that differ from domestic standards;

•                  riskssurrounding any product and software outsourcing activities in foreigncountries; and

•                  political, social and economic instability ina specific country or region.

 

Anynegative effects on our international business could harm our business,operating results and financial condition as a whole. To date, substantiallyall of our international revenue or costs have been denominated in U.S.dollars. As a result, an increase in the value of the U.S. dollar relative toforeign currencies could make our products more expensive and thus lesscompetitive in foreign markets. A portion of our international revenue may bedenominated in foreign currencies in the future, which will subject us to risksassociated with fluctuations in those foreign currencies.

 

**Unforeseenenvironmental costs could impact our future net earnings***.*

 

Some of our operations use substances regulated undervarious federal, state and international laws governing the environment,including those governing the discharge of pollutants into the air and water,the management and disposal of hazardous substances and wastes and the cleanupof contaminated sites. Certain of our products are subject to various federal,state and international laws governing chemical substances in electronicproducts. We could incur costs, fines and civil or criminal sanctions,third-party property damage or personal injury claims if we were to violate orbecome liable under environmental laws. The ultimate costs under environmentallaws and the timing of these costs are difficult to predict.

 

The European Union has finalized the Waste Electricaland Electronic Equipment Directive, which makes producers of electrical goodsfinancially responsible for specified collection, recycling, treatment anddisposal of past and future covered products. This directive must now be enactedand implemented by individual European Union governments by August 13,2004 (such legislation together with the directive, the “WEEE Legislation”),and certain producers are to be financially responsible under the WEEELegislation beginning in August 2005. In addition, the European Parliamenthas enacted a requirement for the recovery of hazardous substance (RoHS).  This legislation governs the recovery ofsuch substances as mercury, lead, cadmium, and hexavalent cadmium. We arecurrently reviewing the applicability of WEEE and RoHS Legislation to ourelectronic products.  Accordingly, wecannot currently estimate the extent of increased costs resulting from the WEEEand RoHS Legislation. Similar legislation may be enacted in other geographies,including federal and state legislation in the United States, the cumulativeimpact of which could be significant costs.

 

**Increasedinternational political instability may decrease customer purchases, increaseour costs and disrupt our business.**

 

Increasedinternational political instability as demonstrated by the September 11,2001 terrorist attacks, disruption in air transportation and enhanced securitymeasures as a result of the terrorist attacks and increasing tension in theMiddle East, may hinder our ability to do business and may increase our costs.Additionally, this increased instability may, for example, negatively impactthe capital markets and the reliability and cost of transportation andadversely affect our ability to obtain adequate insurance at reasonable ratesor require us to incur costs for extra security precautions for our operations.In addition, to the extent that air transportation is delayed or disrupted, theoperations of our contract manufacturers and suppliers may be disrupted, particularlyif shipments of components and raw materials are delayed. If this internationalpolitical instability continues or increases, our business and results ofoperations could be seriously harmed and we may not be able to obtain financingin the capital markets.

 

**If we losekey personnel or if we are unable to hire additional qualified personnel, wemay not be successful.**

 

Oursuccess depends to a significant degree upon the continued contributions of ourkey management, technical, sales and marketing, finance and operationspersonnel, many of whom would be difficult to replace. In particular, webelieve that our future success is highly dependent on our senior executiveteam. In the past we

 

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have experienced highturnover in our senior executive team. A significant portion of the currentsenior executive team was hired during the last year and a half. Although oursenior executive team consists of experienced members, many of them are new toour company and industry and have only worked with each other for a relativelyshort period of time. As a result they may not operate efficiently as part ofan integrated management team.

 

Inaddition, our engineering and product development teams are critical in developingour products and have developed important relationships with customers andtheir technical staffs. The loss of any of these key personnel, including oursenior sales staff, could harm our operations and customer relationships. We donot have key person life insurance on any of our key personnel. Given ourrecent acquisitions of Nishan and Sanera, a large percentage of our engineeringdevelopment team is now located in California, is new to the Company and maynot operate as efficiently during the transition period. In January 2004,we announced a 9% reduction in-force (RIF) of our employee base and we areclosing down our Canadian engineering operations.

 

Webelieve our future success will also depend in large part upon our ability toattract and retain highly skilled managerial, engineering, sales and marketing,and finance and operations personnel. If we increase our production and saleslevels, we will need to attract and retain additional qualified skilled workersfor our operations. In the last year, there has been an increasing demand forsuch personnel by companies, some of which are larger and have greaterresources to attract and retain highly qualified personnel. We cannot assureyou that we will continue to be able to attract and retain qualified personnel,or that delays in hiring required personnel, particularly engineers, will notdelay the development or introduction of products or materially adverselyimpact our ability to sell our products.

 

**Risksrelated to internal controls.**

 

Public companies in the United States are required to review theirinternal controls under the Sarbanes-Oxley Act of 2002.  It should be noted that any system ofcontrols, however well designed and operated, can provide only reasonable, andnot absolute, assurance that the objectives of the system are met. In addition,the design of any control system is based in part upon certain assumptionsabout the likelihood of future events. Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote. If the internal controls put in place by us are notadequate or in conformity with the requirements of the Sarbanes-Oxley Act of2002, and the rules and regulations promulgated by the Securities and ExchangeCommission, we may be forced to restate our financial statements and take otheractions which will take significant financial and managerial resources, as wellas be subject to fines and other government enforcement actions.  See Item 9A-Controls and Procedures fordiscussion of a third quarter balance sheet reclassification/restatementpertaining to our securities lending program.

 

**If we areunable to adequately protect our intellectual property, we may not be able tocompete effectively.**

 

Werely on a combination of patent, copyright, trademark and trade secret laws andrestrictions on disclosure to protect our intellectual property rights. We alsoenter into confidentiality and/or license agreements with our employees,consultants and corporate partners. Despite our efforts to protect ourproprietary rights, unauthorized parties may copy or otherwise obtain and useour products or technology. Monitoring unauthorized use of our products isdifficult and we may not be aware that someone is using our rights without ourauthorization. In addition, the steps we have taken, and those we may take inthe future, may not prevent unauthorized use of our technology, particularly inforeign countries where the laws may not protect our proprietary rights asfully as in the United States.

 

Wemay be a party to intellectual property litigation in the future, either toprotect our intellectual property or as a result of alleged infringements ofothers’ intellectual property. For a discussion of our IP litigation, pleasesee Note 13 of the Consolidated Financial Statements.

 

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Theseor other claims and any resulting litigation or arbitration could subject us tosignificant costs, liability for damages or could cause our proprietary rightsto be invalidated or deemed unenforceable, which could allow third parties touse our rights without reservation. Litigation or arbitration, regardless of themerits of the claim or outcome, would likely be time consuming and expensive toresolve and would divert management time and attention.  Any potential intellectual propertylitigation filed against us could also force us to do one or more of thefollowing:

 

•                  stop using thechallenged intellectual property or selling our products or services thatincorporate it;

•                  obtain a licenseto use the challenged intellectual property or to sell products or servicesthat incorporate it, which license may not be available on reasonable terms, orat all; and

•                  redesign those products or services that arebased on or incorporate the challenged intellectual property.

 

Ifwe are forced to take any of these actions, we may be unable to manufacture andsell our products, our customer relationships would be seriously harmed and ourrevenue would be reduced.

 

InMarch 1999, we, as an EMC subsidiary, granted IBM a license to all of ourpatents under a cross license agreement between IBM and EMC. Under the terms ofthat agreement, effective upon EMC’s February 7, 2001 distribution of ourClass A common stock to its stockholders, the sublicense we previously held tothose IBM patents terminated. We believe that the termination of the sublicensedoes not materially affect our business. We are not aware of any issued orpending IBM patents that are infringed by our products, but if IBM were toallege any such infringement, and we were unable to negotiate a settlement withIBM, our ability to produce the alleged infringing product could be affected,which could materially and adversely affect our business.

 

**We haveexperienced increased inventory costs and delays and have incurredinventory-related write-downs.**

 

Duringfiscal year 2002, we incurred a net $9.5 million inventory related chargerelated primarily to our 1 Gb product inventory. There can be no assurance thatwe will not incur additional inventory write-downs in the future or that anysuch write-downs would not have a material adverse affect on our futureoperating results.

 

**Themulti-protocol SAN market in which we compete is still developing, and if thismarket does not continue to develop and expand as we anticipate, our businesswill suffer.**

 

Themarket for multi-protocol SAN and related products is still developing and continuesto evolve. Because this market is relatively new, it is difficult to predictits potential size or future growth rate. Potential end-user customers who haveinvested substantial resources in their existing data storage and managementsystems may be reluctant or slow to adopt a new approach, like multi-protocolSANs. Our success in generating net revenue in this developing market willtherefore depend on, among other things, our ability to:

 

•                  educatepotential OEMs, reseller and systems integrator customers and end users aboutthe benefits and the use of our products in the SAN environment; and

•                  predict, develop and base our products onstandards that ultimately become industry standards.

 

Accordingly,because substantially all of our revenues are derived from our Fibre ChannelSAN solutions, our ability to provide multi-protocol and multi-capable productsand solutions is critical to our future success and delays or a failure toprovide such products and solutions could have a material adverse effect on ourrevenue and operations.

 

**If we failto optimize our distribution channels and manage our distributionrelationships, our revenue or operating results could be significantlyreduced.  Our competitors may sell theirproducts directly to end-user customers.**

 

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Oursuccess will depend on our continuing ability to develop and managerelationships with significant OEMs, resellers and systems integrators, as wellas on the sales efforts and success of these customers. We cannot provideassurance that we will be able to expand our distribution channels or manageour distribution relationships successfully or that our customers will marketour products effectively. Our failure to expand our distribution channels ormanage successfully our distribution relationships or the failure of our OEMand reseller customers to sell our products could reduce our revenue andoperating results. Moreover, to the extent our competitors sell directly toend-user customers, we may not be able to compete given the lack of a directsales force and the current inability to directly provide first and secondlevel customer support. If this occurs, we may need to substantially invest ina direct sales force and direct customer support which would increase ourexpenses.

 

**We aredependent on a single or limited number of suppliers for certain key componentsof our products, and the failure of any of those suppliers to meet ourproduction needs could seriously harm our ability to manufacture our products,result in delays in the delivery of our products and harm our revenue.**

 

Wecurrently purchase several key components from single or limited sources. Wepurchase application specific integrated circuits (ASICs), special purposeprocessors and power supplies from single sources, and gigabit interfaceconverters and optic transceivers from limited sources. Additional sole orlimited sourced components may be incorporated into our products in the future.Delays in the delivery of components for our products could result in delays orthe inability to meet our customers’ demands and result in decreased revenue.We do not have any long-term supply contracts to ensure sources of supply ofcomponents. In addition, our suppliers may enter into exclusive arrangementswith our competitors, stop selling their products or components to us atcommercially reasonable prices or refuse to sell their products or componentsto us at any price, which could harm our operating results. Further, we havepurchased components from our suppliers from time to time that have beensubsequently found not to meet the supplier’s published specifications. If oursuppliers are unable to provide (or we are unable otherwise to obtain)components for our products on the schedule and in the quantities andquality we require, we will be unable to manufacture our products. We haveexperienced and may continue to experience production delays and qualitycontrol problems with certain of our suppliers, which, if not effectivelymanaged, could prevent us from satisfying our production requirements. If wefail to effectively manage our relationships with these key suppliers, or ifour suppliers experience delays, disruptions, capacity constraints or qualitycontrol problems in their manufacturing operations, our ability to manufactureand ship products to our customers could be delayed, and our competitiveposition, reputation, business, financial condition and results of operationscould be seriously harmed.

 

**The loss ofour contract manufacturers, or the failure to forecast demand accurately forour products or to manage our relationship with our contract manufacturerssuccessfully, would negatively impact our ability to manufacture and sell ourproducts.**

 

Werely on Sanmina SCI, Inc. (SSCI), Solectron Corporation, Pycon Incorporated,IBM and LSI Logic, together our contract manufacturers, to manufacture ourproducts. Our contract manufacturers are not obligated to supply products to usfor any specific period, or in any specific quantity, except as may be providedin a particular purchase order. In addition, our contract manufacturers do notguarantee that adequate capacity will be available to us within the timerequired to meet additional demand for our products. We generally place forecastsfor products with our contract manufacturers approximately four to five monthsprior to the anticipated delivery date, with order volumes based on forecastsof demand for our products. We generally place purchase orders sixty calendardays in advance of delivery. If we fail to forecast demand for our productsaccurately, we may be unable to obtain adequate manufacturing capacity from ourcontract manufacturers to meet our customers’ delivery requirements orunexpected increases in customer purchase orders. As a result, we may not beable to benefit from any incremental demand and could lose customers. If weover-estimate demand for our product, we may accumulate excess inventories andobligations to our contract manufacturers under binding purchase orders inexcess of our needs. At January 31, 2004, our commitment with our contractmanufacturers for purchases and anticipated transformation costs over the nextsixty days totaled approximately $48.1 million.

 

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Inaddition, we coordinate our efforts with those of our component suppliers andcontract manufacturers in order to rapidly achieve volume production. We haveexperienced and may continue to experience production delays and qualitycontrol problems with certain of our suppliers and with our contractmanufacturers, which, if not effectively managed, could prevent us fromsatisfying our production requirements on a timely basis and could harm ourcustomer relationships. If we should fail to manage effectively ourrelationships with our component suppliers or contract manufacturers, or if anyof our suppliers or our manufacturers experience delays, disruptions, capacityconstraints or quality control problems in their manufacturing operations, ourability to ship products to our customers could be delayed, and our competitiveposition and reputation could be harmed. Qualifying a new contract manufacturerand commencing volume production can be expensive and time consuming. If we arerequired to change or choose to change contract manufacturers, we may losesignificant revenue and seriously damage our customer relationships.

 

**Thecontinued general economic slowdown may significantly reduce expenditures oninformation technology infrastructure.**

 

Unfavorablegeneral economic conditions over the last 3 plus years have had a pronouncednegative impact on information technology, or IT, spending. Demand for SANproducts in the enterprise-class sector may continue to be adversely impactedas a result of the weakened economy and because larger businesses have begun tofocus on more efficiently using their existing IT infrastructure rather thanmaking new equipment purchases. This in turn may decrease the demand for ourSAN products. If there are further reductions in either domestic orinternational IT expenditure, or if IT expenditure does not increase fromcurrent levels, our revenues, operating results and financial condition may bematerially adversely affected.

 

**Failure tomanage expansion effectively could seriously harm our business, financialcondition and prospects.**

 

Ourability to successfully implement our business plan, develop and offerproducts, and manage expansion in a rapidly evolving market requires acomprehensive and effective planning and management process. We continue toincrease the scope of our operations domestically and internationally. Inaddition, in September 2003, we acquired Sanera and Nishan whichsignificantly increased the size of our operations.  Our growth in business and relationships with customers and otherthird parties has placed, and will continue to place, a significant strain onmanagement systems, resources, intercompany communication and coordination. Aswe grow, our failure to maintain and to continue to improve upon our operational,managerial and financial controls, reporting systems, processes and procedures,and /or our failure to continue to expand, train, and manage our work forceworldwide, could seriously harm our business and financial results.

 

**If we failto successfully develop the McDATA brand, our revenue may not grow.**

 

Ourname is not widely recognized as a brand in the marketplace given our indirectsales model. We believe that establishing and maintaining the McDATA brand is acritical component in maintaining and developing strategic OEM, reseller andsystems integrator relationships, and the importance of brand recognition willincrease as the number of vendors of competitive products increases. Ourfailure to successfully develop our brand may prevent us from expanding ourbusiness and growing our revenue. Similarly, if we incur excessive expenses inan attempt to promote and maintain the McDATA brand, our business, financialcondition and results of operations could be seriously harmed.

 

**Undetectedsoftware or hardware defects in our products could result in loss of or delayin market acceptance of our products and could increase our costs or reduce ourrevenue.**

 

Ourproducts may contain undetected software or hardware errors when firstintroduced or when new versions are released. Our products are complex, and wehave from time to time detected errors in existing

 

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products. In addition, ourproducts are combined with products from other vendors. As a result, shouldproblems occur, it might be difficult to identify the source of the problem.These errors could result in a loss of or delay in market acceptance of ourproducts, cause delays in delivering our products or meeting customer demandsand would increase our costs, reduce our revenue and cause significant customerrelations problems. Errors could also result in the need for us to upgradeexisting products at customer locations which would increase our costs or causesignificant customer relations problems.

 

**We are adefendant in a class action lawsuit and we may be subject to further litigationin the future which could seriously harm our business.**

 

Asmore fully set forth in Note 13 to our Consolidated Financial Statements, weare a defendant in a consolidated securities class action know as *In Re Initial Public Offering Securities Litigation(SDNY).*We may become subject to additional class action litigationfollowing a period of volatility in the market price of our common stock.  Securities class action litigation resultsin substantial costs and diverts the attention of management and our resourcesand seriously harms our business, financial condition and results ofoperations.

 

**Our changeof fiscal year may not result in more predictable quarterly earnings.**

 

Historically,our quarterly operating results have depended on our performance in the laterpart of each calendar quarter, when a large percentage of our product shipmentstypically occur. This fluctuation has made consistent quarter-to-quarter performanceand revenue forecasting difficult. We have adopted a number of measures toaddress this issue, including changing our fiscal year end to January 31,rather than December 31. We cannot be certain that changing our fiscalyear or adopting other measures will result in product shipments occurring moreevenly during each quarter, resulting in consistent quarter-to-quarterperformance or improving revenue forecasts.

 

Additionalfactors that affect us and which could cause our revenue and operating resultsto vary in future periods include:

 

•                  the size,timing, terms and fluctuations of customer orders, particularly large ordersfrom EMC,  IBM or HDS;

•                  pricingdiscussions late in a quarter and a limited capability to ramp shipments nearthe end of that quarter;

•                  our ability toattain and maintain market acceptance of our products;

•                  seasonalfluctuations in customer buying patterns;

•                  the timing ofthe introduction of or enhancement to, products by us, our significant OEM orreseller customers or our competitors (e.g., transition to higher speed, higherport density and multi-protocol products);

•                  our ability to obtain sufficient supplies ofsingle- or limited-source components of our products; and

•                  increased operating expenses, particularly inconnection with our strategies to increase customer touch and purchasepreference for our products or to invest in research and development.

 

Ouruneven sales pattern makes it difficult for our management to predict near-termdemand and adjust manufacturing capacity. Further, our OEM and resellerpartners may purchase certain of our products ahead of end-user customerdemand, which could reduce subsequent purchases by those partners. Accordingly,if orders for our products vary substantially from the predicted demand, ourability to assemble, test and ship orders received in the last weeks and daysof each quarter may be limited, which could seriously harm quarterly revenue orearnings. Moreover, an unexpected decline in revenue without a correspondingand timely reduction in expenses could intensify the impact of these factors onour business, financial condition and results of operations.

 

**The salescycle for our products is long, and we may incur substantial non-recoverableexpenses and devote significant resources to prospects that do not producerevenues in the foreseeable future or at all.**

 

18

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OurOEMs, reseller and systems integrator customers typically conduct significantevaluation, testing, implementation and acceptance procedures before they beginto market and sell new solutions that include our products. This evaluationprocess is lengthy and may extend up to one year or more. This process iscomplex and may require significant sales, marketing and management efforts onour part. This process becomes more complex as we simultaneously qualify ourproducts with multiple customers. As a result, we may expend significantresources to develop customer relationships before we recognize revenue, ifany, from these relationships. Products that are not qualified by storage andsystem OEMs and resellers, may not gain market acceptance.  Our OEM and reseller customers have multiplesources for products similar to ours, and as such, may not qualify our productsfor any number of reasons.

 

**We mayengage in future acquisitions that dilute our stockholders ownership and causeus to use cash, incur debt or assume contingent liabilities.**

 

Aspart of our strategy, from time to time we expect to review opportunities tobuy other businesses or technologies that would complement our currentproducts, expand the breadth of our markets or enhance our technicalcapabilities, or that may otherwise offer growth opportunities. We may buybusinesses, products or technologies in the future. In the event of any futurepurchases, we could:

 

•                  issue stock thatwould dilute our current stockholders’ percentage ownership;

•                  use cash, whichmay result in a reduction of our liquidity;

•                  incur debt; or

•                  assume liabilities.

 

Thesepurchases also involve numerous risks, including:

 

•                  problemscombining and integrating the purchased operations, technologies, personnel orproducts;

•                  unanticipatedcosts;

•                  diversion ofmanagement’s attention from our core business;

•                  adverse effectson existing business relationships with suppliers and customers;

•                  risks associatedwith entering markets in which we have no or limited prior experience; and

•                  potential loss of key employees of acquiredorganizations.

 

Wemay not be able to successfully integrate any businesses, products,technologies or personnel that we might acquire in the future. In addition,technology acquisitions of start-up companies could result in one-time chargesrelated to acquisition costs, severance costs, employee retention costs andin-process research and development.

 

**We mayrequire, or could elect, to seek additional funding.**

 

Ourfuture capital requirements will depend on many factors, including our rate ofrevenue growth, the timing and extent of spending to support development of newproducts and expansion of sales and marketing, the timing of new productintroductions and enhancements to existing products, any acquisitions ofbusinesses, and market acceptance of our products. With changes in operatingand industry expectations, we could require, or could elect, to seek additionalfunding including accessing the equity and debt markets.

 

**If webecome subject to unfair hiring claims, we could incur substantial costs indefending ourselves.**

 

Companiesin our industry whose employees accept positions with competitors frequentlyclaim that their competitors have engaged in unfair hiring practices or thatemployees have misappropriated confidential information or trade secrets.Because we often seek to hire individuals with relevant experience in ourindustry, we may be subject to claims of this kind or other claims relating toour employees in the future. We could incur substantial costs in defendingourselves or our employees against such claims, regardless of their merits.  In

 

19

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addition, defendingourselves or our employees from such claims could divert the attention of ourmanagement away from our operations.

 

**Ourproducts must comply with governmental regulation.**

 

Inthe United States, our products comply with various regulations and standardsdefined by the Federal Communications Commission and Underwriters Laboratories.Internationally, products that we develop will be required to comply withstandards established by authorities in various countries. In the last severalyears, the European Union (EU) has adopted a number of initiatives (WEEE, RoHS,etc.) related to equipment emissions, electronic waste, privacy of informationand expanded consumer warranties. Failure to comply with existing or evolvingindustry standards or to obtain timely domestic or foreign regulatory approvalsor certificates could seriously harm our business.

 

**Provisionsin our charter documents, our rights agreement and Delaware law could preventor delay a change in control of McDATA and may reduce the market price of ourcommon stock.**

 

Provisionsof our certificate of incorporation, by-laws and rights agreement maydiscourage, delay or prevent a merger, acquisition or other businesscombination that a stockholder may consider favorable. These provisionsinclude:

 

•                  authorizing theissuance of preferred stock without stockholder approval;

•                  providing for aclassified board of directors with staggered three year terms;

•                  limiting thepersons who may call special meetings of stockholders;

•                  requiring super-majority voting forstockholder action by written consent;

•                  establishingadvance notice requirements for nominations for election to the board ofdirectors and for proposing other matters that can be acted on by stockholdersat stockholder meetings;

•                  prohibitingcumulative voting for the election of directors;

•                  requiringsuper-majority voting to effect certain amendments to our certificate ofincorporation and by-laws; and

•                  requiring parties to request board approvalprior to acquiring 15% or more of the voting power of our common stock to avoideconomic and voting dilution of their stock holdings.

 

Weare incorporated in Delaware and certain provisions of Delaware law may alsodiscourage, delay or prevent someone from acquiring or merging with us, whichmay cause the market price of our common stock to decline.

 

**Our stockprice is volatile.**

 

Themarket price of our common stock has been volatile. Because we are a technologycompany, the market price of our common stock is usually subject to similarvolatility and fluctuations that occur in our sector and to our competitors.This volatility is often unrelated or disproportionate to the operatingperformance of our company and, as a result, the price of our common stock couldfall regardless of our performance.

 

***Risks Related to Our Relationship With EMC***

 

**We haveentered into agreements with EMC that, due to our prior parent-subsidiaryrelationship, may contain terms less beneficial to us than if they had beennegotiated with unaffiliated third parties.**

 

InOctober 1997, and in connection with the reorganization of our business,we entered into certain agreements with EMC relating to our businessrelationship with EMC. In addition, we have entered into agreements with EMCrelating to our relationship with EMC after the completion of our initialpublic offering in August 2000 and the distribution by EMC of our Class Acommon stock in February 2001. We have also entered into an OEM Purchaseand License Agreement with EMC that governs EMC’s purchases of our products and

 

20

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grants EMC rights to use,support and distribute software for use in connection with these products. Theagreement does not provide for the purchase of a guaranteed minimum amount ofproduct. These agreements were negotiated and made in the context of our priorparent-subsidiary relationship. As a result, some of these agreements may haveterms and conditions, including the terms of pricing, that are less beneficialto us than agreements negotiated with unaffiliated third parties. Sales andservices revenue pursuant to these agreements with EMC representedapproximately 56% of our revenue for the fiscal year ended January 31,2004. In addition, in some instances, our ability to terminate these agreementsis limited, which may prevent us from being able to negotiate more favorableterms with EMC or from entering into similar agreements with third parties.

 

**Provisionsof our agreements with EMC relating to our relationship with EMC after thedistribution of our Class A common stock to EMC’s stockholders may prevent achange in control of our company.**

 

Underthe terms of the May 2000 Master Confidential Disclosure and License Agreementbetween EMC and us, EMC has granted us a license to then existing EMC patentsand we granted to EMC a license to then existing McDATA patents. If we areacquired, our acquirer will retain this license as long as our acquirer grantsto EMC a license under all of the acquirer’s patents for all products licensedunder the agreement under the same terms as the license we have granted to EMCunder the agreement. The potential loss of the license from EMC under thisagreement could decrease our attractiveness as an acquisition target.

 

**We may beobligated to indemnify EMC if the distribution of our Class A common stock toEMC’s stockholders was not tax free.**

 

TheMay 2000 Tax Sharing Agreement that we have entered into with EMC obligates usto indemnify EMC for taxes relating to the failure of EMC’s distribution toEMC’s stockholders of our Class A common stock to be tax free if that failureresults from, among other things:

 

•                  any act oromission by us that would cause the distribution to fail to qualify as atax-free distribution under the Internal Revenue Code;

•                  any act oromission by us that is inconsistent with any representation made to theInternal Revenue Service in connection with the request for a private letterruling regarding the tax-free nature of the distribution by EMC of our Class Acommon stock indirectly held by it to its stockholders;

•                  any acquisitionby a third party of our stock or assets; or

•                  any issuance byus of stock or any change in ownership of our stock.

 

While the risk associated with the Company’sobligations under the Tax Sharing Agreement should diminish over time, theCompany’s tax years covered by the agreement, as it relates to theDistribution, will remain open to examination by the IRS for at least threeyears from the date the returns for those years were filed.

 

21

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**ITEM 2****. Properties**

 

Our principal facilities for administration, sales, marketing, customersupport, manufacturing, engineering and research and development are describedbelow.

 
| **Location**                                                                      |   | **Size**                     |   | **Lease  Termination**                  |   | **General Use**                                        |
|-----------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------------------------------|--------|--------------------------------------------------------|
|                                                                              |   |                         |   |                                    |   |                                                   |
| 1. 380 Interlocken Crescent, Broomfield, CO                                       |   | 100,207 sq.ft                |   | April 2006                         |   | Admin, Sales, Support                                  |
| 2. 1722 Boxelder Street, Louisville CO (1)  Intended to commence March 2004: |   | 91,497 sq. ft 45,552 sq. ft  |   | March 2004  March 2009   |   | Manufacturing, Product Test Facility                   |
| 3. 4 McDATA parkway, Broomfield, CO                                               |   | 164,984 sq. ft               |   | Owned                                   |   | Engineering, Labs, Education and Support               |
| 4. 4555 Great America Parkway, Santa Clara,  CA (2)  Newly amended to:            |   | 23,542 sq. ft 103,622 sq. ft |   | June 2010  November 2016 |   | Software Development SW, Engineering, Labs and Support |
| 5. 3850 N. 1st Street, San Jose, CA (Nishan)                                      |   | 48,000 sq. ft                |   | August 2004                        |   | Engineering, Labs, Support, and G&A                |
| 6. 370 San Aleso Ave., Sunnyvale, CA (Sanera)                                     |   | 32,538 sq. ft                |   | July 2005                          |   | Engineering & Labs, G&A                        |
| 7. 105 Commerce Valley Dr. West, Markham, ON (3)                                  |   | 19,045 sq. ft                |   | June 2009                          |   | Engineering & Labs                                 |

 

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(1)          We are in the process of negotiating a newlease that will reduce the size of our rented space at 1722 BoxelderStreet.  We have signed a letter ofintent with the building owner that specifies a reduction of space down to46,184 sq. ft and a new lease term of 5 years. We intend for the new lease to terminate in March 2009.  The new lease will also provide for an earlytermination option in March 2007 in exchange for a 1-time payment if wechoose to exercise this option.

 

(2)          We have recently signed a lease amendmentwhich increases the size of our rented space and lengthens the term of ourlease at 4555 Great America Parkway.  Weintend to consolidate our three major California facilities into the newlyleased space at 4555 Great America Parkway. It is our current intent to complete this consolidation byAugust 2004.  The new lease alsoprovides for early termination options in June 2010 and June 2011 inexchange for a 1-time payment if we choose to exercise either of those options.

 

(3)          We are in the process of closing thisfacility as part of our January 2004 restructuring plan.  We are subject to a long-term leaseobligation with regard to this facility.

 

In addition to the facilities discussed above, we also lease smallersales, marketing and administrative office space in various locationsthroughout the world.

 

22

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**ITEM 3****. Legal Proceedings**

 

Fromtime to time, we become involved in various lawsuits and legal proceedings thatarise in the normal course of business. Litigation is subject to inherent risksand uncertainties and an adverse result in a matter that may arise from time totime may harm our business, financial condition or results of operations. Whileit is the current opinion of management that the ultimate disposition of any ofthe lawsuits described herein should not have a material adverse effect on ourbusiness, financial condition or results of operations, we are incurringsignificant legal costs and expenses, and such litigation is subject toinherent risks and uncertainties. Please see Note 13 of the Notes to theConsolidated Financial Statements for a description of significant litigationmatters.

 

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

 

No shareholder meeting was held in the fourth quarter of 2003. Weintend to hold our annual meeting of shareholders in September of 2004.Accordingly, shareholder proposals for inclusion in the annual meeting proxystatement should have been sent to our Secretary at 380 Interlocken Crescent,Broomfield, Colorado 80021 and must have been received by February 16,2004.

 

**PARTII**

 

**ITEM 5****. Market for Registrant’s Common Equity and RelatedStockholder Matters**

 

Our Class B common stock has been quoted on theNasdaq National Market under the symbol “MCDT” since our initial publicoffering on August 9, 2000. Our Class A common stock has been quotedon the Nasdaq National Market under the symbol “MCDTA” since EMC’s distributionof that stock on February 7, 2001. Prior to those respective times therewas no public market for either class of stock.

 

We currently expect to retain future earnings, ifany, for use in the operation and expansion of our business and we have notdeclared or paid any cash dividends on our capital stock since inception, anddo not anticipate paying any cash dividends in the foreseeable future. AtApril 2, 2004, there were approximately 10,500 stockholders of record ofour Class A common stock and approximately 348 stockholders of record ofour Class B common stock.

 

The following table sets forth the range of high andlow bid quotation per share of our Class A and Class B common stockreported on the Nasdaq National Market during fiscal 2003 and 2002:

 
|                                 |   | **Class A** |   | **Class B** |   |
|--------------------------------------|--------|------------------|--------|------------------|--------|
|                                 |   | **High**         |   | **Low**          |   | **High** |   | **Low** |   |
| *Year Ended  December 31, 2002* |   |             |   |             |   |   |   |   |   |
| January - March                 |   | $                | 32.45  |             | $      | 11.08 |   | $ | 33.11 |   | $ | 11.41 |   |
| April - June                    |   | $                | 12.99  |             | $      | 5.88 |   | $ | 13.26 |   | $ | 6.11 |   |
| July - September                |   | $                | 11.02  |             | $      | 5.43 |   | $ | 11.30 |   | $ | 5.49 |   |
| October - December              |   | $                | 8.99   |             | $      | 4.40 |   | $ | 8.29 |   | $ | 4.35 |   |
|                                 |   |             |   |             |   |   |   |   |   |
| *Year Ended  January 31, 2004** |   |             |   |             |   |   |   |   |   |
| January                              |   | $                | 10.23  |             | $      | 7.07 |   | $ | 10.25 |   | $ | 7.02 |   |
| February - April                |   | $                | 10.76  |             | $      | 7.00 |   | $ | 10.79 |   | $ | 7.05 |   |
| May - July                           |   | $                | 15.88  |             | $      | 9.21 |   | $ | 15.79 |   | $ | 9.19 |   |
| August - October                |   | $                | 13.15  |             | $      | 10.05 |   | $ | 12.93 |   | $ | 9.89 |   |
| November - January              |   | $                | 10.95  |             | $      | 8.09 |   | $ | 10.88 |   | $ | 8.10 |   |

 

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* McDATA changed its fiscal year end to January 31.  The corresponding fiscal quarter ends areApril 30, July 31, October 31 and January 31.

 

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InMay 2003, the Company’s Board of Directors authorized a plan for the Company torepurchase up to $50 million of its common stock (Class A, Class B or acombination thereof). This repurchase plan does not obligate the Company toacquire any specific number of shares or acquire shares over any specifiedperiod of time. At January 31, 2004, approximately 976,000 shares havebeen repurchased under the plan with a total cost at $8.8 million, as morefully described below.

 
| **Period**                 |   | **Total  number of  shares (or units)  purchased*** |   | **Average price paid  per share (or unit)*** |   | **Total  number of  shares (or units)  purchased as part of  publicly announced  plans or program** |   | **Maximum  number (or  approximate dollar value) of  shares (or units) that may yet  be purchased under the plans or  programs**** |   |
|----------------------------|--------|-----------------------------------------------------|--------|----------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------|--------|
| December 15-16,  2003 |   | 678,574 Class A                                     |   | $8.99                                        |   | 678,574 Class A                                                                                     |   | $41.25 Million                                                                                                                     |   |
| December 15-16,  2003 |   | 297,156 Class B                                     |   | $8.93                                        |   | 297,156 Class B                                                                                     |   | $41.25 Million                                                                                                                     |   |

 

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(*) Inclusive of commissions.

(**) No more than $41.25 million of Class A common stock, Class Bcommon stock or a combination thereof may be purchased.

 

**ITEM 6****. Selected Financial Data**

 

You should read the following selected consolidated financial data inconjunction with our consolidated financial statements and related notes and *“Management’s Discussion and Analysis of FinancialCondition and Results of Operations,”* and other financialinformation appearing elsewhere in this Annual Report. The consolidated incomestatement data set forth below with respect to the fiscal years endedJanuary 31, 2004, December 31, 2002, and 2001, and the consolidatedbalance sheet data as of January 31, 2004 and December 31, 2002, arederived from our audited financial statements appearing in Item 8. Theconsolidated income statement data set forth below with respect to the fiscalyears ended December 31, 2000 and 1999, and the consolidated balance sheetdata as of December 31, 2001, 2000 and 1999 were derived from auditedfinancial statements not included herein. Historical results are notnecessarily indicative of the results of any future period.

 
|                                                          |   | **Year Ended  January 31,**          |    | **Years Ended December 31,** |   |
|---------------------------------------------------------------|--------|-------------------------------------------|---------|-----------------------------------|--------|
|                                                          |   | **2004 (1)**                              |    | **2002**                          |   | **2001** |   | **2000** |   | **1999** |   |
|                                                          |   | **(in thousands, except per share date)** |    |
| **Consolidated Income  Statement Data:**                      |   |                                      |    |                              |   |   |   |   |   |   |   |
| Total revenue                                                 |   | $                                         | 418,860 |                              | $      | 328,279 |   | $ | 344,406 |   | $ | 248,686 |   | $ | 95,263 |   |
| Total cost of revenue                                         |   | 177,329                                   |    | 178,114                           |   | 215,751 |   | 119,543 |   | 50,280 |   |
| Gross profit                                                  |   | 241,531                                   |    | 150,165                           |   | 128,655 |   | 129,143 |   | 44,983 |   |
| Total operating expenses (2)                                  |   | 249,340                                   |    | 172,312                           |   | 156,578 |   | 85,724 |   | 45,913 |   |
| Income (loss) from operations (2)                             |   | (7,809                                    | )       | (22,147                           | )      | (27,923 | ) | 43,419 |   | (930 | ) |
| Net income (loss)                                             |   | $                                         | (43,133 | )                                 | $      | (9,987 | ) | $ | (8,656 | ) | $ | 30,764 |   | $ | (1,616 | ) |
|                                                          |   |                                      |    |                              |   |   |   |   |   |   |   |
| Basic net income (loss) per share                             |   | $                                         | (0.38   | )                                 | $      | (0.09 | ) | $ | (0.08 | ) | $ | 0.31 |   | $ | (0.02 | ) |
| Diluted net income (loss) per share                           |   | $                                         | (0.38   | )                                 | $      | (0.09 | ) | $ | (0.08 | ) | $ | 0.28 |   | $ | (0.02 | ) |
|                                                          |   |                                      |    |                              |   |   |   |   |   |   |   |
| Shares used in computing basic net income  (loss) per share   |   | 114,682                                   |    | 113,185                           |   | 111,475 |   | 99,989 |   | 91,638 |   |
| Shares used in computing diluted net income  (loss) per share |   | 114,682                                   |    | 113,185                           |   | 111,475 |   | 107,953 |   | 91,638 |   |

 

24

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|                                   |   | **January 31,** |    | **December 31,** |   |
|----------------------------------------|--------|----------------------|---------|-----------------------|--------|
|                                   |   | **2004 (1)**         |    | **2002**              |   | **2001** |   | **2000** |   | **1999** |   |
|                                   |   | **(in thousands)**   |    |
| **Consolidated  Balance Sheets Data:** |   |                 |    |                  |   |   |   |   |   |   |   |
| Total assets (3)                       |   | $                    | 830,968 |                  | $      | 555,191 |   | $ | 513,953 |   | $ | 511,369 |   | $ | 48,424 |   |
| Working capital (3)                    |   | 195,708              |    | 283,627               |   | 277,471 |   | 404,359 |   | 15,813 |   |
| Long-term portion of obligations (4)   |   | 173,591              |    | 1,540                 |   | 789 |   | 1,624 |   | 3,075 |   |
| Total stockholders’ equity        |   | 417,642              |    | 474,505               |   | 469,791 |   | 453,813 |   | 29,624 |   |
|                                        |        |                      |         |                       |        |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          On January 15, 2003, the Company changedits fiscal year to end on January 31 rather than December 31.  We believe that the twelve months endedDecember 31, 2002 and 2001 provide a meaningful comparison to the twelvemonths ended January 31, 2004.

 

(2)          In fiscal 2003, we incurred restructuring costsand acquisition-related charges totaling approximately $13.7 million.  In 2001, we incurred acquisition-relatedcharges of $9.3 million.

 

(3)          Reflects approximately $127 million incurrent assets and current liabilities related to our securities lendingprogram entered into during fiscal 2003.

 

(4)          Includes long-term convertible debt issuedduring fiscal 2003, notes payable acquired in fiscal 2003 with our acquisitionof Nishan and Sanera, and capital leases, excluding current portion.

 

**ITEM 7****. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*This section of the Annual Report onForm 10-K discusses the comparative year over year results of our operations,our liquidity and financial condition, our risk management practices and ourcritical accounting policies.  Youshould read the following discussion and analysis in conjunction with theconsolidated financial statements and related notes that are included insections F-3 through F-34 of this document.*

 

# **Overview**

# ** **

## ***Change of Fiscal Year***

## ** **

On January 15, 2003, we changed our fiscal yearend to January 31, from December 31. We believe that the twelvemonths ended December 31, 2002 and 2001 provide a meaningful comparison tothe twelve months ended January 31, 2004. There are no factors, of whichwe are aware, seasonal or otherwise, that would impact the comparability ofinformation or trends, if results for the twelve months ended January 31,2003 and 2002 were presented in lieu of results for the twelve months ended December 31,2002 and 2001. References in this discussion to fiscal 2003 represent thetwelve months ended January 31, 2004. References to fiscal 2002 and 2001represent the twelve months ended December 31, 2002 and 2001.

 

# ***Revenue Growth and Competitive Industry***

# ** **

Our revenue for the fiscal year ended January 31, 2004 representeda 28% increase over fiscal year 2002 and a 22% increase from fiscal year2001.  This year over year revenuegrowth was driven by strong demand for our new IntrepidTM, SphereonTMand Eclipse® director and switch products, as well as increased sales of oursoftware and services products.  Inaddition, we broadened our channel mix with the addition of HDS as a greaterthan 10% customer and initial sales to two new OEMs, Sun and STK.  This revenue growth has occurred while themarket for our SAN products and solutions has grown more competitive with (a)the entrance of new competitors into our market, (b) pricing pressuresresulting from an increase in competitive products and solutions, (c) challengesto our direct-assist sales model, and (d) anticipated competition from our ownstorage OEM partners through their recent acquisitions of, or alliances with,competitive software management products and/or application providers thatwould utilize the intelligence in the network. These market conditions presentunique risks and uncertainties in a number of respects.  In particular, we anticipate continuedlengthened sales cycles and downward pricing pressures that could negativelyimpact our revenue growth rate. Moreover, revenue

 

25

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growth in 2004 is dependenton the introduction of our new products. We are currently proceeding with the development of new products, whichincorporate the new technologies from our acquisitions of Nishan and Sanera. Inaddition, we are taking action to continue sales of existing products acquiredin connection with our acquisition of Nishan. As with any product introduction, we face risks in the design, testing,qualification and market acceptance our new products.  Some of the products we are developing may be more complex andfeature-rich than our current products, and some of the development on thoseproducts was undertaken externally prior to the Nishan and Sanera acquisitions.  If we fail to timely introduce new products,or if there is no demand for these or our current products, we may experience adecline in revenue.

 

Inaddition to the recent increased competition in the industry, we haveexperienced a migration in the buying patterns of our customers from configureddirector products to non-configured product sales including our switchproducts, port cards, and our FlexPort upgrades.  Our OEM and reseller partners may purchase certain of thesecomponent products ahead of end-user demand, which could reduce subsequentpurchases by those partners.  Variationsin the buying patterns of our customers would limit our ability to assemble,test and ship orders received in the last weeks and days of each quarter andcould cause fluctuations in our quarterly revenue or earnings.  Moreover, an unexpected decline in revenuewithout a corresponding and timely reduction in expenses could intensify theimpact of these factors on our business, financial condition and results of operations.

 

# ***Acquisitions***

# ** **

On September 19, 2003, we completed ouracquisition of all of the outstanding stock of Nishan, a provider ofmulti-protocol native IP storage switching solutions that builds open storagenetworking products based on IP and Ethernet, both international networkingstandards.  On September 30, 2003,we completed our acquisition of all of the outstanding stock of Sanera, aproducer of intelligent director class switching platform technologies.  The results of operations discussed below reflectthe operating results of Nishan and Sanera from the dates of acquisition.

 

OnAugust 22, 2003, the Company purchased 13.6 million shares of preferredstock of Aarohi Communications (Aarohi). At January 31, 2004, thisrepresented approximately 17.3% of the total outstanding shares of Aarohi.  The shares were acquired at a total cost of$6 million. Approximately $3.6 million of this purchase price was determined torepresent in-process research and development and, as such, management of theCompany has expensed this amount during fiscal year 2003.  Inaddition to the equity investment, we have entered into a non-exclusive supplyarrangement with Aarohi to purchase their ASIC chip for inclusion in theCompany’s new product launches when, and if, Aarohi’s product becomes generallyavailable.  We have recorded our share of Aarohi’s netloss of approximately $984,000 from the date of purchase throughJanuary 31, 2004.

 

***Restructuring Activities***

 

In January 2004, we announced that we were taking certain costimprovement actions, which included a workforce reduction and facilityconsolidation. As a result, in the fiscal fourth quarter of 2003, the Companyrecorded an approximate $2.3 million restructuring charge related to thereduction in workforce. In addition, we expect to incur an approximate $2.2million restructuring charge in our fiscal first quarter of 2004, primarilyrelated to a facilities closure, as well as additional severance costs.

 

**Results of Operations**

 

The following table sets forth certain financial data for the periodsindicated as a percentage of total revenues.

# ** **

|                                                                                     |   | **Year Ended  January 31,** |   | **Years Ended December 31,** |   |
|------------------------------------------------------------------------------------------|--------|----------------------------------|--------|-----------------------------------|--------|
|                                                                                     |   | **2004**                         |   | **2002**                          |   | **2001** |   |
|                                                                                     |   |                             |   |                              |   |   |   |
| Revenue                                                                                  |   | 100.0                            | %      | 100.0                             | %      | 100.0 | % |
| Cost of revenue                                                                          |   | 42.3                             |   | 54.2                              |   | 62.6 |   |
| Gross profit                                                                             |   | 57.7                             |   | 45.8                              |   | 37.4 |   |
| Operating Expenses:                                                                      |   |                             |   |                              |   |   |   |
| Research and development                                                                 |   | 21.2                             |   | 18.1                              |   | 14.3 |   |
| Selling and marketing                                                                    |   | 22.9                             |   | 22.9                              |   | 20.5 |   |
| General and administrative                                                               |   | 9.3                              |   | 9.0                               |   | 5.9 |   |
| Acquired in-process research & development and other  acquisition related costs |   | 2.7                              |   | —                            |   | 2.7 |   |
| Amortization of deferred compensation                                                    |   | 2.9                              |   | 2.5                               |   | 2.1 |   |
| Restructuring charges                                                                    |   | 0.6                              |   | —                            |   | — |   |
| Operating expenses                                                                       |   | 59.6                             |   | 52.5                              |   | 45.5 |   |
| Loss from operations                                                                     |   | (1.9                             | )      | (6.7                              | )      | (8.1 | ) |
| Interest and other income, net                                                           |   | 1.0                              |   | 2.0                               |   | 4.1 |   |
| Loss before income taxes                                                                 |   | (0.9                             | )      | (4.7                              | )      | (4.0 | ) |
| Income tax expense (benefit)                                                             |   | 9.2                              |   | (1.7                              | )      | (1.5 | ) |
| Loss before equity in net loss of affiliated company                                     |   | (10.1                            | )      | (3.0                              | )      | (2.5 | ) |
| Equity in net loss of affiliated company                                                 |   | (0.2                             | )      | —                            |   | — |   |
| Net loss                                                                                 |   | (10.3                            | )%     | (3.0                              | )%     | (2.5 | )% |

 

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**Revenues**

 
|                         |   | **Year Ended****January 31,** |       | **Years Ended December 31,** |   |
|------------------------------|--------|------------------------------------|------------|-----------------------------------|--------|
|                         |   | **2004**                           |       | **2002**                          |   | **2001** |   |
|                         |   | **(in millions)**                  | ** ** |
| Product revenue              |   | $                                  | 360.1      |                              | $      | 284.1 |   | $ | 300.3 |   |
| Software and service revenue |   | 41.7                               |       | 29.8                              |   | 27.5 |   |
| Other                        |   | 17.1                               |       | 14.4                              |   | 16.6 |   |
|                         |   | $                                  | 418.9      |                              | $      | 328.3 |   | $ | 344.4 |   |

 

Our revenue for the year ended January 31, 2004 was $418.9million, which represented a 28% increase over fiscal year 2002 and a 22%increase from fiscal year 2001.  Thisincrease in revenue reflects strong demand for our switching and softwareproducts. Although we continue to see solid end-user demand and increasedyear-over-year revenue for our products and solutions, the on-going competitivemarketplace is expected to create a challenging sales environment for theforeseeable future. Given the entrance of new competitors and products in ourindustry, we anticipate longer sales cycles and price declines that couldnegatively impact our revenue growth rate.

 

Product revenue of $360.1 million for fiscal year 2003 was a 27%increase over fiscal year 2002 and a 20% increase from fiscal year 2001.  This revenue increase was generated from theincreased demand in our storage products, in particular our 140-port IntrepidTM 6000 Series Director andFlexPort SphereonTM4500 Fabric Switch that were introduced in the last half of 2002.  Our fiscal year 2002 revenue was negativelyimpacted by the unfavorable economic conditions and suppressed IT storage andinfrastructure spending, in particular in the high-end director market and ourtransition from 1 Gb to 2 Gb products in the first half of 2002.  This environment had a particularly negativeeffect on our product revenue which declined from fiscal year 2001 levels.  Our new product introductions in the lasthalf of 2002, however, were widely received with higher than expected demandand revenue.

 

Software and service revenue of $41.7 million for fiscal year 2003 wasa 40% increase over fiscal year 2002 and a 52% increase from fiscal year 2001.  This revenue growth is due tocontinued revenue growth from all of our software products, in particular ourSANavigator® and SANtegrity® software. A significantportion of our software revenue is generated from sales of our EnterpriseFabric Connectivity Manager, or EFCM, software product.

 

Other revenues for the 2003 year, including servicefees earned under an ESCON Service agreement with EMC, were $17.1 million infiscal year 2003.  This represents a 19%increase from fiscal year 2002 and a 3%

 

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increase from fiscal year 2001. This increasereflects the growth in maintenance fees, which outpaced the decline in servicefees related to the ESCON products.  Wecontinue to realize increased attached rates of our extended maintenancecontracts to sales of our switching and software solutions.  We anticipate that service revenue from EMCunder the ESCON service agreement will continue to decrease in future years.

 

A significant portion of our revenue is concentrated with the largeststorage OEMs. For the year ended January 31, 2004, approximately 56% ofour total revenue came from EMC, compared to 54% and 69% for fiscal years 2002and 2001 respectively.  IBM contributedapproximately 21% of our revenue for fiscal year 2003 compared to 25% and 17%for fiscal years 2002 and 2001, respectively.  In addition, in 2003 HDS became our third largest OEM customer andcontributed approximately 10% of total revenue for the year endedJanuary 31, 2004.  McDATA solutionsare offered by other major storage and system vendors, including Dell, HP, STKand Sun. In addition to our storage and system vendors, we have relationshipswith many resellers, distributors and systems integrators. Expanding ourreseller, distributor and system integrator channels into Small MediumEnterprise (SME) and vertical markets will be a strategic focus for us as wecontinue to expand our business, however, the level of sales to any singlecustomer may vary and the loss of any one significant customer, or a decreasein the level of sales to any significant or group of significant customers,could harm our financial condition and results of operations. Given thedependencies on our limited number of OEM resellers combined with anincreasingly competitive environment, we may experience continued adverse pricepressures at critical times near the end of the fiscal quarters.

 

Domestic and international revenue was approximately 67% and 33% of ourtotal revenue, respectively, for the fiscal year ended January 31,2004.  For the year endedDecember 31, 2002, domestic and international revenue was approximately63% and 37% of our total revenue, respectively.  For the year ended December 31, 2001, domestic andinternational revenue was approximately 76% and 24% of our total revenue,respectively.  Revenues areattributed to geographic areas based on the location of the customers to whichour products are shipped. International revenues primarily consist of sales tocustomers in Western Europe and the greater Asia Pacific region. Included indomestic revenues are sales to certain OEM customers who take possession of ourproducts domestically and then distribute these products to their internationalcustomers. In addition, included in revenues from Western Europe are sales tocertain OEM customers who take possession of our products in distributioncenters designated for international-bound product and then distribute theseproducts among various international regions. Our mix of international anddomestic revenue can, therefore, vary depending on the relative mix of sales tocertain OEM customers. The increase in international revenues as a percentageof revenue for fiscal year 2002 was the result of a large domestic orderreduction by EMC during the first quarter of that year associated with thetechnology transition to 2 Gb products.

 

**Gross Profit**

 

Gross profit for the fiscal year 2003 was 58% compared to 46% and 37%in fiscal years 2002 and 2001, respectively. The significant increase in our gross margin was the result of strongrevenue growth from our higher margin switching and software products as wellas an improved mix of sales to our channel partners.  Additionally, during fiscal year 2002 and 2001, weincurred significant inventory-related charges of $9.4 million and $21 millionrespectively.  These charges weregenerated primarily from our transition to multiple product lines and qualityproblems on component parts.  We havesignificantly reduced inventory costs with the implementation of ouroutsource-focused-manufacturing model, which was completed during fiscal year2003.

 

**Operating Expenses**

 

*Research and Development Expenses.*  Research and development expenses increasedto $88.8 million for fiscal year 2003, compared with $59.3 million for fiscalyear 2002 and $49.2 million for fiscal year 2001.  The approximate $29.5 million, or 50%, increase from fiscal 2002was primarily attributable to retentionbonuses and incremental spending associated with our acquisitions, reductionsin capitalized software costs, increases in personnel costs, non-recurringengineering charges, and depreciation related to engineering and test equipment

 

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and the new engineeringbuilding occupied in the second half of 2002. Capitalized software costs wereapproximately $5.1 million, $8.7 million and $481,000 for the 2003, 2002 and2001 fiscal years, respectively. Capitalized software development costs havedecreased in conjunction with the varying stages of development of our applicationsoftware, our new director and switch products and the related firmwaresoftware. We anticipate the level of spending for the design, testing andqualification of our products to increase over prior years’ levels as wecontinue to broaden our product offerings and integrate the personnel andtechnology of Nishan and Sanera.

 

*Selling and Marketing Expenses.*  Selling and marketing expenses increased to$95.8 million for fiscal year 2003 compared with $75.2 million and $70.5million for fiscal years 2002 and 2001, respectively.  Increases in sales andmarketing expenses were primarily due to increased salaries, commissions andtravel costs associated with increased revenues. In addition, demonstrationequipment and marketing costs associated with the completion of two new OEMcontracts as well as market development activities with our partners increasedour overall sales and marketing expenses. We believe that selling and marketingexpenses will increase as we grow our sales force to assist our channelpartners and increase our contact with end-user customers to createproduct pull through our channels.

 

*General and Administrative Expenses.*  General and administrative expensesincreased to $39.1 million for fiscal year 2003, compared to $29.5 million and$20.3 million for fiscal year 2002 and 2001, respectively.  Amortizationexpense for purchased intangible assets increased approximately $7.1 million asa result of our acquisitions of Sanera and Nishan. In addition, we experiencedincreased personnel costs, equipment and facilities costs while realizingoverall reductions in bad debt and legal expenses. Expenses for fiscal year2002 included significant legal expenses related to the costs of litigatingBrocade patent infringement lawsuit (see Item 3, Legal Proceedings) and $1.75million in charges related to the termination of a collateralized lease and thedisposal of fixed assets. Amortization expense will continue to increase infiscal year 2004 as a full year of Nishan and Sanera intangible asset amortizationwill be reflected.

 

*Acquired In-Process Research and Development(IPR&D) and Other Acquisition-related Costs.*  In connection with our equity investment inAarohi and our acquisition of Nishan in September 2003, a portion of therespective purchase prices was allocated to IPR&D. This IPR&D wasexpensed at the time of purchase because technological feasibility had not beenestablished and no future alternative use existed. The IPR&D charge forfiscal year 2003 totaled $11.4 million. In connection with our acquisition of SANavigator in fiscal 2001, weincurred non-recurring acquisition costs and integration-related charges.Additionally, a portion of the SANavigator purchase price was allocated toIPR&D. This IPR&D was expensed at the time of purchase becausetechnological feasibility had not been established and no future alternativeuse existed.  The IPR&D chargetotaled $7.2 million for the year ended December 31, 2001.  The other acquisition-related chargesrecorded during the year ended December 31, 2001, related primarily toone-time consideration paid for the completion of ongoing employmentarrangements with SANavigator employees. See Note 5 to the Notes to theConsolidated Financial Statements.

 

*Amortization of Deferred Compensation*. We have recorded deferred compensation inconnection with Class B stock options granted prior to our August 9, 2000initial public offering and restricted Class B stock grants granted through ourequity incentive plans. In connection with our acquisitions during fiscal 2003,we issued approximately 1.0 million shares of Class B restricted common stockwith vesting periods ranging from 12 to 24 months. In addition, 300,000 sharesvested immediately upon the retention of employees at Nishan and Sanera andwere fully expensed. We are amortizing all deferred compensation on astraight-line basis over the vesting period of the applicable options and stockawards, resulting in amortization expense of $12.7 million for fiscal year2003, $8.9 million for fiscal year 2002 and $8.7 million for fiscal year 2001(of which approximately $739,000, $601,000 and $1,437,000 was included in costof revenue, respectively). Deferred compensation expense levels fluctuate withthe Class B option and restricted stock award activity. Additional grants ofthese awards under existing compensations plans, future plans or throughacquisitions could increase the level of deferred compensation expense.

 

29

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*Restructuring Charges.*InJanuary 2004, we announced that we were taking certain cost improvementactions, which included a workforce reduction and facility consolidation. As aresult, in the fiscal fourth quarter of 2003, the Company recorded anapproximate $2.3 million restructuring charge related to the reduction inworkforce. In addition, we expect to incur an approximate $2.2 millionrestructuring charge in the fiscal first quarter 2004, primarily related to afacilities closure, as well as additional severance costs.

 

*Interest and Other Income.*  Interest and other income consistedprimarily of interest earnings on our cash, cash equivalents and variousinvestment holdings.  Interest incomewas $6.8 million, $6.9 million, and $14.5 million for fiscal years 2003, 2002and 2001, respectively.  The decrease inincome from 2001 levels reflects the decline in interest rates during 2002 and2003 fiscal years.  These declinesoffset the effects of higher cash and investment balances resulting from cash generated from operations and the netproceeds from convertible subordinated notes that were issued inFebruary 2003 (see Note 8 – “Convertible Subordinated Debt” in the Notesto Consolidated Financial Statements). The average rate of return oninvestments for the year ended January 31, 2004 was 1.8% compared to 2.2%for fiscal year 2002, and 3.9% for fiscal year 2001.

 

*Interest Expense.*Interest expense was $2.8 million for the year ended January 31,2004 compared with $293,000 and $349,000 for fiscal years 2002 and 2001,respectively.   The increase in interestexpense represents the interest cost associated with our 2.25% convertiblesubordinated notes issued in February 2003. In July 2003, we enteredinto an interest-rate swap agreement that has the economic effect of modifyingthe fixed interest obligations associated with the Notes so that the interestpayable on the majority of the Notes effectively becomes variable based on thesix month LIBOR minus 152 basis points. The reset dates of the swap areFebruary 15 and August 15 of each year until maturity onFebruary 15, 2010. The six-month LIBOR setting for the swap was 1.1283%during the 2003 fiscal year, creating a rate of approximately minus 0.39%,which is effective until February 15, 2004. This rate significantlyreduced our overall interest expense during this period. On February 15,2004, the six-month LIBOR setting was reset to 1.175%, resulting in a rate ofapproximately minus 0.345%, which is effective until August 15, 2004.  Significant increases in interest rates infuture periods could significantly increase interest expense.

 

*Provision for Income Taxes.*  During the 2003 fiscal year we recorded anon-cash charge of $38.8 million to create a valuation allowance against thedeferred tax asset as of the beginning of the fiscal year.  Generally, the effective tax rate isdetermined by the relationship between pre-tax book income or loss and certainamounts which are reported differently between the financial statements and thetax return.  During 2003, the tax rateis favorably impacted primarily by the settlement of tax items related toprevious years, the deductibility of costs associated with our convertiblesubordinated debt, and the research tax credit.  The tax rate is unfavorably impacted by deferred compensation andthe write-off of the IPR&D related to Aarohi, as well as by the non-cashcharge for the valuation allowance. During 2002, the tax rate was favorably impacted primarily by tax-exemptinterest and the research tax credit. The tax rate was unfavorably impacted by deferred compensation.  During 2001, the tax rate was favorablyimpacted primarily by tax-exempt interest and the benefit attributable toexport sales.  The tax rate wasunfavorably impacted by deferred compensation.

 

A full valuation allowance was also created in fiscal 2003 againstacquired deferred tax assets for $35.1 million and against deferred tax assetsrelating to tax benefits recorded directly to shareholders’ equity for $1.0million.  Neither of these itemsresulted in a current charge to income tax expense.  The valuation allowance related to acquired deferred tax assetsresulted in an increase in goodwill.  Ifthis portion of the valuation allowance is released in subsequent periods,goodwill will decrease by a like amount and we will record a charge to taxexpense when the related deferred tax asset is realized.  If the valuation allowance charged toshareholders’ equity is released in subsequent periods, shareholders’ equitywill increase by a like amount and we will record a charge to tax expense whenthe related deferred tax asset is realized.

 

**Liquidity and Capital Resources**

 

**In summary, our cash flows were (in thousands):**

** **

**30**

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** **
|                                                 |   | **Year Ended  January 31,** |   | **Years Ended December 31,** |   |
|------------------------------------------------------|--------|----------------------------------|--------|-----------------------------------|--------|
|                                                 |   | **2004**                         |   | **2002**                          |   | **2001** |   |
|                                                 |   |                             |   |                              |   |   |   |
| Net cash provided by operating activities            |   | $                                | 61,060 |                              | $      | 30,456 |   | $ | 8,336 |   |
| Net cash used in investing activities                |   | (244,259                         | )      | (27,039                           | )      | (115,688 | ) |
| Net cash provided by (used in) financing  activities |   | 125,332                          |   | (291                              | )      | 2,007 |   |
|                                                      |        |                                  |        |                                   |        |  |  |  |  |  |

 

We invest excess cash predominantly in debt instruments that are highlyliquid, of high-quality investment grade, and predominantly have maturities ofless than three years with the intent to make such funds readily available foroperating purposes, including expansion of operations and potentialacquisitions or other transactions.  Asof January 31, 2004, we had cash and cash equivalents andavailable-for-sale investments, including restricted cash, of $317 millioncompared to approximately $303 million as of December 31, 2002.

 

Cash provided by operating activities of $61 millionfor 2003 primarily consists of our net loss adjusted for non-cash charges(including depreciation, amortization, in-process R&D charges related toour acquisitions, deferred compensation, deferred taxes and inventory-relatedcharges) offset by approximately $6.5 million of changes in working capital andother activities.  Working capitalchanges included an increase in accounts receivable balances of approximately$26 million, reflecting increases related to our revenue growth particularly,in the last month of the fiscal fourth quarter.  Days sales outstanding (DSO) has decreased in 2003 to 51 dayscompared to 64 days in 2002.  Thisreflects the impact of the change in fiscal year and increased level of accountsreceivable collection.  We believe thatDSO may increase in 2004 as compared to 2003 as we see the linearity of oursales shift towards the third month of our fiscal quarters and as our channelmix continues to diversify.  Our cashflows from operations were impacted by the growth in deferred revenue balancesof approximately $17.8 million in 2003 representing primarily increased salesof extended maintenance contracts attached to sales of our hardware andsoftware products. In addition, the growth in deferred revenue reflectsdeferred service fee revenue related to our ESCON agreement with EMC.  From fiscal year 2002 to 2003, the increasein cash provided by operating activities was primarily the result of higherrevenues and a lower net loss before income taxes.  Cash provided by operating activities in 2002 of $30.5 millionconsisted primarily of the net loss adjusted for non-cash charges ofapproximately $44.9 million offset by approximately $4.4 million used byworking capital and other activities.  Fromfiscal year 2001 to 2002, the increase in cash from operations was primarily aresult of large inventory purchases in 2001 and larger income tax payments fromour profitable 2000 fiscal year.  Cashprovided by operating activities in 2001 of approximately $8.3 millionconsisted primarily of a net loss of approximately $8.7 million adjusted fornon-cash items of approximately $55.5 million and approximately $38.5 millionused by working capital and other activities.

 

Cash used in investing activities in 2003 ofapproximately $244 million was primarily attributable to cash used inacquisitions and purchases of equity investments of $177.4 million, cash usedto purchase (net of sales and maturities) investments in marketable securitiesduring the year, cash used to secure restricted investments related to ourinterest rate swap transaction of approximately $5.1 million, and capitalexpenditures totaling approximately $18.0 million.  Cash used in investing activities increased from 2002 to 2003primarily as a result of the acquisitions of Sanera and Nishan, as well asincreased net purchases of marketable securities related to higher cashbalances available for investing from our issuance of convertible subordinatednotes in February 2003.   Reducedspending for capital expenditures in 2003 from 2002 offset these increases.Cash used in investing activities in 2002 of approximately $27 million wasprimarily attributable to capital expenditures of $72 million, contributed toby our completion and occupation of our office and engineering building.  The cash purchases were offset by proceedsfrom sales and maturities (net of purchases) of marketable securities forapproximately $46 million.  Cash usedfor investing activities decreased in 2002 from 2001 primarily as a result ofcash used for acquisitions in 2001, as well as net purchases of investments in2001, compared to net proceeds from investments in 2002.  Cash used in investing activities in 2001 ofapproximately $115.7 million was primarily attributable to cash used inacquisitions of $29.8 million, capital expenditures totaling approximately$21.5 million and net purchases (net of sales and maturities) of investments of$64.5 million.

 

Cash provided by financings in 2003 of $125 million was primarily dueto proceeds from issuance of convertible subordinated notes of $172.5 millionin principal amount, with proceeds of $167 million  and proceedsfrom the issuance of stock related to our stock option and employee purchaseplans of $5.8 million.  The

 

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2.25%convertible subordinated notes mature in February 2010, unless convertedinto McDATA common stock at a conversion price of $10.71 per share, subject tocertain conversion price adjustments. Upon conversion, McDATA has the right to deliver cash, stock or acombination of both.  See Note 8 in theNotes to the Consolidated Financial Statements for further information relatedto the issuance of convertible subordinated notes.  Offsetting these net proceeds were the use of $20.5million of those proceeds to enter into share option transactions, cashused for payments made on notes payable and capital lease obligations ofapproximately $18 million, and $8.8 million of cash used to repurchase commonstock under our stock buy-back program. See Note 9 in the Notes to the Consolidated Financial Statements forfurther information related to the Company’s repurchase of common stock.  Cash used in financing activities in 2002 of$291,000 was primarily due to principal payments on capital leases of $2.7million offset by proceeds of approximately $2.4 million from the issuance ofcommon stock.  Cash provided byfinancing activities in 2001 of $2.0 million was primarily due to proceeds fromthe issuance of common stock of $4.9 million offset by payments on our capitallease obligations of $2.9 million.

 

**Commitments**

 

TheCompany has contracted with Sanmina SCI Systems, Inc. (SSCI) and SolectronCorporation (Solectron) (collectively, Contract Manufacturers) for themanufacture of printed circuit boards and box build assembly and configurationfor specific multi-protocol directors and switches.  The agreements require us to submit purchasingforecasts and place orders sixty calendar days in advance of delivery.  At January 31, 2004, our commitmentwith the contract manufacturers for purchases over the next sixty days totaled$48.1 million.  Additionally, theContract Manufacturers have outstanding purchase commitments related tomaterials that have been ordered on our behalf.  We may be liable for materials that the Contract Manufacturerspurchase on our behalf if our actual requirements do not meet or exceed ourforecasts and those materials cannot be redirected to other uses.  At January 31, 2004, we had recordedobligations of approximately $8 million primarily related to materialspurchased by our Contract Manufacturers for certain end-of-life and obsoletematerial used to manufacture our products. We do not expect the remaining commitments under these agreements tohave a continued material adverse effect on our business, results ofoperations, financial position or cash flows.

 

InFebruary 2003, the Company sold $172.5 million of 2.25% convertiblesubordinated notes due February 15, 2010 (see Note 8, “ConvertibleSubordinated Debt,” of the Notes to Consolidated Financial Statements). TheNotes are convertible into our Class A common stock at conversion rate of93.3986 shares per $1,000 principal amount of notes (aggregate of approximately16.1 million shares) or $10.71 per share, subject to certain conversionadjustments. Upon a conversion, the Company may choose to deliver shares of ourClass A common stock, or, in lieu of shares of our Class A common stock, cashor a combination of cash and shares of Class A common stock. We are required topay interest on February 15 and August 15 of each year, beginningAugust 15, 2003. Debt issuance costs of $5.6 million are being amortizedover the term of the notes. The amortization of debt issuance costs willaccelerate upon early redemption or conversion of the notes. The net proceedsremain available for general corporate purposes, including working capitalrequirements and capital expenditures.

 

Concurrentwith the issuance of the Notes, the Company entered into share optiontransactions using approximately $20.5 million of proceeds. As part of theseshare option transactions, the Company purchased options that coverapproximately 16.1 million shares of Class A common stock, at a strike price of$10.71. The Company also sold options that cover approximately 16.9 millionshares of Class A common stock, at a strike price of $15.08. The net cost ofthe share option transactions was recorded against additional paid in capital.These share option transactions are intended to give the Company the option tomitigate dilution as a result of the Notes being converted to common shares upto the $15.08 price per common share and mitigate dilution if the share priceexceeds $15.08 at that time. Should there be an early unwind of either of theshare option transactions, the amount of cash or net shares potentiallyreceived or paid by the Company will be dependent on then existing overallmarket conditions, the stock price, the volatility of the stock, and the amountof time remaining until expiration of the options.

 

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In July 2003, we entered into an interest-rate swap agreement witha notional amount of $155.25 million that has the economic effect of modifyingthe fixed interest obligations associated with the Notes so that the interestpayable on the majority of the Notes effectively becomes variable based on thesix month London Interbank Offered Rate (LIBOR) minus 152 basis points. Thereset dates of the swap are February 15 and August 15 of each yearuntil maturity on February 15, 2010. The six-month LIBOR setting for theswap at January 31, 2004 was 1.1283%, creating a rate of approximatelyminus 0.39%, which was effective until February 15, 2004. OnFebruary 15, 2004, the six-month LIBOR setting was reset to 1.175%,resulting in a rate of approximately minus 0.345%, which is effective untilAugust 15, 2004.  Significantincreases in interest rates could significantly increase the interest expensewe are obligated to pay to holders of the Notes in future periods. The swap wasdesignated as a fair value hedge and, as such, the gain or loss on thederivative instrument, as well as the fully offsetting gain or loss on theNotes attributable to the swap, were recognized in earnings. AtJanuary 31, 2004, the fair value of the interest rate swap had decreasedfrom inception to $349,000 and is included in other long-term liabilities.Corresponding to this change, the carrying value of the Notes has decreased by$349,000. We are also required to post collateral based on changes in the fairvalue of the interest rate swap. This collateral, in the form of restrictedcash, was $5.1 million at January 31, 2004.

 

The following table summarizes our contractual obligations (includinginterest expense) and commitments as of January 31, 2004 (in thousands):

 
|                               |   | **Total** |    | **Less Than  1Year** |   | **1-3 Years** |   | **More  than  5 years** |   |
|------------------------------------|--------|-----------|---------|----------------------|--------|---------------|--------|-------------------------|--------|
|                               |   |      |    |                 |   |          |   |                    |   |
| Convertible subordinated debt      |   | $         | 172,500 |                 | $      | —        |   | $                       | — |   | $ | 172,500 |   |
| Non-cancelable operating leases    |   | 20,295    |    | 8,097                |   | 9,568         |   | 2,630                   |   |
| Non-cancelable purchase agreements |   | 48,063    |    | 48,063               |   | —        |   | —                  |   |
| Capital leases, including interest |   | 2,376     |    | 1,453                |   | 923           |   | —                  |   |
| Total contractual obligations      |   | $         | 243,234 |                 | $      | 57,613        |   | $                       | 10,491 |   | $ | 175,130 |   |

 

**Long-Term Cash Availability**

 

We believe our existing cash, short-term and long-term investmentbalances, and cash expected to be generated from future operations will besufficient to meet our capital and operating requirements at least through thenext twelve months, although we could be required, or could elect, to seekadditional funding prior to that time. Our future capital requirements will depend on many factors, includingour rate of revenue growth, the timing and extent of spending to supportdevelopment of new products and expansion of sales and marketing, the timing ofnew product introductions and enhancements to existing products, and marketacceptance of our products.

 

**Inflation**

 

We believe that our revenue and results of operations have not beensignificantly impacted by inflation during the last three fiscal years.

 

**Recent Accounting Pronouncements**

 

Forinformation regarding recent accounting pronouncements, see Note 1 of Notes toConsolidated Financial Statements included in the F-pages of this Form 10-K.

 

**Critical Accounting Policies**

 

***General***

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of these financial statements requires management to

 

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makeestimates and assumptions that affect the reported amounts of assets andliabilities, revenue and expenses, and the related disclosure of contingentassets and liabilities as of the date of the financial statements. Managementbases its estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Seniormanagement has discussed the development, selection and disclosure of theseestimates with the Audit Committee of McDATA’s Board of Directors. Actualresults may differ materially from these estimates under different assumptionsor conditions. Management believes the following critical accounting policiesreflect its more significant estimates and assumptions used in the preparationof its consolidated financial statements.

 

***Revenue Recognition***

 

Werecognize revenue, in accordance with SEC Staff Accounting Bulletin No. 104, *Revenue Recognition*(SAB 104) and theAmerican Institute of Certified Public Accountants’ Statement of Position 97-2(SOP 97-2), as amended, when persuasive evidence of an arrangement exists,products are delivered or services rendered, the sales price is fixed ordeterminable and collectibility is assured. In instances when any one of thesefour criteria is not met, we will defer recognition of revenue until all thecriteria have been met.

 

Withrespect to revenue from our configured products, we request evidence ofsell-through from our OEM and distributor partners prior to recognizingrevenue. In situations where our OEM and distributor partners refuse to providesell-through information when requested, but all the criteria under SAB 104 (asdiscussed above) have been met, we recognize revenue for such configuredproducts. These configured products represent high value, customized solutionsof directors, cabinets and various combinations of port cards ordered by oursales partners as required by the end user. Non-configured products andcomponents, such as our switch products, port cards, and FlexPort upgrades, arerecognized as revenue when the criteria for SAB 104 (as discussed above) havebeen met, generally at time of shipment. Revenue for both configured andnon-configured products and components is reduced for estimated customerreturns, price protection, rebates, and other offerings that occur under salesprograms established with the Company’s OEMs, distributors and resellers.

 

Servicerevenues, which to date have not been material, include training, consultingand customer support. Revenue from training and consulting are recognized whenthe service has been performed and the customer has accepted the work. Werecognize revenue from support or maintenance contracts, includingpost-contract customer support (PCS) services, ratably over the contractualperiod.

 

Werecognize revenue from software products in accordance with the SOP 97-2.Software revenue is allocated to the software license and PCS service elementsusing vendor specific objective evidence of fair value, or VSOE, and recognizedappropriately as discussed above. VSOE of the fair value for an element is basedupon the price charged when the element is sold separately.

 

Intransactions that include multiple products, services and/or software, weallocate the revenue to each element based on their relative fair values (or inthe absence of fair value, the residual method) and recognize the revenue whenthe above recognition criteria have been met for each element.

 

***Inventory Reserves***

 

Wevalue our inventory at the lower of cost or net realizable values. We regularlyreview inventory on hand and record a provision for excess and obsoleteinventory based upon assumptions about current and future demand for ourproducts, the current market conditions, new product introductions, newtechnologies and the current life cycle of our products. Adverse changes inthese factors and our assumptions could result in an increase in the amount ofexcess and obsolete inventory on hand and increase our cost of revenue.

 

Additionally,we have certain purchase commitments with our Contract Manufacturers that arenon-cancelable. We may be liable for materials that our third-partymanufacturers purchase on our behalf if our actual

 

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requirementsdo not meet or exceed our forecasts and those materials cannot be redirected toother uses by the Contract Manufacturers. We evaluate these open purchaseorders in light of our current inventory on hand, expected demand, marketconditions and new product introductions. Based on this information, we recordpurchase obligations for inventory we believe is excess or obsolete and cannotbe redirected to other uses by our contract manufacturers. Adverse changes inour and our contract manufacturers’ calculations and assumptions concerningthese purchase commitments may result in an increase to our vendor obligationsand increase our cost of revenue.

 

***Valuation of Accounts Receivable***

 

Wereview accounts receivable to determine which are doubtful of collection. Inaddition, we also make estimates of potential future product returns. In makingthe determination of the appropriate allowance for doubtful accounts andproduct returns, we consider specific accounts, analysis of our accountsreceivable aging, changes in customer payment terms, historical write-offs andreturns, changes in customer demand and relationships, concentrations of creditrisk and customer credit worthiness. Historically, we have experienced a lowlevel of write-offs and returns given our customer relationships, contractprovisions and credit assessments. Changes in the credit worthiness ofcustomers, general economic conditions and other factors may impact the levelof future write-offs and product returns and increase our general andadministrative expenses or decrease product revenues.

 

***Warranty Provision***

 

Wealso provide for estimated expenses for warranty obligations as revenue isrecognized. Our warranty accruals utilize management’s estimates of potentialfuture product warranty claims including the estimated numbers of failures byproduct and estimated costs to repair or replace failed product. We have notexperienced material warranty claims, however material warranty claims,including the catastrophic or epidemic failure of any one of our products,would require revisions to the estimated warranty liability and could significantlyincrease our product costs, reduce revenue and cause significant customerrelations problems.

 

***Income Taxes***

 

Significantmanagement judgment is required in determining the provision for income taxes,deferred tax assets and liabilities and any valuation allowance recordedagainst deferred tax assets. We are required to estimate our income taxes ineach jurisdiction where we operate. This process involves estimating our actualcurrent income tax expense together with assessing temporary differences resultingfrom the different treatment of items for income tax and accounting purposes.These differences result in deferred tax assets and liabilities, which areincluded in our consolidated balance sheet. At January 31, 2004, our netdeferred tax assets equaled $77.4 million before any valuation allowance. Thisbalance relates to various items in McDATA’s results of operations that havedifferent timing or treatment for income tax and financial accounting purposes,such as the timing of revenue recognition and accrued expenses, depreciationmethods, and reserve accounts, as well as research and development credits.

 

Inevaluating the need for a valuation allowance, we assessed the likelihood thatour net deferred tax assets will be recovered from future taxable income. Wehave considered past operating losses, cumulative losses for financialaccounting in recent years, estimated future taxable income and our ongoingprudent and feasible tax planning strategies in assessing the need for avaluation allowance. After considering all available evidence, both positiveand negative, management concluded, after applying the provisions of SFAS 109,that it is more likely than not that we will not be able to realize ourdeferred tax assets in the future. Therefore, a full valuation allowance hasbeen provided against those deferred tax assets. The portion relating to theacquisitions is applied as an increase to the basis of other assets from theacquired companies.

 

Weare subject to audit by federal, state and foreign tax authorities.  These audits may result in additional taxliabilities.  We account for suchcontingent liabilities in accordance with SFAS No. 5, Accounting for

 

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Contingencies,and believe that we have appropriately provided for taxes for all years.  Several factors drive the calculation of ourtax reserves including (i) the expiration of statutes of limitations, (ii)changes in tax law and regulations, and (iii) settlements with taxauthorities.  Changes in any of thesefactors may result in adjustments to our reserves which could impact ourreported financial results.

 

***Valuation of Long-Lived Assets IncludingGoodwill and Purchased Intangible Assets***

 

Wereview property, plant and equipment and purchased intangible assets forimpairment whenever events or changes in circumstances indicate the carryingvalue of an asset may not be recoverable. Our asset impairment review assessesthe fair value of the assets based on the future cash flows the assets are expectedto generate. An impairment loss is recognized when estimated undiscountedfuture cash flows expected to result from the use of the asset plus netproceeds expected from disposition of the asset (if any) are less than thecarrying value of the asset. This approach uses our estimates of future marketgrowth, forecasted revenue and costs, expected periods the assets will beutilized and appropriate discount rates.

 

Wehave performed and will perform an annual impairment test for goodwill inaccordance with Statement of Financial Accounting Standards No. 142 (SFAS 142).This review is based on a comparison of the carrying value of our net assetsincluding goodwill balances to the fair value of our net assets using thequoted market price of our common stock. We performed the 2003 impairment testduring our first fiscal quarter and determined that no impairment loss shouldbe recognized. In the event that business conditions change, future tests mayresult in a need to record a loss due to write down of the value of goodwill.At January 31, 2004, goodwill recorded in the consolidated balance sheettotaled $78.8 million.

 

Wecurrently operate our business as a single solutions business and do notmaintain separate cash flows or operating margins for any other businesssegments. Future operating losses, deterioration of our business orsegmentation of our operations in the future could also lead to impairmentadjustments as such issues are identified.

 

***Sales Commission Estimates***

 

Oursales approach is focused on an indirect model executed primarily through OEMsand resellers. Our field sales and service personnel support these distributionchannels using a direct-assist model and are commissioned based on salesresults achieved during the reporting period. Because specific sales data usedto calculate these commissions is not always available at the time ourfinancial results are released, we routinely make certain estimates based onknown revenue achievement, historical experience and assumptions regardingindividual sales contributions. Changes to these assumptions and estimatescould cause revisions to our sales commission liabilities and result invariations between estimated liabilities and actual payments.

 

***Restructuring Charges***

 

Wemonitor and regularly evaluate our organization structure and associatedoperating expenses.  Depending on eventsand circumstances, we may decide to restructure our operations to reduce futureoperating costs.  In determining therestructuring charges, we analyze our future operating requirements, includingthe required headcount by functions and facility space requirements.  Our restructuring costs, and any resultingaccruals, involve significant estimates made by management using the best informationavailable at the time the estimates are made, some of which may be provided bythird parties.  In recording facilitieslease loss reserves, we make various assumptions, including the time periodover which the facilities will be vacant, expected sublease terms, expectedsublease rates, anticipated future operating expenses, and expected future useof the facilities.  Our estimatesinvolve a number of risks and uncertainties, some of which are beyond ourcontrol, including future real estate market conditions and our ability tosuccessfully enter into subleases or lease termination agreements with terms asfavorable as those assumed when arriving at our estimates.  We regularly evaluate a number of factors todetermine the appropriateness and reasonableness of our restructuring and lease

 

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lossaccruals including the various assumptions noted above.  If actual results differ significantly fromour estimates, we may be required to adjust our restructuring accruals in thefuture.

 

**Item 7A. Qualitativeand Quantitative Disclosure about Market Risk**

 

We are exposed to market risk, primarily from changes in interest ratesand credit risks.

 

# **InterestRate Risk**

 

Our exposure to market risk due to changes in the general level ofUnited States interest rates relates primarily to our cash and cash equivalentsand our investment portfolio. Our investment portfolio is primarily maintainedin four major financial institutions in the United States and consistsprimarily of readily marketable investment-grade debt securities of variousissuers and maturities ranging from overnight to greater than ten years.All investments are denominated in U.S. dollars and are classified as“available for sale.” These instruments are not leveraged, and are not held fortrading purposes. As interest rates change, the amount of unrealized gain orloss on these securities will change.

 

We have performed a sensitivity analysis as of January 31, 2004,using a modeling technique that measures the change in the fair values arisingfrom a hypothetical 10% adverse movement in the levels of interest rates withall other variables held constant. The discount rates used were based on themarket interest rates in effect at January 31, 2004. The sensitivityanalysis indicated that a hypothetical 10% increase in interest rates wouldresult in a decrease in the fair values of our investment instruments ofapproximately $275,000 assuming that such investment holdings remained constantthrough the year 2003 and an increase of investment income of approximately$398,000. A hypothetical 10% decrease in interest rates would result in anincrease of the fair values of our investment instruments of approximately$276,000 and a decrease in investment income of approximately $416,000.

 

Our convertible subordinated notes aresubject to a fixed interest rate and such notes are based on a fixed conversionratio into Class A common stock. In July 2003, the Company entered into aninterest-rate swap agreement with a notional amount of $155.3 million that hasthe economic effect of modifying the fixed interest obligations associated withthe notes so that the interest payable on the majority of the notes effectivelybecomes variable based on the six month London Interbank Offered Rate (LIBOR)minus 152 basis points. If interest rates on this variable rate debt were toincrease or decrease by 100 basis points, our annual interest expense wouldincrease or decrease by approximately $1.6 million. This increased or decreasedinterest expense would be partially offset by the effects of these interestrate changes on our cash and investment portfolio. The notes are not listed onany securities exchange or included in any automated quotation system; however,the notes are eligible for trading on the PortalSM Market. OnJanuary 31, 2004, the approximate bid price of our notes was $116.00 and theapproximate ask price of our notes was $116.50, resulting in an aggregate fairvalue of between $200.1 million and $201.0 million. Our Class A common stock isquoted on the Nasdaq National Market under the symbol, “MCDTA.” On January 31,2004, the last reported sale price of our Class A common stock on the NasdaqNational Market was $8.79 per share.

 

*Credit Risk*

 

Financial instruments which potentially subject the Company to concentrationsof credit risk consist principally of temporary cash investments, short andlong term investments, including collateral held under the securities lendingprogram as discussed in Note 7 of our Notes to the Consolidated FinancialStatements, trade receivables and certain share option transactions. TheCompany places its temporary cash investments and short- and long-terminvestments in investment grade instruments and limits the amount of investmentwith any one financial institution. The Company evaluates the credit riskassociated with each of its customers and has concluded that it does not have amaterial exposure to credit risk with its customers.

 

In February 2003, the Company sold $172.5 million of 2.25%convertible subordinated notes due February 15, 2010. In conjunction withthe issuance of these convertible notes, we also entered into share optiontransactions on our Class A common stock with Bank of America, N.A. and/or certain of its affiliates. Subject to the movement in our Class A commonstock price, we could be exposed to credit risk arising out of net settlementof these options in our favor. Based on our review of the possible netsettlements and the credit strength of Bank of America, N.A. and itsaffiliates, we have concluded that we do not have a material exposure to creditrisk as a result of these share option transactions.

 

**ITEM 8. Consolidated Financial Statements andSupplementary Data**

 

For a discussion of the information required by this item, you shouldrefer to F- pages in Item 15(a) of this Annual Report on Form 10-K.

 

**ITEM 9. ChangesIn and Disagreements With Accountants on Accounting and FinancialDisclosure**

 

We have nothing to report under this item.

 

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**ITEM 9A. Controlsand Procedures**

 

*Disclosure controls and procedures*

 

Ourmanagement evaluated, with the participation of our Chief Executive Officer andChief Financial Officer, the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Annual Report onForm 10-K. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities ExchangeAct of 1934 (the Exchange Act)), as of the end of such period, and except asdisclosed in this Annual Report, are effective to ensure that informationrequired to be disclosed by us in reports that we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in Securities and Exchange Commission rules and forms. Itshould be noted that the design of any system of controls is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions, regardless of how remote.

 

*Changes in internal control over financial reporting*

 

Exceptas disclosed below, there was no change in our internal control over financialreporting that occurred during the period covered by this Annual Report onForm 10-K that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

*Third QuarterBalance Sheet Reclassification/Restatement*

 

OnFebruary 26, 2004, the Company announced that it would amend its Form 10-Qfor the quarter ending October 31, 2003 to reflect a balance sheetreclassification. The reclassification did not affect either the incomestatement or the statement of cash flows for the quarter. The reclassificationresults from a securities lending program with Wells Fargo Bank, N.A. (WellsFargo), which the company began during that quarter. Under the program theCompany’s investment securities may be loaned against a pledge of cashcollateral, which is held by Wells Fargo as the Company’s agent.

 

Inaccordance with generally accepted accounting principles, the balance sheet inthat amended Form 10-Q for the quarter ended October 31, 2003, shows theaddition of a line item entitled “*Securitieslending collateral*” as a current asset and the addition of a lineitem entitled “*Securities lending collateralpayable*” as a current liability, both for the approximate amount of$109.5 million. These two balance sheet adjustments net to zero, and neitherthe income statement nor the statement of cash flows is affected. See Note 7 tothe Notes to the Consolidated Financial Statements for further discussion ofthis program and the balances as of January 31, 2004.

 

Aspart of its year-end review, the Company subsequently identified theapplicability of SFAS 140 to the previous quarter’s securities lending program.In its review, the Company investigated the cause of the reclassification andhas concluded that while the transaction was communicated prior to the filing,the Company did not appropriately apply SFAS 140 to the securities lendingprogram in preparing its financial statements for the quarter endingOctober 31, 2003. In response to the reclassification, the Company’sindependent auditors have indicated in a letter to the Company that it believesthat a material weakness under AU 325, *Communicationof Internal Control Related Matters Noted In An Audit*, existed withregard to the evaluation of the appropriate accounting treatment for thesecurities lending program. As a result, the Company has implemented enhancedpolicies and procedures including additional cross-functional meetings with theFinance organization, establishment of an issues log, adding additional supportpersonnel dedicated to this area and improvements in existing formal investmentpolicies. The Company believes that it has implemented these changes within itsinternal controls to improve the timely accounting evaluation and treatment ofsuch transactions.

 

Itshould be noted that any system of controls, however well designed andoperated, can provide only reasonable, and not absolute, assurance that theobjectives of the system are met. In addition, the design of any control systemis based in part upon certain assumptions about the likelihood of futureevents. Because of these and other inherent limitations of control systems,there can be no assurance that any design will succeed in

 

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achievingits stated goals under all potential future conditions, regardless of howremote.

 

Within 90 days prior to the date of this report, we carried out anevaluation, under the supervision and with the participation of our principalexecutive officer and principal financial officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures. Based on thisevaluation, our principal executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective in timelyalerting them to material information required to be included in our periodicSEC reports. It should be noted that the design of any system of controls isbased in part upon certain assumptions, and there can be no assurance that anydesign will succeed in achieving its stated goals.

 

**PARTIII**

 

**ITEM 10. Directorsand Executive Officers of the Registrant**

 

The following table sets forth certain information regarding ourexecutive officers and directors as of the date of this Annual Report on Form10-K:

 
| **Name**                  |   | **Age** |   | **Position**                                                               |
|---------------------------|--------|---------|--------|----------------------------------------------------------------------------|
|                      |   |    |   |                                                                       |
| John A. Kelley, Jr.       |   | 54      |   | Chairman of the Board of Directors, President and Chief Executive  Officer |
| Ernest J. Sampias         |   | 53      |   | Chief Financial Officer and Senior Vice President of Finance               |
| Thomas O. McGimpsey       |   | 42      |   | General Counsel, Vice President of Business Development                    |
| Gary M. Gysin             |   | 44      |   | Senior Vice President of Worldwide Sales and Service                       |
| Jean M. Becker            |   | 44      |   | Senior Vice President of Engineering                                       |
| Robert F. Finley          |   | 54      |   | Vice President of Manufacturing                                            |
| Michael B. Gustafson      |   | 37      |   | Senior Vice President of Worldwide Marketing                               |
| Karen L. Niparko          |   | 47      |   | Vice President of Human Resources                                          |
| Laurence G. Walker (2)(4) |   | 55      |   | Lead Director                                                              |
| Charles C. Johnston (1)   |   | 69      |   | Director                                                                   |
| D. Van Skilling (1)(3)    |   | 70      |   | Director                                                                   |
| Thomas M. Uhlman (2)(4)   |   | 55      |   | Director                                                                   |
| John W. Gerdelman (3)(4)  |   | 51      |   | Director                                                                   |
| Betsy S. Atkins (2)(3)    |   | 48      |   | Director                                                                   |
| Michael J. Sophie (1)     |   | 46      |   | Director                                                                   |
| Alex Mendez (4)           |   | 46      |   | Director                                                                   |

 

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(1)                                  Member of AuditCommittee

(2)                                  Member of CompensationCommittee

(3)                                  Memberof Governance and Nominating Committee

(4)                                  Member of TechnologyCommittee

 

**Executive Officers and Directors**

 

*John A. Kelley, Jr.*hasbeen Chairman of the Board of Directors since February 2004, President andChief Executive Officer since August 2002 and was President and ChiefOperating Officer from August 2001 to August 2002. Prior to joiningMcDATA, Mr. Kelley was Executive Vice President for Qwest CommunicationsInternational Inc., or Qwest, from July 2000 to January 2001.Prior to the acquisition of US WEST by Qwest, he was Executive VicePresident for U S WEST from April 1995 to June 2000. Prior to hisemployment at US WEST, Mr. Kelley was in key senior leadershippositions at Mead Corporation from 1991 to 1995. Mr. Kelley received hisBachelor of Science degree in business from the University of Missouri, St.Louis. He serves on the board of directors of Polycom, Inc. andCaptaris, Inc., and is also Vice Chairman of the National INROADS Board, anot-for-profit mentoring program and a board member of the Women’s VisionFoundation and Tie-Rockies.

 

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*Ernest J. Sampias*has been the Senior Vice President of Finance and Chief Financial Officer sinceJune 1, 2002. Prior thereto he was Vice President of Finance fromSeptember 2001 to June 2002 and Controller from September 2001to February 2003. Prior to joining McDATA, Mr. Sampias was VicePresident and Chief Financial Officer of Convergent Communications, Inc.from November 2000 to May 2001, was Vice President and ChiefFinancial Officer of U S WEST Dex, Inc. from 1997 to 2000 andheld various financial management positions with U S WEST from 1985to 2000. Mr. Sampias is a Certified Public Accountant, received a Mastersdegree in Taxation in 1979 from DePaul University in Chicago, Illinois, andreceived a Bachelor of Science degree (with distinction) in Business in 1973from Indiana University. Mr. Sampias also sat on the Board of Directors ofPointServe Corporation from March 2000 to November 2000.

 

*Thomas O. McGimpsey*is General Counsel and Vice President of Business Development.  In 2002, Mr. McGimpsey also held theposition of Vice President of Corporate Development. Mr. McGimpsey isresponsible for managing all internal and external legal efforts, corporategovernance matters, business development, mergers and acquisition activities,hardware and software purchase/licensing contracts, and theinternationalization efforts for the company. Prior to joining McDATA inJune 2000, Mr. McGimpsey was the Senior Corporate and SecuritiesAttorney at U S WEST, Inc. and U S WESTCommunications, Inc. from 1998 until U S WEST’s merger with Qwest in June 2000. From 1991 to 1998,Mr. McGimpsey was in private practice at national law firms. From 1984 to1988, Mr. McGimpsey was a Senior Engineer for SoftwareTechnology, Inc. Mr. McGimpsey received his Juris Doctor degree fromthe University of Colorado in 1991 and his Bachelor of Science degree inComputer Science (with a minor in electrical and microprocessor systems) fromEmbry-Riddle Aeronautical University in 1984.

 

*Gary M. Gysin,*hasbeen the Senior Vice President of World Wide Sales and Services sinceJanuary 2004.  Mr. Gysin joinedMcDATA in December 2002 as Vice President and General Manager of Software.Prior to joining McDATA, Mr. Gysin was Senior Vice President of products atVolera from February 2000 to November 2002, where he drovedevelopment of strategic direction, and Sales and Marketing activities.Additionally, Mr. Gysin has shown strong success in previous sales leadershipsroles at growth companies, and has a wide range of sales leadership experienceincluding previous vice president of sales positions, territory management,compensation organization, and routes-to-market development. Mr. Gysin received his Bachelor of Artsdegree in Economics in 1992 from the University of California at Santa Cruz.

 

*Jean M. Becker* hasbeen the Senior Vice President of Engineering since December 2002. Justprior to joining McDATA, Ms. Becker was President of Qwest Solutions fromJuly 2001 and Senior Vice President of Qwest National xDSL/BroadbandDeployment from July 2000. Prior to Qwest, Ms. Becker held the ChiefTechnology Officer and Senior Vice President, Vice President of Network Planningand other senior management positions with U S WEST since 1988.Ms. Becker earned a Masters of Business and Administration degree in 1992from Portland State University and earned a Bachelor of Science degree inelectrical engineering in 1988 from Portland State University.  Ms. Becker also serves on the board ofdirectors of Aarohi Communications,Inc.

 

*Robert F. Finley* hasbeen the Vice President of Manufacturing since June 2001. Prior to joiningMcDATA, he served as Vice President, Business Programs Management—GlobalAccounts at SMTC Corp. from December 1996 to May 2001. Prior tojoining McDATA, Mr. Finley held several positions at SMTC includingDirector of Materials, MIS, Document Control, Component Engineering andSupplier Quality Assurance and Director of Manufacturing Operations fromFebruary 1991 to December 1996. In addition, Mr. Finley workedfor McDATA from 1987 to 1990 as a manager of quality assurance, reliabilityengineering and mechanical procurement and a manager of turnkey operations.Mr. Finley holds a Bachelor of Science degree in electronics engineeringtechnology from Arizona State University.

 

*Michael B. Gustafson*has been the Senior Vice President of Worldwide Marketing since June 2002.From March 1999 until June 2002, he served as our Vice President ofWorldwide Sales. Mr. Gustafson also had responsibility for McDATA’sProfessional and Learning Services offerings from March 1999 toDecember 2000. From May 1998, when he joined McDATA, untilMarch 1999, Mr. Gustafson served as a regional sales manager ofMcDATA. Prior to joining McDATA, Mr. Gustafson spent nine years withIBM serving in various sales management positions, including most recently asBusiness Unit Executive and Director of U.S. Channel Field Sales

 

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of IBM from June 1997 until May 1998. Mr. Gustafsonreceived his Bachelor of Science degree in business administration fromWashington University in St. Louis.  Mr.Gustafson joined the Board of Directors of InPhase Technologies in December 2003.

 

*Karen L. Niparko* hasbeen Vice President of Human Resources since January 2004, Vice Presidentof Business Operations since October 2002 and prior thereto was VicePresident of Human Resources from September 2001 to October 2002.Prior to joining McDATA, Mrs. Niparko was Executive Consultant forCorporate Solutions, Inc. from April 2001 to September 2001,Corporate Vice President of Human Resources and Officer and formerVice-President of Human Resources for Worldwide Sales & Service ofStorage Technology Corporation from April 1997 to February 2001, andVice President of Operations for Auto-trol Technology Corporation fromJanuary 1993 to April 1997. Mrs. Niparko has a Masters ofBusiness Administration degree from the University of Colorado, a Bachelor ofArts degree from the University of Michigan and a Certificate for Leadershipfor Sr. Executives Programs from Harvard University. Mrs. Niparko serveson the Boards of the Colorado Safety Association andINROADS-Colorado Inc., both non-profit organizations. She served as Chairfor the eLearning committee of Governor Owen’s Strategy Workforce DevelopmentCouncil. She is an advisor for the Chancellor’s Community Advisory Committeefor the University of Colorado at Boulder and a member of the Women’s VisionFoundation.

 

*Laurence G. Walker,*an independent investor, has served as a Director of McDATA since May 1998and Lead Director since February 2004. Previously, Mr. Walker servedas Vice President of Strategy of the Network & Computing Systems Groupof Motorola from February 2002 until May 2002. From August 2001until February 2002, Mr. Walker served as Vice President and GeneralManager of the Network & Computing Systems Group of Motorola.Mr. Walker co-founded C-Port in November 1997 and was Chief ExecutiveOfficer until August 2001. C-Port was acquired by Motorola inMay 2000. From June 1997 until October 1997, Mr. Walker wasself-employed. From August 1996 until May 1997, Mr. Walkerserved as Chief Executive Officer of CertCo, a digital certification supplier.Prior thereto, he was Vice President and General Manager, Network ProductBusiness Unit, Digital Equipment Corporationfrom January 1994 to July 1996. From 1981 to 1994, he held a varietyof other management positions at Digital Equipment Corporation. He received hisPh.D. and Master of Science degree in electrical engineering from theMassachusetts Institute of Technology and his Bachelor of Science degree inElectrical Engineering from Princeton. He serves as a Director of SiliconLaboratories, Oasis Semiconductors, and Propagate Networks.

 

*Charles C. Johnston,*has served as a Director of McDATA since May 1998. Mr. Johnston hasbeen Chairman of AFD Technologies, Inc., J&C Resources, LLC, andUltraclenz Corporation since 1992 and Chairman of VentexTechnologies, Inc. since 1994. Mr. Johnston was founder, Chairman and CEO of ISI Systems, adeveloper of software systems and related services, from 1969 to 1992 (ISI wassold to Teleglobe Corporation of Montreal, Canada in 1989). He served invarious capacities at IBM from 1959 until 1965 and served as Director ofGrumman Corporation and Teleglobe Corporation from 1989 to 1994. He receivedhis Bachelor of Science degree in 1957 from Worcester Polytechnic Institute. Hecurrently serves as a Director of AuthentiDate Holding Corporation, InternetCommerce Company and Visual Data.

 

*D. Van Skilling,* has served as a Director of McDATA sinceMay 1998. Mr. Skilling has been as President of Skilling Enterprisessince March 1999. He retired as Chairman and Chief Executive Officer ofExperian Information Solutions, Inc., formerly TRW InformationSystems & Services, in April 1999. From September 1996 untilApril 1999, Mr. Skilling was Chairman and Chief Executive Officer ofExperian. From March 1970 until September 1996, Mr. Skilling wasthe Executive Vice President of TRW Information Systems and Services. Hereceived his Bachelor of Science degree in chemistry from Colorado College andhis Masters of Business Administration degree in International Business fromPepperdine University. He currently serves on the Boards of Directors of TheLamson & Sessions Company, First American Corporation and AmericanBusiness Bank and is Chairman of the Board of Trustees of Colorado College.

 

*Thomas M. Uhlman,* has served as a Director of McDATA sinceMay 1998. Mr. Uhlman has been Managing Partner, New Venture Partners,LLC since January 2001. From 1997 to 2001, Mr. Uhlman was President,New Ventures Group at Lucent Technologies. From 1996 to 1997, Mr. Uhlmanwas Senior Vice President, Corporate Strategy, Business Development and PublicAffairs of Lucent Technologies. From 1995 to

 

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1996Mr. Uhlman was the Vice President, Corporate Development of AT&T Corp.Prior to joining AT&T, he was with Hewlett-Packard Company in variousadvisory and management roles. He received his Ph.D. in Political Science fromthe University of North Carolina—Chapel Hill, his Masters degree in managementfrom Stanford University School of Business and his Bachelor of Arts degree inpolitical science from the University of Rochester.

 

*John W. Gerdelman*,has served as a director of McDATA since May 1998.  Since January 2004, he has been the Executive Chairman ofIntelliden Corporation a company he co-founded which provides softwaresolutions that enable networks to operate more intelligently by automatingnetwork change management and enforcing business policy in networkoperations.  In April 2002, Mr.Gerdelman took on the bankruptcy reorganization of Metromedia Fiber Networksand successfully emerged from Chapter 11 in September 2003 and completedhis contract in December 2003. From April 1999 until 2002, Mr. Gerdelman worked with several newventures as Managing Member of Mortonsgroup LLC.  From 1986 until 1999, Mr. Gerdelman held various positions withMCI Telecommunications Corporation in Sales, Marketing, Sales Operations,Network Operations and Information Technology. For four of these years, he served as President of the Network andInformation Technology Division.  He wasalso CEO of a startup call center company and returned to MCI upon itsacquisition.  Before joining MCI, Mr.Gerdelman was with Baxter Travenol Corporation in Sales Operations.  He served in the U.S. Navy as a NavalAviator.  He received his Bachelor ofScience degree in chemistry from the College of William and Mary where he nowserves on the Board of Visitors.  Mr.Gerdelman currently serves as a Director of APAC, Sycamore Networks, Inc. andthe Terebeam Corporation.

 

*Betsy S. Atkins*, hasserved as a Director of McDATA since April 2002. Ms. Atkins has beenthe Chief Executive Officer of Baja Accordiant Ventures, an independent venturecapital firm focused on the technology and life sciences industry since 1994.From 1991 through 1993, Ms. Atkins was CEO of NCI, Inc. aNutraceutical company. Ms. Atkins was a co-founder of AscendCommunications, Inc. in 1989 and served as a member of its Board ofDirectors, until its acquisition by Lucent Technologies in 1999. Ms. Atkinscurrently serves on the Boards of Directors of Polycom, Inc. andUTStarcom. She received her Bachelor of Arts degree from the University ofMassachusetts. Ms. Atkins publishes and keynote speaks on board governancematters and best practices for the National Association of Corporate Directors.Ms. Atkins is also a member of the President-appointed Pension BenefitGuaranty Corporation advisory committee and a Governor-appointed member of theFlorida International University Board of Trustees.

 

*Michael J. Sophie,* has served as a Director of McDATA sinceMarch 2003. Mr. Sophie has served as Senior Vice President Finance ofUTStarcom Inc., a manufacturer and marketer of telecommunicationsequipment for use in worldwide markets, from January 2003 to present andas Chief Financial Officer from August 1999 to present. He served as VicePresident Finance of UTStarcom from August 1999 to January 2003. From1993 to 1999, Mr. Sophie was Vice President Finance and Chief FinancialOfficer of P-Com, Inc., a manufacturer of microwave radio stations forworldwide wireless telecommunications markets. Mr. Sophie holds a Bachelorof Science degree in business administration from California State Universityand a Masters of Business Administration degree from the Santa ClaraUniversity.

 

*Alex Mendez*, hasserved as a Director of McDATA since December 2003. Mr. Mendez hastwenty-five years of experience in the high technology industry at ROLM, IBM,Stratacom, and Cisco, holding several executive positions in operations,marketing and business development, most recently as an SVP/GM at Cisco. He waspart of the founding team of Stratacom which Cisco acquired in 1996. He is alsoFounding General Partner of Storm Ventures, and ex-CEO and Chairman of SaneraSystems which McData acquired in 2003. He is on the board of directors ofAirespace, Venturi Wireless, and Inovys. He is also Executive Chairman of InkraNetworks and Chairman of Bivio Networks. Mr. Mendez holds a Bachelor of Science degree in electrical engineeringfrom Stanford University and a Masters of Business Administration degree fromSanta Clara University. He was born in Buenos Aires, Argentina and speaks bothSpanish and German fluently.

 

Our Board of Directors is divided into three classes, the members ofwhich serve for a staggered three-year term until they or their successors areduly elected and qualified. Messrs. Gerdelman and Kelley andMs. Atkins

 

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serve in class I whose term expires at the annual meeting ofstockholders in 2004, Messrs. Skilling, Uhlman and Sophie serve in classII whose term expires at the annual meeting of stockholders in 2005 and Messrs.Johnston, Walker and Mendez serve in class III whose term expires at an annualmeeting of stockholders in 2006. Upon the expiration of the term of a class ofdirectors, directors in that class will be elected for three-year terms at theannual meeting of stockholders in the year in which that term expires. Upon theappointment of John A. Kelley, Jr. as Chairman of the Board in February 2004,the Board also elected Laurence G. Walker as the Lead Director of theindependent directors of the Board.

 

Our officers serve at the discretion of the Board of Directors. Thereare no family relationships among our directors and officers.

 

**Board Committees and Other Information**

 

Our Board of Directors has a separately designated Audit Committee,Compensation Committee, Governance and Nominating Committee and TechnologyCommittee. The Audit Committee, currently comprised of Messrs. Johnston,Skilling and Sophie, reviews our accounting policies and practices, financialreporting and internal control structures, recommends to our Board of Directorsthe appointment of independent auditors to audit our financial statements eachyear and confers with our officers for purposes of reviewing our internalcontrols, accounting practices, financial structures and financial reporting.In addition, the Audit Committee confers with the independent auditors on anysignificant matters regarding internal controls over financial reporting thathave come to their attention during the conduct of their audit. Our AuditCommittee has been established in accordance with section 3(a)(58)(A) ofthe Securities Exchange Act and is comprised of directors who are independentwithin the meaning of the NASDAQ Stock Market, Inc. director independencestandards, as currently in effect.  TheBoard of Directors has determined that Mr. Sophie is an “audit committeefinancial expert” as defined by SEC rules. The Audit Committee held nine meetings in fiscal year 2003 and threemeetings since our fiscal year ended. The Compensation Committee currentlycomprised of Messrs. Uhlman and Walker and Ms. Atkins, reviewssalaries, incentives and other forms of compensation for our executive officersand administers our incentive compensation plans. The Compensation Committeehas delegated its duties with respect to option grants for employees andnon-executive officers to a compensation subcommittee, which is chaired byMr. Kelley, in accordance with the terms of the Company’s 2001 EquityIncentive Plan (formerly the 1997 Stock Option Plan). The Governance andNominating Committee, currently comprised of Messrs. Gerdelman andSkilling and Ms. Atkins, reviews corporate governance, board compensationmatters, oversees the evaluation and nomination process for new board members,reviews committee charters and the composition of new Board committees andconsiders questions of conflicts of interest of Board members and corporateofficers. The Technology Committee, currently comprised ofMessrs. Gerdelman, Uhlman, Walker and Mendez, reviews the Company’slong-term strategic technical direction and product roadmap and the Company’splanned investments in research and development.

 

***StockholderRecommendations***

 

It is the policy of the Board of Directors of McDATA to considerrecommendations for candidates to the Board of Directors from stockholdersholding no less than 100,000 shares of our common stock continuously for atleast six (6) months prior to the date of the submission of therecommendation.  Stockholderrecommendations for candidates to the Board of Directors must be directed inwriting to McDATA Corporation, Corporate Secretary, 380 Interlocken Crescent,Broomfield, CO 80021, and must include the candidate’s name, home and businesscontact information, detailed biographical data and qualifications, informationregarding any relationships between the candidate and McDATA within the lastthree years and evidence of the nominating person’s ownership of company Stock

 

Stockholder nominations to the Board of Directors must meet therequirements set forth in Article 3, Section 2(c) of our Bylaws.  Under these requirements, nominations forelection to the Board of Directors may be made at a meeting of stockholders byany stockholder entitled to vote in the election of directors who providestimely written notice to the Secretary of the Company.  This notice must contain specifiedinformation concerning the nominee and concerning the stockholder proposing thenomination.  In order to be timely, astockholder’s notice must be delivered to or mailed and received by theSecretary of the Company not

 

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less than 120 calendar days before the date of our proxy statementreleased to stockholders in connection with the previous year’s annual meetingof stockholders.

 

The Governing/Nominating Committee’s Criteria and process forevaluating and identifying the candidates that it selects, or recommends to thefull Board for selection, as director nominees, are as follows:

 

•                  TheGoverning/Nominating Committee regularly reviews the composition and size ofthe Board and determines the criteria for Board membership including issues ofcharacter, judgment, diversity, age, expertise, corporate experience and thelike.

 

•                  TheGoverning/Nominating Committee considers and recommends candidates to fill newpositions or vacancies on the Board, and reviews any candidates recommended bystockholders in accordance with the bylaws.

 

•                  The Governing/NominatingCommittee conducts an annual evaluation of the Board as a whole and evaluatesthe performance of current Board members proposed for reelection, andrecommends the Director nominees each year for approval by the Board andstockholders.

 

•                  In evaluatingthe qualifications of candidates, the Governing/Nominating Committee considersmany factors, including issues of character, judgment, diversity, age,independence, expertise, (especially in the Company’s industry but also thesystems manufacturing industry), corporate/business experience (especially as amember of senior Management of a high growth company), internationalexperience, length of service, other commitments and the like.  While the Governing/Nominating Committee hasnot established specific minimum qualifications for Director candidates, theGoverning/Nominating Committee believes that candidates and nominees mustreflect a Board that is comprised of directors who (i) are predominantlyindependent, (ii) are of high integrity, (iii) have qualifications that willincrease overall Board effectiveness and (iv) meet other requirements as may berequired by applicable rules, such as financial literacy or financial expertisewith respect to audit committee members.

 

•                  With regard tocandidates who are properly recommended by stockholders, theGoverning/Nominating Committee will review the qualifications of any suchcandidate, which review may, in the Governing/Nominating Committee’s direction,include interviewing references for the candidate, direct interview with thecandidate, or other actions that the Governing/Nominating Committee deemsnecessary or proper.

 

•                  In evaluatingand identifying candidates, the Governing/Nominating Committee has theauthority to retain and terminate any third party search firm that is used toidentify director candidates, and has the authority to approve the fees andretention terms of any search firm.

 

•                  TheGoverning/Nominating Committee will apply these same principles when evaluatingBoard candidates who may be elected initially by the full Board to fillvacancies or add additional directors prior to the annual meeting ofstockholders at which directors are elected.

 

•                  After completingits review and evaluation of director candidates, the Governing/NominatingCommittee selects, or recommends to the full Board of Directors for selection,the director nominees.

 

***Code of Ethics***

 

We have adopted a code of ethics that applies to our principalexecutive officer,  members of ourfinance department (including the principal financial officer and principalaccounting officer) and employees. This code of ethics, which is entitled “*McDATA’s Corporate Code of Conduct*,” isposted on our website. The Internet

 

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address for our code is located at the following Website:http://www.mcdata.com/about/board/gov.

 

We intend to satisfy the disclosure requirement under Item 10 of Form8-K regarding an amendment to, or waiver from, a provision of this code ofethics by posting such information on our website, at the address and locationspecified above.

 

**Section 16(a) Beneficial OwnershipReporting Compliance**

 

Section 16(a) of the Securities Exchange Act of 1934, asamended, requires our executive officers and directors, and persons who ownmore than 10% of our common stock, to file with the SEC reports of ownershipand changes in ownership of common stock and other equity securities of ourCompany. Executive officers, directors and greater than 10% stockholders arerequired by the SEC regulation to furnish to us copies of allSection 16(a) forms they file.

 

Based solely on a review of the copies of Section 16(a) formsfurnished to us and written representations that no other filings wererequired, we believe that all the SEC filing requirements applicable to ourexecutive officers, directors and greater than 10% stockholders were compliedwith for 2003, other than the late filing of a report on Form 4 for JohnA. Kelley, Jr. with regard to his January 2003 grant of 400,000 class Bstock options.

 

**ITEM 11. ExecutiveCompensation**

 

The following table sets forth information for the fiscal year endedJanuary 31, 2004 concerning the compensation paid to persons who served asour Chief Executive Officer, our four other most highly compensated executiveofficers at fiscal year end and one executive that resigned prior to fiscalyear end, all of whose total salary and bonus for such fiscal year exceeded$100,000, collectively referred to below as the Named Executive Officers.Long-term compensation awards include awards grant during the period January 1,2003 through January 31, 2004.

 

**Summary Compensation Table**

 
|                                 |   |     |   |                     |   |          |   | **Long-Term  Compensation**            |   |                                   |   |
|--------------------------------------|--------|----------|--------|--------------------------|--------|---------------|--------|----------------------------------------|--------|----------------------------------------|--------|
|                                 |   |     |   | **Annual  Compensation** |   | **Awards**    |   |                                   |   |
| **Name and Principal Position**      |   | **Year** |   | **Salary($)**            |   | **Bonus($)**  |   | **Restricted  Stock Award(s)  ($)(1)** |   | **Securities  Underlying  Options(#)** |   | **All Other  Compensation  ($)** |   |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| John A. Kelley, Jr.                  |   | 2003     |   | $390,854                 |   | $125,000      |   | $590,606                               |   | 400,000                                |   | $14,533 | (2) |
| Chairman, President and Chief        |   | 2002     |   | $339,234                 |   | $127,452      |   | $427,490                               |   | 315,000                                |   | $4,068 | (3) |
| Executive Officer                    |   | 2001     |   | $98,082                  |   | $56,829       |   | —                                 |   | 250,000                                |   | $2,817 | (4) |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| Ernest J. Sampias                    |   | 2003     |   | $312,972                 |   | $54,750  |   | $248,834                               |   | 200,000                                |   | $5,855 | (5) |
| Chief Financial Officer and Senior   |   | 2002     |   | $217,308                 |   | $150,000      |   | $180,000                               |   | 70,000                                 |   | $5,165 | (6) |
| Vice President of Finance            |   | 2001     |   | $46,769                  |   | $12,469       |   | —                                 |   | 15,000                                 |   | $238 | (7) |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| Michael B. Gustafson                 |   | 2003     |   | $260,273                 |   | $43,125       |   | $262,350                               |   | 50,000                                 |   | $11,563 | (8) |
| Senior Vice President of Worldwide   |   | 2002     |   | $234,615                 |   | $192,871      |   | —                                 |   | 90,000                                 |   | $5,855 | (9) |
| Marketing                            |   | 2001     |   | $136,669                 |   | $245,794      |   | —                                 |   | —                                 |   | $5,720 | (10) |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| Jean M. Becker                       |   | 2003     |   | $258,885                 |   | $43,125       |   | $173,640                               |   | —                                 |   | $15,022 | (11) |
| Senior Vice President of Engineering |   | 2002     |   | —                   |   | —        |   | $42,840                                |   | 150,000                                |   | — |   |
|                                 |   | 2001     |   | —                   |   | —        |   | —                                 |   | —                                 |   | — |   |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| Gary M. Gysin                        |   | 2003     |   | $219,254                 |   | $61,250       |   | $173,640                               |   | —                                 |   | $11,018 | (12) |
| Senior Vice President of Worldwide   |   | 2002     |   | —                   |   | —        |   | $42,840                                |   | 200,000                                |   | — |   |
| Sales and Service                    |   | 2001     |   | —                   |   | —        |   | —                                 |   | —                                 |   | — |   |
|                                 |   |     |   |                     |   |          |   |                                   |   |                                   |   |   |   |
| Alain F. Andreoli (14)               |   | 2003     |   | $285,769                 |   | $65,938       |   | —                                 |   | —                                 |   | $34,284 | (13) |
| Former Senior Vice President of      |   | 2002     |   | —                   |   | —        |   | —                                 |   | —                                 |   | — |   |
| Worldwide Sales and Services         |   | 2001     |   | —                   |   | —        |   | —                                 |   | —                                 |   | — |   |

 

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(1)                      The Named Executive Officers wereeach granted restricted Class B common stock under the Company’s ExecutivePerformance Incentive Bonus (EPIB) Plan from February 1, 2003 throughJanuary 31, 2004.  Messrs. Kelley,Gustafson, Sampias, Gysin, Andreoli and Ms. Becker were granted 19,700, 6,875,8,300, 6,000, 7,775 and 6,000 shares both on August 1, 2003 at a per shareprice of $10.61 and on November 1, 2003 at a per share price of$9.90.  These shares are restrictedunder the EPIB Plan for 48 months from the date of grant however a portion ofthe grant may have the restricted period accelerated to 18 months if certainquarterly targets are met.  The Companymet its quarterly objectives for the first and second quarter of 2003, and accordingly,the shares relating to those quarters were accelerated to 18 month cliffvesting.  In addition, Messrs. Kelley,Sampias , Gustafson, Gysin, Andreoli and Ms. Becker were granted 19,700, 8,300,13,750, 6,000, 7,800 and 6,000 shares on January 29, 2003 at a per share priceof $8.18.

 

(2)                      For 2003, this amount includes$1,645 of term life insurance premium, $2,804 paid to Mr. Kelley’s account inour 401(k) plan, $4,000 for tax and financial planning and $6,084 for a taxablefringe sales trip.

 

(3)                      For 2002, this amount includes$1,868 of term life insurance premium and $2,200 paid to Mr. Kelley’s accountin our 401(k) plan.

 

(4)                      For 2001, this amount includes$531 of term life insurance premium and $2,286 paid to Mr. Kelley’s account inour 401(k) plan.

 

(5)                      For 2003, this amount includes$1,528 of term life insurance premium, $3,396 paid to Mr. Sampias’s account inour 401(k) plan, and $931 for a taxable fringe sales trip.

 

(6)                      For 2002, this amount includes$1,040 of term life insurance premium and $4,125 paid to Mr. Sampias’s accountin our 401(k) plan.

 

(7)                      For 2001, this amount includes$238 of term life insurance premium.

 

(8)                      For 2003, this amount includes$513 of term life insurance premium, $6,000 paid to Mr. Gustafson’s account inour 401 (k) plan, and $5,050 for a taxable fringe sales trip.

 

(9)                      For 2002, this amount includes$355 of term life insurance premium and $5,500 paid to Mr. Gustafson’s accountin our 401(k) plan.

 

(10)                For 2001, This amount includes $216 forterm life insurance premium and $5,504 paid to Mr. Gustafson’s account in our401(k) plan.

 

(11)                For 2003, this amount includes $576 ofterm life insurance premium, $6,000 paid to Ms. Becker’s account in our 401(k)plan, $2,650 for tax and financial planning, and $5,796 for a taxable fringesales trip.

 

(12)                For 2003, this amount includes $425 ofterm life insurance premium, $6,000 paid to Mr. Gysin’s account in our 401(k)plan, and $4,593 for a taxable fringe sales trip.

 

(13)                For 2003, this amount includes $831 ofterm life insurance premium, $6,370 for a taxable fringe sales trip, and$27,083 in severance benefits.

 

(14)                Mr. Andreoli resigned from the CompanyDecember 2003 and forfeited all options and restricted stock.

 

**Option Grants in Last Fiscal Year**

 

The following table sets forth certain information for each grant ofstock options during the year ended January 31, 2004 to each of the NamedExecutive Officers. All of these options were granted under our 2001 McDATAEquity Incentive Plan and have a term of 10 years, subject to earliertermination in the event an optionee’s services to us cease. For moreinformation, see “Employee Benefit Plans” below for descriptions of thematerial terms of these options. During the month ended January 31, 2003 andthe year ended January 31, 2004, we granted options to purchase an aggregateof 1,071,275 shares and 3,682,640 shares, respectively, of Class B commonstock under the 2001 McDATA Equity Incentive Plan. Options were granted at anexercise price equal to the fair market value (as determined under the 2001McDATA Equity Incentive Plan) of our Class B common stock on the day priorto the grant date. Potential realizable values are net of exercise pricesbefore taxes, and are based on the assumption that our Class B commonstock appreciates at the annual rate shown, compounded annually, from the dateof grant until the expiration of the ten-year term and that the option isexercised at the exercise price and sold on the last day of its term at theappreciated price. These numbers are calculated based on SEC requirements anddo not

 

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reflect any projection or estimate of future stock price growth. Nostock appreciation rights were granted during the fiscal year endedJanuary 31, 2004.

 
|                 |   | **Individual  Grants**                          |   |                                                  |   |                           |   |
|----------------------|--------|-------------------------------------------------|--------|-------------------------------------------------------|--------|--------------------------------|--------|
|                 |   | **Number  Of  Securities  Underlying  Options** |   | **Percent of  Total  Options  Granted to  Employees** |   | **Exercise  Price Per  Share** |   | **Expiration** |   | **Potential  Realizable Value at Assumed  Annual Rate of Stock Price  Appreciation for Option Term** |   |
| **Name**             |   | **Granted(#)**                                  |   | **In FY 2003**                                        |   | **($/share)**                  |   | **Date** |   | **5% ($)** |   | **10% ($)** |   |
|                 |   |                                            |   |                                                  |   |                           |   |   |   |   |   |   |   |
| John A. Kelley, Jr.  |   | 100,000                                         | *      |                                                  |   | $                              | 7.90   |   | 1/24/13 |   | $ | 501,229.02 |   | $ | 1,270,212.74 |   |
|                 |   | 300,000                                         | *      | 8.4                                                   | %      | 8.18                           |   | 1/29/13 |   | 1,543,307.42 |   | 3,911,043.99 |   |
| Ernest J.Sampias     |   | 200,000                                         | *      | 4.2                                                   | %      | 8.18                           |   | 1/29/13 |   | 1,028,871.61 |   | 2,607,362.67 |   |
| Michael B. Gustafson |   | 50,000                                          | *      | 1.1                                                   | %      | 8.18                           |   | 1/29/13 |   | 257,217.90 |   | 651,840.67 |   |
| Jean M. Becker       |   | 0                                               |   |                                                  | **     | —                         |   | — |   | — |   | — |   |
| Gary M. Gysin        |   | 0                                               |   |                                                  | **     | —                         |   | — |   | — |   | — |   |
| Alain Andreoli       |   | 0                                               |   |                                                  | **     | —                         |   | — |   | — |   | — |   |
|                      |        |                                                 |        |                                                       |        |                                |        |  |  |  |  |  |  |  |  |  |

 

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* McDATA changed its fiscal year end to January 31.  While these 2003 grants did not occur duringthe 2003 fiscal year, we have nonetheless disclosed the gap period betweenJanuary 1, 2003 and January 31, 2003.

 

**Less than 1%

 

**Aggregated Option Exercises in Last FiscalYear and Fiscal Year-End Option Values**

 

The following table sets forth information with respect to the NamedExecutive Officers concerning exercisable and unexercisable options held as ofJanuary 31, 2004. The dollar value of in-the-money options atJanuary 31, 2004 is calculated by determining the difference between theyear-end fair market value of $8.71 per share and the option exercise price.

 
|                 |   | **Shares  Acquired on** |   | **Value**       |    | **Number of  Securities  Underlying Unexercised  Options at  January 31, 2004** |    | **Value of  Unexercised  In-the-Money Options at  January 31, 2004** |    |
|----------------------|--------|-------------------------|--------|-----------------|---------|--------------------------------------------------------------------------------------|---------|---------------------------------------------------------------------------|---------|
| **Name**             |   | **Exercise(#)**         |   | **Realized($)** |    | **Exercisable**                                                                      |    | **Unexercisable**                                                         |    | **Exercisable** |   | **Unexercisable** |   |
|                 |   |                    |   |            |    |                                                                                 |    |                                                                      |    |   |   |   |   |
| John A. Kelley, Jr.  |   | —                  |   | —          |    | 300,750                                                                              |    | 652,085                                                                   |    | $ | 60,000 |   | $ | 180,000 |   |
| Ernest J. Sampias    |   | —                  |   | —          |    | 80,000                                                                               |    | 205,000                                                                   |    | 33,500 |   | 100,500 |   |
| Michael B. Gustafson |   | 40,000                  |   | $               | 333,625 |                                                                                 | 225,000 |                                                                      | 134,761 |   | 856,225 |   | 19,875 |   |
| Jean M. Becker       |   | —                  |   | —          |    | 37,500                                                                               |    | 112,500                                                                   |    | 58,875 |   | 176,625 |   |
| Gary M. Gysin        |   | —                  |   | —          |    | 50,000                                                                               |    | 150,000                                                                   |    | 78,500 |   | 235,500 |   |
| Alain F. Andreoli    |   | —                  |   | —          |    | —                                                                               |    | —                                                                    |    | — |   | — |   |
|                      |        |                         |        |                 |         |                                                                                      |         |                                                                           |         |  |  |  |  |  |  |  |

 

**Management Bonus Program**

 

Beginningin the third quarter of 2002, a revised Executive Performance Incentive Bonus(EPIB) plan was implemented in lieu of the prior cash bonus plan. The EPIB planuses restricted Class B common stock with accelerated vesting opportunities toreward participants for the collective achievement of strategic corporaterevenue and EPS goals on a quarterly basis. The EPIB plan is designed tofurther drive performance beyond target levels through the availability ofadditional cash bonus opportunities when target metrics are substantiallyexceeded. Currently the cash bonus component of the EPIB plan is calculated asa percentage of base compensation and can range from 7.5% to 18.75% ofquarterly base salary if corporate objectives are achieved, and from 30% to 75%if more progressive objectives are met.

 

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John F. McDonnell, the former Chairman of the Board of Directors,participated in an incentive compensation plan which was based upon theattainment of annual corporate financial objectives established by the Board ofDirectors. Upon attainment of these objectives, the plan provided for a paymentequal to a percentage of annual salary.

 

**Change of Control Arrangements/EmploymentAgreements**

 

Named Executive Officers and certain other officers have entered intochange of control severance agreements and employment agreements with us. Thechange of control severance agreements provide these officers with (i) apayment (in a lump sum or according to our normal payroll timetable) equal tofour times the average of their quarterly compensation over the preceding eightcalendar quarters, (ii) payment for all accrued but unused vacation days,(iii) the provision of health benefits for a period of time and (iv) automaticacceleration of the vesting of all stock options held if we terminate withoutcause their employment upon a change in control; provided that our executiveofficers will not engage in any activity that conflicts with their obligationsto us, induce other employees to leave us, or compete with us for a period ofone year after termination of their employment. Under the terms of theemployment agreements to which we are party with certain of our executiveofficers, all confidential, proprietary or other trade secret information andall other discoveries, inventions, processes, methods and improvements made bythe employee are our property. In addition, pursuant to these agreements,employees may not compete with us for one year after termination of their employment.

 

InDecember 2003, the Company entered into a one year single triggerseverance agreement with John A. Kelley, Jr., the Company’s Chief ExecutiveOfficer and President, should he be terminated without cause or voluntarilyleaves for good reason. The Company received in consideration for the severanceagreement (a) an extension to 24 months of Mr. Kelley’s current 12 monthrestriction, to not compete against the Company and to not solicit Companyemployees after such termination, and (b) a release of all claims, if any,against the Company before payment of any benefits there under. The benefitsunder the severance agreement would include one year of salary and targetbonus, medical benefits under COBRA for up to one year, an extension of optionexercisablity from ninety days to one year for subsequently issued options andcontinued vesting of restricted stock for one year after termination. Mr.Kelley’s existing change of control severance agreement, as described above,will continue to be in full force and effect, however benefits under the newsingle trigger severance agreement would not be payable if the Change ofControl Severance Agreement is triggered.

 

**Limitation of Liability and Indemnification**

 

Our amended and restated certificate of incorporation and amended andrestated by-laws provide that we shall indemnify our directors and officers tothe fullest extent that Delaware law permits. Delaware law permits acorporation to indemnify any director, officer, employee or agent made orthreatened to be made a party to any pending or completed proceeding if theperson acted in good faith and in a manner that the person reasonably believedto be in the best interests of the corporation and, with respect to anycriminal proceeding, had no reasonable cause to believe that his or her conductwas unlawful.

 

Our amended and restated certificate of incorporation limits theliability of our directors to the maximum extent permitted by Delaware law.Delaware law provides that directors will not be personally liable for monetarydamages for breach of their fiduciary duties as directors, except liabilityfor:

 

•                  any breach oftheir duty of loyalty to the corporation or its stockholders;

 

•                  acts oromissions not in good faith or which involve intentional misconduct or aknowing violation of law;

 

•                  unlawfulpayments of dividends or unlawful stock repurchases or redemptions; or

 

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•                  any transactionfrom which the director derived an improper personal benefit.

 

This provision has no effect on any non-monetary remedies that may beavailable to us or our stockholders, nor does it relieve us or our officers ordirectors from compliance with federal or state securities laws.

 

Given the increasing difficulty in obtaining additional liabilityinsurance for directors and officers and in recognition of the need to protectcertain directors and officers from unwarranted personal liability, we extendindemnification agreements to our board members and certain key officers to providespecific contractual assurance that the indemnification protection promised bythe laws will be available to such officers.

 

Insofar as indemnification for liabilities arising under the SecuritiesAct may be permitted to directors, officers, or persons controlling us underthe provisions that we describe above or otherwise, we have been informed thatin the opinion of the SEC, this indemnification is against public policy asexpressed in the Securities Act and is therefore unenforceable.

 

Our amended and restated by-laws also permit us to purchase andmaintain insurance on behalf of any officer or director for any liabilityarising out of his or her actions in that capacity, regardless of whether ourby-laws would otherwise permit indemnification for that liability. We currentlyhave such liability insurance for our officers and directors.

 

At the present time, there are several class action lawsuits (see Item3. Legal Proceedings) involving certain of our current and former officers. Webelieve these lawsuits are without legal merit. Accordingly, the Board ofDirectors has authorized indemnification for such current and former officers.

 

**Employee Benefit Plans**

 

***2001 McDATA EquityIncentive Plan***

 

OurBoard of Directors and our stockholders originally approved and adopted ourMcDATA Stock Option Plan in October 1997. This plan was subsequently renamed the 2001 McDATA Equity IncentivePlan, or the 2001 Plan, and was amended to increase (from 24 million to 30 millionshares) the authorized number of Class B common shares issuable under the planand expand the type of awards to include restricted stock and stock awards andother necessary changes. As of January 31, 2004, approximately6,473,692 million shares of our Class B common stock were reservedfor issuance under the 2001 Plan. Under the terms of the 2001 Plan, our Boardof Directors may grant incentive stock options, non-qualified stock options,stock bonuses and rights to acquire restricted stock to our employees andnon-qualified stock options to our directors, provided that certain eligibilityrequirements are satisfied. Our Board of Directors administers the 2001 Plan,but has delegated to the Compensation Committee the authority to administer theplan. A summary of the terms related to options are as follows:

 

•                  the duration of the option, which may notexceed 10 years for incentive stock options and 10 years and 1 month fornonstatutory stock options;

 

•                  whether an option will be an incentive stockoption or a non-qualified stock option;

 

•                  the number of shares of Class B commonstock covered by the option; and

 

•                  when the option becomes exercisable.

 

Theexercise price per share of Class B common stock for:

 

•                  non-qualified options must be no less than85% of the fair market value per share of the Class B common stock subjectto the option;

 

•                  incentive stock options must be no less thanthe fair market value of the Class B common stock

 

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subjectto the option; and

 

•                  incentive stock options granted to anemployee owning more than 10% of the total combined voting power of all classesof our capital stock, or of any related company, must not be less than 110% ofthe fair market value per share of the Class B common stock.

 

Initially, each incentive stock option granted is exercisable over aperiod determined by the Compensation Committee in its discretion, not toexceed ten years from the date of the grant as required by the Internal RevenueCode of 1986. In addition, the exercise period for an incentive stock optionmay not exceed five years from the date of the grant if the option isgranted to an individual who, at the time of the grant, owns more than 10% ofthe total combined voting power of all classes of our capital stock. TheCompensation Committee generally has the right to accelerate the exercisabilityof any options granted under the 2001 Plan that would otherwise beunexercisable. In the event of certain changes in control, the acquiring orsuccessor corporation may assume or grant substitute options for options thenoutstanding under the 2001 Plan, or such options shall terminate.

 

The2001 Plan expires on September 30, 2010, except as to options or awardsoutstanding on that date. Subject to the terms of the 2001 Plan, the Board ofDirectors or the Compensation Committee may terminate or amend the 2001 EquityIncentive Plan at any time.

 

TheCompensation Committee determines the purchase price of other stock awards.However, the Compensation Committee may award stock bonuses in consideration ofpast services without purchase payment. Shares that we sell or award under the2001 Plan may, but need not be, restricted and subject to a repurchase optionin our favor in accordance with a vesting schedule that the CompensationCommittee determines. The Compensation Committee, however, may accelerate thevesting of the restricted stock. In accordance with the terms of the 2001 Plan,the Compensation Committee has delegated its duties with respect to equitygrants for non-executive officers to a Compensation Subcommittee, which ischaired by Mr. Kelley.

 

Asof January 31, 2004, outstanding Class B common stock awards consisting ofoptions and restricted stock totaled 14,000,000.  Of this amount 415,000 shares of restricted Class B common stockhave been issued and 2,585,000 are available for issuance.  The weighted average exercise price ofrestricted stock awards was $11.04.  Asof January 31, 2004, the weighted average exercise price of outstanding stockoptions was $11.38.

 

***2003 McDATA Acquisition Equity IncentivePlan***

 

Our Board of Directors approved and adopted our 2003 McDATA AcquisitionEquity Incentive Plan, or the 2003 Plan, in August 2003.  The 2003 Plan is a limited purpose plan toallow for the issuance of inducement grants of restricted and unrestrictedClass B common stock to new employees in connection with a merger with oracquisition of a company or business by McDATA.  The authorized number of Class B common shares issuable under theplan is 3,000,000 and includes awards such as restricted stock and stockawards.  As of January 31, 2004,approximately 1,300,000 shares of our Class B common stock had been issuedunder the 2003 Plan in connection with the 2003 acquisitions of Nishan andSanera and 1,700,000 shares of our Class B common stock are availablefor future issuances.   The 2003 Plan expires inSeptember 30, 2013, except as to awards outstanding on that date. Subjectto the terms of the 2003 Plan, the Board of Directors or the CompensationCommittee may terminate or amend the 2003 Plan at any time.  TheCompensation Committee may accelerate the vesting of restricted stock.

 

***2002 Employee Stock Purchase Plan***

 

In2002, our Board of Directors adopted and our stockholders approved the McDATAEmployee Stock Purchase Plan, or the Purchase Plan. The Purchase Plan becameeffective as of August 1, 2002. The Purchase Plan is an employee stockpurchase plan under Section 423 of the Internal Revenue Code. The PurchasePlan is administered by the Compensation Committee, and the CompensationCommittee is authorized to determine any questions arising in theadministration, interpretation and application of the Purchase Plan. The Boardof Directors may at any time amend the Purchase Plan in any respect which shallnot adversely affect the rights of

 

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participantspursuant to shares previously acquired under the Purchase Plan, provided thatapproval by our stockholders of the Company is required to (i) increasethe number of shares to be reserved under the Purchase Plan (except foradjustments by reason of stock dividends, stock splits, corporate separations,recapitalizations, mergers, consolidations, combinations, exchanges of sharesand similar transactions), (ii) decrease the minimum purchase price, (iii) withdrawthe administration of the Purchase Plan from the Compensation Committee, or(iv) change the definition of employees eligible to participate in thePurchase Plan.

 

Upto 1,200,000 shares of our Class B common stock are available fordistribution under the Purchase Plan, subject to appropriate adjustments by theCompensation Committee in the event of certain changes in the outstandingshares of Class B common stock by reason of stock dividends, stock splits,corporate separations, recapitalizations, mergers, consolidations,combinations, exchanges of shares or similar transactions. As ofJanuary 31, 2004 approximately 679,000 shares of our Class Bcommon stock remain available for issuance under the Purchase Plan.

 

Any of our employees or, subject to approval by the Board of Directors,employees of any of our subsidiary corporations (including officers and anydirectors who are also employees) will be eligible to participate in thePurchase Plan for any Purchase Period. “Purchase Period” means a six-monthperiod ending on the last day of February or August of each year (oranother period determined by the Compensation Committee). No employee mayparticipate in the Purchase Plan if such employee would be deemed for purposesof the Internal Revenue Code to own stock possessing 5% or more of the totalcombined voting power or value of all classes of our stock. If the employmentof a participant terminates for any reason, including death, disability orretirement, the amounts previously withheld will be refunded. The rights of aparticipant under the Purchase Plan are exercisable only by the participantduring his or her lifetime. No right or interest of any participant in thePurchase Plan may be sold, pledged, assigned or transferred in any manner otherthan by will or the laws of descent and distribution.

 

Aneligible employee who elects to participate in the Purchase Plan will deliver asigned election form which authorizes us to make payroll deductions of aspecified whole percentage from 1% to 10% of the employee’s gross cashcompensation as defined in the Purchase Plan. A participant may elect towithdraw from the Purchase Plan at any time before the end of a PurchasePeriod. As of the last day of each Purchase Period, the amounts withheld for aparticipant in the Purchase Plan will be used to purchase shares of ourClass B common stock. The purchase price of each share will be equal to85% of the lesser of the fair market value (as determined under the provisionsof the Purchase Plan) of a share of Class B common stock on either thefirst or last day of the Purchase Period. All amounts so withheld will be usedto purchase the number of shares of Class B common stock that can bepurchased with such amounts at such price, unless the participant has properlynotified us that he or she elects to purchase a lesser number of shares or toreceive all or a portion of the entire amount in cash in accordance with theterms of the Purchase Plan.

 

Nomore than $25,000 in fair market value (determined on the first day of therespective Purchase Periods) of shares of Class B common stock may bepurchased by any participant for each calendar year under the Purchase Plan andall other employee stock purchase plans, if any, that we or any of our parentor subsidiary corporations may establish. If purchases by all participantswould exceed the number of shares of Class B common stock available forpurchase under the Purchase Plan, each participant will be allocated a ratableportion of such available shares. Any amount not used to purchase shares ofClass B common stock will be refunded to the participant in cash.

 

Sharesof Class B common stock acquired by each participant will be held in ageneral securities brokerage account maintained by the Agent for the benefit ofall participants, with an agent, selected by us, maintaining individual subaccounts for each participant. Each participant will be entitled to vote allshares held for the benefit of such participant in the general securitiesbrokerage account. After meeting certain holding requirements, certificates forthe number of shares of Class B common stock purchased by a participantwill be issued and delivered to him or her only upon the request of suchparticipant or his or her representative.

 

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Allrights of participants in any offering under the Purchase Plan will terminateat the earlier of (i) the day that participants become entitled topurchase a number of shares of Class B common stock equal to or greater thanthe number of shares remaining available for purchase or (ii) at any time,at the discretion of the Board of Directors, after 30 days’ notice hasbeen given to all participants. Upon termination of the Purchase Plan, sharesof Class B common stock will be purchased for participants in accordancewith the terms of the Purchase Plan, and cash, if any, previously withheld andnot used to purchase Class B common stock will be refunded to theparticipants, as if the Purchase Plan were terminated at the end of a PurchasePeriod.

 

***401(k) Plan***

 

TheCompany has adopted a 401(k) Plan. Participants in our 401(k) planmay contribute up to 15% of their total annual compensation, not to exceed thespecified statutory limit, which was $12,000 in calendar year 2003. The401(k) plan permits, but does not require, us to make contributions to the401(k) plan on behalf of our employees. Our current practice is to match$0.50 on each dollar of an employee’s contributions up to the first 6% of anemployee’s compensation with a total maximum matching contribution of 3% of anemployee’s compensation. All contributions to the 401(k) plan by or onbehalf of employees are subject to the aggregate annual limits prescribed bythe Internal Revenue Service. Under our 401(k) plan, our participantsreceived full and immediate vesting of their contributions and are vested inmatching contributions over a three-year period.

 

***Profit Sharing***

 

Subjectto approval by the Board of Directors or the Compensation Committee, we havehistorically awarded limited profit sharing to eligible employees based onCompany performance. For 2001, the amount approved was 2.5% of annual basesalary. For 2002, the amount approved was 7.5% of an employee’s fourth quarterbase earnings if the employee did not participate in any other incentivecompensation plan of the Company. In 2003, the profit sharing program wasreplaced by the success share program described below.

 

***Other Bonus Program***

 

APerformance Incentive Bonus (PIB) plan was implemented in the third quarter of2002 for eligible managers that were not eligible under the EPIB plan forexecutives or any other sales or incentive compensation plan.  The PIB plan is designed to further driveperformance beyond target levels through the availability of additional cashbonus opportunities when target metrics are substantially exceeded. The targetcash bonus of the PIB plan can range from 8% to 22% of the manager’s quarterlybase salary if certain quarterly corporate and individual objectives areachieved. The Compensation Committee has significant discretion in determiningwhether objectives have been met under the plan.

 

Inaddition, a Success Share plan was implemented in the third quarter of 2002 foreligible employees that are not managers and are not otherwise eligible underthe EPIB plan for executives, the PIB plan for managers or any other sales orincentive compensation plan.  TheSuccess Share plan is designed to further drive performance beyond targetlevels through the availability of additional cash bonus opportunities whentarget metrics are substantially exceeded. The target cash bonus of the SuccessShare plan may not exceed more than 5% of the eligible employee’s quarterlybase salary if certain quarterly corporate objectives are achieved. The CompensationCommittee has significant discretion in determining whether the objectives havebeen met under the plan.

 

**Director Compensation**

 

Director’sfees for 2003, paid only to Directors who are not McDATA employees, are asfollows:

 
| Lead Director Retainer      |   | $  10,000 |   |
|-----------------------------|--------|----------------|--------|
| Annual Director Retainer    |   | 15,000         |   |
| Board Meeting Fee           |   | 2,000          |   |
| Audit Committee Chair Fee   |   | 2,000          |   |
| Other Committee Chair Fee   |   | 1,500          |   |
| Audit Committee Meeting Fee |   | 1,500          |   |
| Other Committee Meeting Fee |   | 1,000          |   |

 

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AnyDirector who is an employee of McDATA or one of its subsidiaries receives nocompensation for serving as a Director. Accordingly, John F. McDonnell and JohnA. Kelley, Jr., did not receive fees for their services as Board members infiscal year 2003. With regard to incentive compensation for our directors, ourpractice has been to grant Directors options to purchase 50,000 shares of ourClass B common stock when they become directors and to grant them optionsto purchase an additional 30,000 shares of our Class B common stock eachyear thereafter, with each grant vesting as to fifty percent each year.  The Lead Director is granted anadditional  10,000 shares of our Class Bcommon stock each year.

 

InOctober 1997, before he became a director, Mr. McDonnell was grantedan option to purchase 1,000,000 shares of our Class B common stock. InAugust 2001, Mr. Kelley was hired as President and Chief OperatingOfficer and was granted an option to purchase 250,000 shares of ourClass B common stock. In August 2002 and January 2003,Mr. Kelley, our current Chairman, Chief Executive Officer and President,was granted an option to purchase 315,000 and 400,000 shares of ourClass B common stock, respectively.

 

**Compensation Committee Interlocks and Insider Participation**

 

The members of the Compensation Committee for the fiscal year endedJanuary 31, 2004 were Betsy S. Atkins, Thomas M. Uhlman and Laurence G.Walker. No member of this committee was at any time during the 2003 fiscal yearor at any other time an officer or employee of the Company, and no member hadany relationship with the Company requiring disclosure under Item 404 ofRegulation S-K. No executive officer of the Company has served on the board ofdirectors or compensation committee of any other entity that has or has had oneor more executive officers who served as a member of the Board of Directors orthe Compensation Committee during the fiscal year ended January 31, 2004.

 

Nointerlocking relationship exists between our Board of Directors or CompensationCommittee and the board of directors or compensation committee of any otherentity, nor has any interlocking relationship existed in the past.

 

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**REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OFDIRECTORS**

 

Thefollowing is the report of the Compensation Committee of the Board of Directorswith respect to the compensation paid to the Company’s executive officersduring fiscal year 2003. Actual compensation earned during fiscal year 2003 bythe Named Executive Officers is shown in the Summary Compensation Table.

 

**Compensation Philosophy**

 

TheCompany operates in the extremely competitive and rapidly changing hightechnology industry. The Compensation Committee believes that the compensationprograms for the executive officers should be designed to attract, motivate andretain talented executives responsible for the success of the Company andshould be determined within a competitive framework and based on theachievement of designated business objectives, individual contribution,customer satisfaction and financial performance. Within this overallphilosophy, the Compensation Committee’s objectives are to:

 

•                  Provide a competitive total compensationpackage that takes into consideration the compensation practices of companieswith which the Company competes for executive talent.

 

•                  Provide variable compensation opportunitiesthat are linked to achievement of financial, organization, management andindividual performance goals.

 

•                  Align the financial interests of executiveofficers with those of stockholders by providing executives with an equitystake in the Company.

 

**Components of Executive Compensation**

 

Thecompensation program for the Company’s executive officers consists of the followingcomponents:

 

•                  Base Salary

 

•                  Management Bonus Program

 

•                  Long-Term Stock Option Incentives

 

**Base Salary**

 

The Compensation Committee reviews salaries for the Chief ExecutiveOfficer and other executive officers early in the fiscal year. Base salaries areestablished by the Compensation Committee based upon competitive compensationdata, an executive’s job responsibilities, level of experience, individualperformance and contribution to the business. No specific formula is applied todetermine the weight of each factor. The Compensation Committee bases itsdetermination of Mr. Kelley’s salary on his individual performance and thesalaries paid to chief executive officers of peer companies. Based upon areview of competitive compensation data in early 2003, the CompensationCommittee set Mr. Kelley’s base salary to $400,000 for 2003.  The salaries for the other Named ExecutiveOfficers are listed in the *SummaryCompensation Table*.

 

**Management Bonus Program**

 

Beginningin the third quarter of 2002, a revised Executive Performance Incentive Bonus(EPIB) plan was implemented in lieu of the earlier cash only based managementbonus program. The EPIB plan uses restricted stock with accelerated vestingopportunities to reward participants for the collective achievement ofstrategic corporate revenue and pro forma EPS goals on a quarterly basis. TheEPIB plan is designed to further drive performance beyond target levels throughthe availability of additional cash bonus opportunities when target metrics aresubstantially exceeded. Currently the cash bonus component of the EPIB plan iscalculated as a percentage of base compensation and can range from 7.5% to18.75% of quarterly base salary if corporate objectives are achieved, and from30% to 75% if more progressive objectives are met.  The EPIB plan did pay for corporate performance in the first andsecond fiscal quarter of 2003 and the applicable restricted shares for those

 

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quarterswere accelerated per the plan. Under the EPIB plan since January 1, 2003, Mr.Kelley was granted 59,100 shares of restricted Class B common stock with a 48month cliff restriction period.  As aresult of the achievement of goals set under the EPIB plan in the first andsecond fiscal quarters of 2003, 29,550 of these shares of restricted Class Bcommon stock had their restriction period accelerated to 18 months.  The grants under the EPIB plan for the otherNamed Executive Officers are listed in the *SummaryCompensation Table*.

 

**Long-Term Stock Option Incentives**

 

TheCompensation Committee provides the Company’s executive officers with long-termincentive compensation through grants of options to purchase the Company’sClass B common stock. The goal of the long-term stock option incentive programis to align the interests of executive officers with those of the Company’sstockholders and to provide each executive officer with a significant incentiveto manage the Company from the perspective of an owner with an equity stake inthe business. It is the belief of the Compensation Committee that stock optionsdirectly motivate an executive to maximize long-term stockholder value. Theoptions also utilize vesting periods that encourage key executives to continuein the employ of the Company. The Compensation Committee considers the grant ofeach option subjectively, reviewing factors such as the anticipated futurecontribution of the executive toward the attainment of the Company’s long-termstrategic performance goals. Under the 2001 McDATA Equity Incentive Plan, Mr.Kelley was granted 400,000 options to purchase Class B common stock sinceJanuary 1, 2003.  The grants under the2001 McDATA Equity Incentive Plan for the other Named Executive Officers arelisted in the *Summary Compensation Table*.

 

**Section 162(m)**

 

TheCompany has considered the potential future effects of Section 162(m) ofthe Internal Revenue Code on the compensation paid to the Company’s executiveofficers. Section 162(m) disallows a tax deduction for any publicly heldcorporation for individual compensation exceeding $1.0 million in anytaxable year for any of the Named Executive Officers, unless compensation isperformance-based. The Company will seek to qualify the variable compensationpaid to its executive officers for an exemption from the deductibilitylimitations of Section 162(m).

 
|   | Respectfully  submitted by:    |
|--------|--------------------------------|
|   |                           |
|   | **The Compensation Committee** |
|   | Thomas  M. Uhlman, *Chairman*  |
|   | Betsy  S. Atkins               |
|   | Laurence  G. Walker            |

 

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**Performance Graph**

 

Set forth below is a line graph comparing the annual percentage changein the cumulative return to the stockholders of our Class A Common Stockwith the cumulative return of the NASDAQ Market Index and the SIC Code ComputerPeripheral Equipment Index for the period commencing February 5, 2001 andending on January 30, 2004. Returns for the indices are weighted based onmarket capitalization at the beginning of each measurement point.

 

**COMPARING CUMULATIVE TOTAL RETURNAMONG MCDATA CORPORATION CLASS A,NASDAQ MARKET INDEX AND SIC CODE INDEX**

 

 

ASSUMES $100 INVESTED ON FEB. 5 2001ASSUMES DIVIDENDS REINVESTEDFISCAL YEAR ENDING JANUARY 31, 2004

 
|                    |   | **2/5/2001** |   | **1/31/2002** |   | **1/31/2003** |   | **1/30/2004** |   |
|-------------------------|--------|--------------|--------|---------------|--------|---------------|--------|---------------|--------|
|                    |   |         |   |          |   |          |   |          |   |
| McDATA Corporation Cl A |   | $            | 100.00 |          | $      | 53.62         |   | $             | 17.06  |   | $ | 19.00 |   |
| SIC Code 3669           |   | $            | 100.00 |          | $      | 27.07         |   | $             | 10.46  |   | $ | 22.19 |   |
| NASDAQ Market Index     |   | $            | 100.00 |          | $      | 70.45         |   | $             | 48.63  |   | $ | 76.33 |   |

 

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(1)                                  Thegraph assumes that $100 was invested on February 5, 2001 in the Company’sClass A common stock, in the NASDAQ Market Index, and the SIC Code, and thatall dividends were reinvested.  Nodividends have been declared or paid on the Company’s Class A commonstock.  Stockholder returns over theindicated period should not be considered indicative of future stockholderreturns.

 

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                Set forthbelow is a line graph comparing the annual percentage change in the cumulativereturn to the stockholders of our Class B Common Stock with the cumulativereturn of the NASDAQ Market Index and the SIC Code Computer PeripheralEquipment Index for the period commencing August 9, 2000 and ending onJanuary 30, 2004. Returns for the indices are weighted based on marketcapitalization at the beginning of each measurement point.

 

**COMPARING CUMULATIVE TOTAL RETURNAMONG MCDATA CORPORATION CLASS B,NASDAQ MARKET INDEX AND SIC CODE INDEX**

 

 

ASSUMES $100 INVESTED ON AUG. 9, 2000ASSUMES DIVIDENDS REINVESTEDFISCAL YEAR ENDING  JANUARY 30,2004

 
|                    |   | **8/9/2000** |   | **1/31/2001** |   | **1/31/2002** |   | **1/31/2003** |   | **1/30/2004** |   |
|-------------------------|--------|--------------|--------|---------------|--------|---------------|--------|---------------|--------|---------------|--------|
| McDATA Corporation Cl B |   | $            | 100.00 |          | $      | 64.28         |   | $             | 30.74  |          | $      | 9.27 |   | $ | 10.18 |   |
| SIC Code 3669           |   | $            | 100.00 |          | $      | 74.53         |   | $             | 20.18  |          | $      | 7.79 |   | $ | 16.54 |   |
| NASDAQ Market Index     |   | $            | 100.00 |          | $      | 73.53         |   | $             | 51.80  |          | $      | 35.79 |   | $ | 56.12 |   |

 

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(1)                                  The graph assumesthat $100 was invested on August 9, 2000 in the Company’s Class B commonstock, in the NASDAQ Market Index, and the SIC Code Index, and that alldividends were reinvested.  No dividendshave been declared or paid on the Company’s Class B common stock.  Stockholder returns over the indicatedperiod should not be considered indicative of future stockholder returns.  The information contained above under thecaptions “*Report of the CompensationCommittee of the Board of Directors*” and “*Performance Graph*” shall not be deemed to be “solicitingmaterial” or to be “filed” with the SEC, nor shall such information beincorporated by reference into any future filing under the Securities Act orthe Securities Exchange Act, except to the extent that the Company specificallyincorporates it by reference into such filing.

 

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**ITEM12. Security Ownership of Certain BeneficialOwners and Management**

 

The following table sets forth certain information concerning thebeneficial ownership of our common stock as of January 31, 2004.  Unless otherwise indicated, the address ofeach listed stockholder is c/o McDATA Corporation, 380 Interlocken Crescent,Broomfield, Colorado 80021.

 

We have determined beneficial ownership in accordance with the rules ofthe SEC. Except as indicated by the footnotes below, we believe, based on theinformation furnished to us, that the persons and entities named in the tablesbelow have sole voting and investment power with respect to all shares ofcommon stock that they beneficially own, subject to applicable communityproperty laws.  We have based ourcalculation of the percentage of beneficial ownership on the number of sharesof Class A common stock outstanding on January 31, 2004, or the number ofshares of Class B common stock outstanding on January 31, 2004, as thecase may be.  There were 81,000,000shares of Class A common stock outstanding on January 31, 2004, and36,051,473 shares of Class B common stock outstanding on January 31, 2004.

 

In computing the number of shares of Class B common stock beneficiallyowned by a person and the percentage ownership of that person, we deemedoutstanding shares of Class B common stock subject to options held by that personthat are currently exercisable or exercisable within 60 days ofJanuary 31, 2004.  Asterisksrepresent beneficial ownership of less than one percent.

 
|                                                                                        |   | **Number of  Shares of Common Stock  Class Beneficially Owned** |   | **Percent of  Shares of  Common Stock Class  Beneficially Owned** |   |
|---------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|-------------------------------------------------------------------|--------|
| **Name and Address of the  Beneficial Owner**                                               |   | **Class A**                                                |   | **Class B**                                                  |   | **Class A** |   | **Class B** |   |
|                                                                                        |   |                                                            |   |                                                              |   |   |   |   |   |
| **5% Stockholders**                                                                         |   |                                                            |   |                                                              |   |   |   |   |   |
| *Essex Investment Management Co. LLC*.  125 High Street, 29th Floor  Boston, MA  02110 |   | 9,172,506                                                       | (1)    | —                                                            |   | 11.3 | % | — |   |
| *Wellington Management Company LLP*75 State Street  Boston, MA  02109                  |   | 6,315,300                                                       | (1)    | 3,105,400                                                         | (1)    | 7.8 | % | 8.6 | % |
| *Oak Associates, LTD*3875 Embassy Parkway #250  Akron, OH  44333                       |   | 5,938,245                                                       | (1)    | —                                                            |   | 7.3 | % | — |   |
| *Mellon Financial Corporation*One Mellon Center  Pittsburgh, PA  15258                 |   | 5,314,522                                                       | (1)    | —                                                            |   | 6.6 | % | — |   |
| *Denver Investment Advisors LLC*1225 17th Street, 26th Floor  Denver, CO  80202        |   | —                                                          |   | 3,604,470                                                         | (1)    | — |   | 10.0 | % |
| *Patricia L.  McDonnell*                                                                    |   | 37,819                                                          | (2)    | 2,961,500                                                         | (1)(3) |   | * | 8.2 | % |
| *John F. McDonnell*                                                                         |   | 28,311                                                          | (4)    | 5,820,000                                                         | (1)    |   | * | 16.1 | % |
| **Executive Officers  and Directors**                                                       |   |                                                            |   |                                                              |   |   |   |   |   |
| John F. McDonnell                                                                           |   | 28,311                                                          | (4)    | 5,820,000                                                         | (5)    |   | * | 16.1 | % |
| John A. Kelley                                                                              |   | —                                                          |   | 417,077                                                           | (6)    | — |   | 1.2 | % |
| Alain Andreoli                                                                              |   | —                                                          |   | —                                                            |   | — |   | — |   |
| Jean M. Becker                                                                              |   | —                                                          |   | 62,672                                                            | (7)    | — |   |   | * |
| Robert F. Finley                                                                            |   | 185                                                             |   | 83,770                                                            | (8)    |   | * |   | * |
| Michael B. Gustafson                                                                        |   | 53                                                              |   | 362,500                                                           | (9)    |   | * | 1.0 | % |
| Gary M. Gysin                                                                               |   | —                                                          |   | 74,000                                                            | (10)   | — |   |   | * |
| Thomas O. McGimpsey                                                                         |   | —                                                          |   | 60,213                                                            | (11)   | — |   |   | * |
| Karen L. Niparko                                                                            |   | —                                                          |   | 88,713                                                            | (12)   | — |   |   | * |
| Ernest J. Sampias                                                                           |   | —                                                          |   | 127,043                                                           | (13)   | — |   |   | * |
| John W. Gerdelman                                                                           |   | —                                                          |   | 132,250                                                           | (14)   | — |   |   | * |
| Charles C. Johnston                                                                         |   | —                                                          |   | 132, 250                                                          | (16)   | — |   |   | * |
| D. Van Skilling                                                                             |   | 300                                                             |   | 132, 250                                                          | (14)   |   | * |   | * |
| Thomas M. Uhlman                                                                            |   | —                                                          |   | 132, 250                                                          | (14)   | — |   |   | * |
| Laurence G. Walker                                                                          |   | 1                                                               | (18)   | 132, 250                                                          | (14)   |   | *  |   | * |
| Betsy S. Atkins                                                                             |   | —                                                          |   | 15,000                                                            | (17)   | — |   |   | * |
| Michael J. Sophie                                                                           |   | —                                                          |   | 12,500                                                            | (15)   | — |   |   | * |
| All Executive Officers and Directors as a  Group (17 persons)                               |   | 28,850                                                          |   | 7,784,738                                                         |   |   | * | 21.6 | % |

 

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(1)           Basedon Schedule 13G filings (as of December 31, 2003).

(2)           Includes28,311 shares held jointly with John F. McDonnell, Ms. McDonnell’shusband, and 1,491 shares held as a trustee and custodian in a custodialaccount for their son.

(3)           Includes51,500 shares held by Ms. McDonnell as trustee and custodian in a custodialaccount for their son.

(4)           Includes28,311 shares held jointly with Ms. McDonnell, Mr. McDonnell’s wife.Mr. McDonnell disclaims beneficial ownership of the shares of Class Acommon stock held by Ms. McDonnell personally and as trustee andcustodian.

(5)           Excludes40,000 shares held by the McDonnell Family Partnership, L.L.L.P., a limitedliability limited partnership of which Mr. McDonnell is the generalpartner. Includes 940,000 shares which remain outstanding and exercisable whileMr. McDonnell provides continuous service under his three-yearJanuary 2004 Litigation Support Agreement with the Company. The number ofshares of common stock beneficially owned by John F. McDonnell does not include2,961,500 shares held by Ms. McDonnell, Mr. McDonnell’s wife, whichincludes 51,500 shares held as trustee and custodian by Ms. McDonnell in acustodial account for their son. Mr. McDonnell disclaims beneficialownership of the shares of Class B common stock held by Ms. McDonnellpersonally and as trustee and custodian.

(6)           Includes98,500 shares of restricted stock and 303,750 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(7)           Includes24,000 shares of restricted stock and 37,500 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(8)           Includes22,500 shares of restricted stock and 60,000 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(9)           Includes27,500 shares of restricted stocks and 275,000 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(10)         Includes24,000 shares of restricted stock and 50,000 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(11)         Includes23,625 shares of restricted stock and 35,250 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(12)         Includes32,745 shares of restricted stock and 52,500 shares subject to stock optionsexercisable within 60 days after January 31, 2004.

(13)         Includes41,500 shares of restricted stock and 80,000 shares exercisable within 60 daysof January 31, 2004.

(14)         Includes132,250 shares subject to stock option exercisable within 60 days ofJanuary 31, 2004.

(15)         Includes12,500 shares subject to stock options exercisable within 60 days afterJanuary 31, 2004.

(16)         Includes67,250 shares subject to stock options exercisable within 60 days afterJanuary 31, 2004 and 65,000 shares held by CCJ Trust.

(17)         Includes15,000 shares subject to stock options exercisable within 60 days ofJanuary 31, 2004.

(18)         Includes1 share of Class A common stock held by Katherine Walker,Mr. Walker’s wife.

 

* Less than 1%

 

59

----

 

On February 7, 2001, EMC distributed all the shares of ourClass A common stock held by EMC to EMC stockholders on a pro rata basisin a transaction that was tax free to EMC. A total of 81,000,000 shares of ourClass A common stock were distributed. EMC stockholders paid noconsideration for the shares of Class A common stock distributed to them.

 

The following table sets forth certain information concerning allequity compensation plans previously approved by stockholders and all equitycompensation plans not previously approved by stockholders as ofJanuary 31, 2004. The 2001 McDATA Equity Incentive Plan is our only equitycompensation plan that was approved by stockholders.  The 2003 McDATA Acquisition Equity Incentive Plan was adopted inAugust 2003 to provide Class B restricted stock grants for newly hiredemployees as a result of acquisitions. The 2003 McDATA Acquisition Equity Incentive Plan was not approved bystockholders in accordance with an exemption available under NASDAQ rules.

 

**Equity Compensation Plan Information as ofJanuary 31, 2004**

 
| **Plan Category**                                           |   | **Number of  Securities to  be issued upon exercise  of outstanding options,  warrants and rights** |   | **Weighted  average  exercise price of  outstanding option,  warrants and rights** |   | **Number of  securities remaining  available for future issuance under  equity compensation plans (excluding  securities reflected in column (a))** |   |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                        |   |                                                                                                |   |                                                                               |   |                                                                                                                                                |   |
| Equity compensation plans approved by  security holders     |   | 14,062,853                                                                                          |   | $11.04                                                                             |   | 6,473,692                                                                                                                                           |   |
| Equity compensation plans not approved by  security holders |   | 818,945                                                                                             |   | $0.00                                                                              |   | 1,754,215                                                                                                                                           |   |
| Total                                                       |   | 14,881,798                                                                                          |   | $11.04                                                                             |   | 8,227,907                                                                                                                                           |   |

 

**Other Matters**

 

In October 2000, new SEC rules went into effect that establishaffirmative defenses to insider trading claims under certain definedcircumstances, irrespective of the possession of material non-publicinformation, for transactions planned before coming into possession of suchinformation. Generally, such persons may purchase or sell such securitiespursuant to a binding pre-existing plan, contract or instruction, orcollectively a Pre-Existing Plan, which sets forth either (a) the amount,price and date of such trade, (b) a formula, algorithm or computer programfor determining amounts, prices and dates; or (c) such Pre-Existing Plandoes not permit the person to exercise any subsequent influence over the trade.Several of our directors and officers have established Pre-Existing Plans forthe purpose of selling a portion of their shares of Class B common stockto diversify their holdings. Other officers may enter into Pre-existing Plansto diversify their holdings.

 

**ITEM 13. CertainRelationships and Related Transactions**

 

There has not been nor is there currently proposed any transaction orseries of similar transactions to which we were or are a party in which theamount involved exceeds $60,000 and in which any director, executive officer,holder of more than 5% of our common stock or any member of the immediatefamily of any of the foregoing persons had or will have a direct or indirectmaterial interest other than (a) compensation agreements and other arrangements,which are described in “Item 11—Executive Compensation,” and (b) thetransactions described below.

 

InJanuary 2004, we entered into a three-year litigation support andconsulting agreement with John F. McDonnell, our former Chairman, pursuant towhich Mr. McDonnell will render litigation support and consulting services toMcDATA. Under the agreement, we are assured on-demand access to Mr. McDonnellat a rate of $250 per hour and the reimbursement of out-of-pocket expenses. Theagreement was reviewed and approved by a committee of independent directors ofthe Board of Directors.

 

InFebruary 2004, we entered into a six-month standard lab services agreementwith JRBM Incorporated (JRBM), a company partially owned by John F. McDonnell,our former Chairman. Under this arrangement, we lease approximately 155 squarefeet of unused lab space and equipment to JRBM at an arms-length market rate,and

 

60

----

 

JRBM may purchase McDATA products under our standard OpenReadyTMequipment discount program. The arrangement was reviewed and approved by acommittee of independent directors of the Board of Directors. JRBM has alsomade a business proposal to McDATA to review our SANavigator®software, over a nine month period, for the purpose of potentially reselling,licensing or utilizing certain features or modules of SANavigator®and potentially developing application program interfaces. The agreementevidencing such an arrangement was signed on February 25, 2004 (with aFebruary 27, 2004 effective date) by both parties after review andapproval by a committee of independent directors of the Board of Directors.

 

The Company has also entered into indemnification agreements with itsdirectors and officers.  For adiscussion regarding the indemnification agreements, please see Item II.Executive Compensation under the caption entitled “Limitation of Liability andIndemnification.”

 

**ITEM 14. PrincipalAccountant Fees and Services**

 

**Audit and Non-Audit Fees**

 

The following table presents fees for professional services rendered byPricewaterhouseCoopers LLP for the fiscal years ended December 31,2002 and January 31, 2004. 

 

|                   |   | **2002** |    | **2003** |   |
|------------------------|--------|----------|---------|----------|--------|
| Audit fees:(1)         |   | $        | 423,328 |     | $      | 477,500 |   |
| Audit related fees:(2) |   | 12,155   |    | 273,459  |   |
| Tax fees:(3)           |   | 73,086   |    | 88,407   |   |
| All other fees:(4)     |   | 47,384   |    | 70,000   |   |
|                   |   |     |    |     |   |
| Total                  |   | $        | 555,953 |     | $      | 909,366 |   |

 

----

(1) Audit fees consisted of audit work performed and billed through thedate of this filing in the preparation of financial statements, as well as workgenerally only the independent auditor can reasonably be expected to provide,such as statutory audits, comfort letters, consents and assistance with andreview of documents filed with the Securities and Exchange Commission.

 

(2) Audit-related fees consisted principally of the review in 2002 ofcertain revenue contracts and our RMA (return materials authorization)reconciliation project. In 2003, fees related to acquisition work in Nishan,Sanera and other projects and initial Sarbanes-Oxley Act discussions.

 

(3) Tax fees consisted principally of assistance with tax planning,compliance and reporting.

 

(4) All other fees consisted principally in 2002 of our convertibledebt offering and in 2003 of our completion of the convertible debt offering.

 

**Policy on Audit Committee Pre-Approval ofAudit and Permissible Non-Audit Services of Independent Auditor**

 

Consistent with SEC policies regarding auditor independence, the AuditCommittee has responsibility for appointing, setting compensation andoverseeing the work of the independent auditor. In recognition of thisresponsibility, the Audit Committee has established a policy to pre-approve allaudit and permissible non-audit services provided by the independent auditor.The Audit Committee has approved of all permissible non-audit servicesconsistent with SEC requirements.

 

Prior to engagement of the independent auditor for the next year’saudit, management will submit an aggregate of services expected to be renderedduring that year for each of four categories of services to the Audit

 

61

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Committee for approval.

 

1.               *Audit* services include audit workperformed in the preparation of financial statements, as well as work thatgenerally only the independent auditor can reasonably be expected to provide,including comfort letters, statutory audits, and attest services andconsultation regarding financial accounting and/or reporting standards.

 

2.               *Audit-Related* services are for assuranceand related services that are traditionally performed by the independentauditor, including due diligence related to mergers and acquisitions, employeebenefit plan audits, and special procedures required to meet certain regulatoryrequirements.

 

3.               *Tax* services include all servicesperformed by the independent auditor’s tax personnel except those servicesspecifically related to the audit of the financial statements, and includesfees in the areas of tax compliance, tax planning, and tax advice. 

 

4.               *Other Fees* are those associated withservices not captured in the other categories.

 

Prior to engagement, the Audit Committee pre-approves these services bycategory of service. The fees are budgeted and the Audit Committee requires theindependent auditor and management to report actual fees versus the budgetperiodically throughout the year by category of service. During the year,circumstances may arise when it may become necessary to engage the independentauditor for additional services not contemplated in the original pre-approval.In those instances, the Audit Committee requires specific pre-approval beforeengaging the independent auditor.   The Audit Committee may delegatepre-approval authority to one or more of its members. The member to whom suchauthority is delegated must report, for informational purposes only, anypre-approval decisions to the Audit Committee at its next scheduled meeting.

 

62

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**PART IV**

 

**ITEM 15. Exhibits,Financial Statement Schedules, and Reports on Form 8-K**

 

(a)                                  Documentsfiled as part of this report

 
|   |                                                             | Page   |
|--------|------------------------------------------------------------------|--------|
| (i)    | Index to Consolidated Financial Statements                       | F-1    |
|   | Report of Independent Auditors                                   | F-2    |
|   | Consolidated Financial Statements:                               |   |
|   | Consolidated Balance Sheets                                      | F-3    |
|   | Consolidated Income Statements                                   | F-4    |
|   | Consolidated Statements of Changes in  Stockholders’ Equity | F-5    |
|   | Consolidated Statements of Cash Flows                            | F-6    |
|   | Notes to Consolidated Financial Statements                       | F-7    |
| (ii)   | Consolidated Financial Statement Schedule:                       |   |
|   | Schedule II—Valuation  and Qualifying Accounts         | S-1    |

 

Financial statement schedules other than the one listed above have beenomitted because the required information is contained in the consolidatedfinancial statements and notes thereto or because such schedules are notrequired or applicable.  

 

(b)                                 Reportson Form 8-K:

 

We filed the following reports on Form 8-K during the fourthquarter of 2003 through the date of the filing of this Annual Report on Form10-K:

 

(1) Form 8-K filed March 8, 2004 announcing the settlement of theBrocade lawsuit

 

(2) Form 8-K filed February 26, 2004 announcing fourth quarterfinancial results

 

(3) Form 8-K filed January 29, 2004 announcing cost improvementactions

 

(4) Form 8-K filed January 9, 2004 announcing retirement ofChairman and settlement of Raytheon lawsuit

 

(5) Form 8-K filed December 4, 2003 announcing election of boardmember

 

(6) Form 8-K filed December 2, 2004 announcing third quarterfinancial results

 

(7) Form 8-K/A filed November 26, 2003 providing financialstatements for the Sanera acquisition

 

(8) Form 8-K filed November 25, 2003 announcing the departure ofthe company’s Executive Vice President of Worldwide Sales and Services

 

(9) Form 8-K/A filed November 13, 2003 providing financialstatements for the Nishan acquisition

 

(10) Form 8-K filed November 6, 2003 announcing preliminary thirdquarter financial results

 

(c)                                  Exhibits:

 

Exhibits identified in parentheses below are on file with the SEC andare incorporated herein by reference. All other exhibits are provided as partof this submission.

 

*Exhibits filed for the Company through thefiling of this Form 10-K.*

 
| (3.1)  |   | Amended and Restated Certificate of Incorporation of the Company   |
|--------|--------|--------------------------------------------------------------------|
|   |   |                                                               |
| (3.2)  |   | Amended and Restated By-laws of the Company                        |
|   |   |                                                               |
| (4.1)  |   | Form of Company’s Class B Common Stock Certificates |

 

63

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| (4.1.1)    |   | Form of Company’s Class A Common Stock Certificates                                                                                                                                                          |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                        |
| (4.2)      |   | Investors’ Rights Agreement dated as of October 1, 1997 by and  among the Company, EMC Corporation, McDATA Holdings Corporation and Certain  Investors                                                            |
|       |   |                                                                                                                                                                                                                        |
| (4.3)      |   | Amendment No. 1 to the Investors’ Rights Agreement dated  May 23, 2000 by and among the Company, McDATA Holdings Corporation and  certain Investors                                                          |
|       |   |                                                                                                                                                                                                                        |
| (4.4)      |   | Rights Agreement dated as of May 18, 2001, by and between the  Company and the Bank of New York, as rights agent (Filed on Form 8-K  dated May 21, 2001).                                                    |
|       |   |                                                                                                                                                                                                                        |
| (4.5)      |   | Form of Indenture dated as of February 7, 2003 by and  between the Company and Wells Fargo Bank Minnesota, National Association  (Filed on Form 8-K dated February 14, 2003)                            |
|       |   |                                                                                                                                                                                                                        |
| (4.6)      |   | Form of Registration Rights Agreement dated as of  February 7, 2003 by and among the Company and the parties thereto (Filed  on Form 8-K dated February 14, 2003)                                       |
|       |   |                                                                                                                                                                                                                        |
| (10.1)     |   | Asset Transfer Agreement dated as of October 1, 1997 by and  among the Company, EMC Corporation, and McDATA Holdings Corporation                                                                                       |
|       |   |                                                                                                                                                                                                                        |
| (10.2)     |   | Investors’ Rights Agreement dated as of October 1, 1997 by and  among the Company, EMC Corporation, McDATA Holdings Corporation and certain  Investors (see Exhibit 4.2)                                     |
|       |   |                                                                                                                                                                                                                        |
| (10.3)     |   | Amendment No. 1 to the Investors’ Rights Agreement dated  May 23, 2000 by and among the Company, McDATA Holdings Corporation and  certain Investors (see Exhibit 4.3)                                   |
|       |   |                                                                                                                                                                                                                        |
| (10.3.1)   |   | Termination of Investors’ Rights Agreement, dated as of  January 24, 2001, by and among the Company, McDATA Holdings Corporation  and Certain Investors (Filed on Form 10-K for the fiscal year ended  2000) |
|       |   |                                                                                                                                                                                                                        |
| (10.4)     |   | Services Agreement dated as of October 1, 1997 by and among EMC  Corporation, McDATA Holdings Corporation and the Company                                                                                              |
|       |   |                                                                                                                                                                                                                        |
| (10.5)     |   | Letter Agreement dated April 19, 1999 by and between the Company  and McDATA Holdings Corporation                                                                                                                      |
|       |   |                                                                                                                                                                                                                        |
| (10.6)     |   | Technology Rights Agreement dated as of October 1, 1997 by and  among the Company, EMC Corporation and McDATA Holdings Corporation                                                                                     |
|       |   |                                                                                                                                                                                                                        |
| (10.7)     |   | Amended and Restated Tax Sharing Agreement dated as of May 31,  2000 by and among EMC Corporation, McDATA Holdings Corporation and the  Company                                                                        |
|       |   |                                                                                                                                                                                                                        |
| (10.8)     |   | Form of Master Transaction Agreement entered into by and among  the Company and EMC Corporation dated May 31, 2000                                                                                                |
|       |   |                                                                                                                                                                                                                        |
| (10.9)     |   | Form of Indemnification and Insurance Matters Agreement entered  into by and among the Company and EMC Corporation dated May 31, 2000                                                                             |
|       |   |                                                                                                                                                                                                                        |
| (10.10)    |   | Master Confidential Disclosure and License Agreement dated as of  May 31, 2000 by and among the Company and EMC Corporation                                                                                            |
|       |   |                                                                                                                                                                                                                        |
| (10.11)+   |   | Reseller Agreement dated as of February 22, 2000 by and between  International Business Machines Corporation and the Company                                                                                           |
|       |   |                                                                                                                                                                                                                        |
| (10.12)    |   | Amendment Number One to the Resale Agreement dated September 30,  2000 by and between International Business Machines Corporation and the  Company                                                                     |
|       |   |                                                                                                                                                                                                                        |
| (10.13)+   |   | OEM Purchase and License Agreement dated as of May 19, 2000 by  and between EMC Corporation and the Company                                                                                                            |
|       |   |                                                                                                                                                                                                                        |
| (10.13.1)+ |   | Amendment to OEM Purchase and License Agreement dated as of  September 21, 2001, by and between EMC Corporation and the Company                                                                                        |
|       |   |                                                                                                                                                                                                                        |
| (10.14)+   |   | Development Agreement dated as of May 19, 2000 by and between  EMC Corporation and the Company                                                                                                                         |

 

64

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| 10.14.1+   |   | Distribution Agreement dated as of December 15, 1999 by and  between the Company and Hitachi Data Systems Corporation                                                                                                   |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                         |
| (10.15)+   |   | Manufacturing Agreement dated as of September 17, 1992 by and  between SCI Systems, Inc. and the Company                                                                                                           |
|       |   |                                                                                                                                                                                                                         |
| (10.15.1)+ |   | Manufacturing and Purchasing Agreement dated as of December 14,  2001 by and between SCI Systems, Inc. and the Company (Filed on  Form 8-K dated February 25, 2002)                                      |
|       |   |                                                                                                                                                                                                                         |
| (10.15.2)+ |   | Manufacturing and Purchase Agreement effective as of March 1,  2003 by and between Sanmina-SCI Corporation and the Company (filed on Form  10-K for the year ended December 31, 2002)                              |
|       |   |                                                                                                                                                                                                                         |
| (10.16)+   |   | OEM and License Agreement dated as of April 27, 1999 by and  between Brocade Communication Systems, Inc. and the Company                                                                                           |
|       |   |                                                                                                                                                                                                                         |
| (10.17)    |   | Lease dated September 12, 1997 by and between the Company and  WHLNF Real Estate Limited Partnership                                                                                                                    |
|       |   |                                                                                                                                                                                                                         |
| (10.18)    |   | Lease dated November 2, 1999 by and between the Company and the  Mills Family LLC                                                                                                                                       |
|       |   |                                                                                                                                                                                                                         |
| (10.19)    |   | Lease dated May 28, 1997 by and between the Company and 1211486  Ontario Limited                                                                                                                                        |
|       |   |                                                                                                                                                                                                                         |
| (10.19.1)  |   | Lease dated October 6, 2000, by and between the Company and  Amber Drive I, LLC (Filed on Form 10-Q for the fiscal quarter ended  September 30, 2000)                                                         |
|       |   |                                                                                                                                                                                                                         |
| (10.19.2)  |   | Lease dated February 9, 2001 by and between the Company and  Deutsche Bank (Filed on Form 10-K for the fiscal year ended 2000)                                                                                     |
|       |   |                                                                                                                                                                                                                         |
| (10.19.3)  |   | Participation Agreement dated February 9, 2001 by and between  the Company and Deutsche Bank (Filed on Form 10-K for the fiscal year  ended 2000)                                                                  |
|       |   |                                                                                                                                                                                                                         |
| (10.19.4)  |   | Second Amendment to Participation Agreement dated November 9,  2001 by and between the Company and Deutsche Bank (Filed on Form 10-Q  for the fiscal quarter ended September 30, 2001)                        |
|       |   |                                                                                                                                                                                                                         |
| (10.19.5)  |   | Third Amendment to Participation Agreement dated January 24,  2002 by and between the Company and Deutsche Bank (Filed on Form 8-K  dated February 25, 2002)                                                  |
|       |   |                                                                                                                                                                                                                         |
| (10.20)*   |   | Form of Change of Control Severance Agreement                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                         |
| (10.20.1)* |   | CEO Severance Agreement dated December 2003 (filed on Form 10-Q  for the fiscal quarter ended October 31, 2003)                                                                                                    |
|       |   |                                                                                                                                                                                                                         |
| (10.21)*   |   | 1997 Stock Option Plan                                                                                                                                                                                                       |
|       |   |                                                                                                                                                                                                                         |
| (10.21.1)* |   | 2001 McDATA Equity Incentive Plan (Filed on Schedule 14A dated  July 3, 2003)                                                                                                                                      |
|       |   |                                                                                                                                                                                                                         |
| (10.21.2)* |   | Employee Stock Purchase Plan (Filed on Schedule 14A Proxy  Statement filed June 10, 2002)                                                                                                                          |
|       |   |                                                                                                                                                                                                                         |
| (10.22)*   |   | Form of Stock Option Agreement for 1997 Stock Option Plan                                                                                                                                                               |
|       |   |                                                                                                                                                                                                                         |
| (10.23)*   |   | Description of the Company’s Management Bonus Program                                                                                                                                                                   |
|       |   |                                                                                                                                                                                                                         |
| (10.24)    |   | Asset Purchase Agreement dated August 3, 2001 by and among the  Company, SANavigator, Inc., Western Digital Corporation and Connex Inc.  (Filed on Form 10-Q for the fiscal quarter ended September 30, 2001) |
|       |   |                                                                                                                                                                                                                         |
| (10.25)*   |   | Performance Incentive Bonus Plan (filed on Form 10-K for the year  ended December 31, 2002)                                                                                                                             |
|       |   |                                                                                                                                                                                                                         |
| (10.25.1)  |   | Agreement and Plan of Merger dated August 25, 2003 by and among  the Company, Nice Acquisition, Inc. and Nishan Systems Inc. (filed on Form  8-K dated August 25, 2003 as Exhibit 99.4)                            |
|       |   |                                                                                                                                                                                                                         |
| (10.25.2)  |   | Agreement and Plan of Merger dated August 25, 2003 by and among  the Company, Whitney Acquisition, Inc. and Sanera Systems, Inc. (filed on  Form 8-K dated August 25, 2003 as Exhibit 99.5)                        |
|       |   |                                                                                                                                                                                                                         |
| (10.26)*   |   | Executive Performance Incentive Bonus Plan (filed on Form 10-K for  the year ended December 31, 2002)                                                                                                                   |

 

65

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| (10.27)* |   | Chairman of the Board of Directors Performance Incentive Bonus Plan  (filed on Form 10-K for the year ended December 31, 2002) |
|----------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                |
| 21       |   | Subsidiaries of Company                                                                                                             |
|     |   |                                                                                                                                |
| 23.1     |   | Consent of PricewaterhouseCoopers LLP                                                                                               |
|     |   |                                                                                                                                |
| 23.2**   |   | Consent of KPMG LLP                                                                                                                 |
|     |   |                                                                                                                                |
| 24       |   | Power of Attorney                                                                                                                   |
|     |   |                                                                                                                                |
| 31.1     |   | Section 302 Certification of Principal Executive Officer                                                                       |
|     |   |                                                                                                                                |
| 31.2     |   | Section 302 Certification of Principal Financial Officer                                                                       |
|     |   |                                                                                                                                |
| 32.1     |   | Section 906 Certification of Principal Executive Officer                                                                       |
|     |   |                                                                                                                                |
| 32.2     |   | Section 906 Certification of Principal Financial Officer                                                                       |
|     |   |                                                                                                                                |
| 99**     |   | Audited Financial Statements of Aarohi Communications, Inc.                                                                         |

 

----

( )                                     Exhibitspreviously filed in the Company’s Registration Statement on Form S-1, SECFile No. 333-38106, declared effective on August 8, 2000 or filed inthe Company’s periodic filings as specifically noted.

 

+                                         Portions ofthese Exhibits have been omitted and filed separately with the SEC pursuant toan order or a request for confidential treatment.

 

*                                         Executivecompensation plans and arrangements.

 

**           Tobe filed

 

66

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized, in theCity of Broomfield, State of Colorado, on April 2, 2004. 

 
|   | McDATA Corporation |
|--------|--------------------|
|   |               |
|   |               |
|   | By:                | /s/ ERNEST J. SAMPIAS |
|   |               | Ernest J. Sampias |
|   |               | *Senior Vice President of Finance and Chief* |
|   |               | *Financial Officer* |

 

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

 

 
| **Principal Executive Officer**       |   |
|---------------------------------------|--------|
|                                  |   |
|                                  |   |
| /s/ JOHN A. KELLEY, JR.               |   | April 2, 2004 |
| John A. Kelley, Jr.                   |   |
| President and Chief Executive Officer |   |
|                                  |   |
|                                  |   |
| **Principal Financial Officer**       |   |
|                                  |   |
|                                  |   |
| /s/ ERNEST J. SAMPIAS                 |   | April 2, 2004 |
| Ernest J. Sampias                     |   |
| Senior Vice President of Finance and  |   |
| Chief Financial Officer               |   |
|                                  |   |
|                                  |   |
| **Principal Accounting Officer**      |   |
|                                  |   |
|                                  |   |
| /s/ ERNEST J. SAMPIAS                 |   | April 2, 2004 |
| Ernest J. Sampias                     |   |
| Senior Vice President of Finance and  |   |
| Chief Financial Officer               |   |

 

67

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| **Directors:**          |   |
|-------------------------|--------|
|                    |   |
|                    |   |
| /s/ JOHN A. KELLEY, JR. |   | April 2, 2004 |
| John A. Kelley, Jr.     |   |
| Chairman and CEO        |   |
|                    |   |
|                    |   |
| /s/ JOHN W. GERDELMAN   |   | April 2, 2004 |
| John W. Gerdelman       |   |
|                    |   |
|                    |   |
| /s/ CHARLES C. JOHNSTON |   | April 2, 2004 |
| Charles C. Johnston     |   |
|                    |   |
|                    |   |
| /s/ D. VAN SKILLING     |   | April 2, 2004 |
| D. Van Skilling         |   |
|                    |   |
|                    |   |
| /s/ THOMAS M. UHLMAN    |   | April 2, 2004 |
| Thomas M. Uhlman        |   |
|                    |   |
|                    |   |
| /s/ LAURENCE G. WALKER  |   | April 2, 2004 |
| Laurence G. Walker      |   |
|                    |   |
|                    |   |
| /s/ BETSY S. ATKINS     |   | April 2, 2004 |
| Betsy S. Atkins         |   |
|                    |   |
|                    |   |
| /s/ MICHAEL J. SOPHIE   |   | April 2, 2004 |
| Michael J. Sophie       |   |
|                    |   |
|                    |   |
| /s/ M. ALEX MENDEZ      |   | April 2, 2004 |
| M. Alex Mende           |   |

 

68

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McDATA CORPORATION

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 
|                                                             | Page   |
|------------------------------------------------------------------|--------|
| Report of Independent Auditors                                   | F-2    |
|                                                             |   |
| Audited Financial Statements                                     |   |
|                                                             |   |
| Consolidated Balance Sheets                                      | F-3    |
| Consolidated Income Statements                                   | F-4    |
| Consolidated Statements of Changes in  Stockholders’ Equity | F-5    |
| Consolidated Statements of Cash Flows                            | F-6    |
| Notes to Consolidated Financial Statements                       | F-7    |
|                                                             |   |
| Schedule:                                                        |   |
|                                                             |   |
| Schedule II—Valuation  and Qualifying Accounts         | S-1    |

 

Note: All other financial statement schedules are omitted because theyare not applicable or the required information is included in the consolidatedfinancial statements or notes thereto.

 

F-1

----

 

REPORT OF INDEPENDENT AUDITORS

 

To the Board of Directors and Stockholders

of McDATA Corporation:

 

In our opinion, the consolidated financial statements listed in the accompanyingindex present fairly, in all material respects, the financial position ofMcDATA Corporation and its subsidiaries at January 31, 2004 andDecember 31, 2002, and the results of their operations and their cashflows for the year ended January 31, 2004, month ended January 31,2003 and the years ended December 31, 2002 and 2001, in conformity withaccounting principles generally accepted in the United States of America. Inaddition, in our opinion, the financial statement schedule listed in theaccompanying index presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedule are the responsibility of the Company’s management; our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits. We conducted our audits of these statements inaccordance with auditing standards generally accepted in the United States ofAmerica, which require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

PricewaterhouseCoopersLLP

 

Denver, Colorado

April 14, 2004

 

F-2

----

 

**McDATA CORPORATIONCONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**
|                                                                                                                                |   | **January 31,  2004** |    | **December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|-----------------------------|--------|
| **Assets**                                                                                                                          |   |                       |    |                        |   |
| Current assets:                                                                                                                     |   |                       |    |                        |   |
| Cash and cash equivalents                                                                                                           |   | $                          | 50,301  |                        | $      | 72,411 |   |
| Securities lending collateral                                                                                                       |   | 126,681                    |    | —                      |   |
| Short-term investments                                                                                                              |   | 157,740                    |    | 157,260                     |   |
| Accounts receivable, net of allowances for  doubtful accounts of $926 and $1,265,respectively                                       |   | 62,670                     |    | 73,867                      |   |
| Inventories, net                                                                                                                    |   | 11,364                     |    | 8,097                       |   |
| Deferred tax asset                                                                                                                  |   | —                     |    | 33,325                      |   |
| Prepaid expenses and other current assets                                                                                           |   | 6,055                      |    | 4,699                       |   |
| Total current assets                                                                                                                |   | 414,811                    |    | 349,659                     |   |
|                                                                                                                                |   |                       |    |                        |   |
| Property and equipment, net                                                                                                         |   | 99,225                     |    | 99,927                      |   |
| Long-term investments                                                                                                               |   | 103,483                    |    | 73,099                      |   |
| Restricted cash                                                                                                                     |   | 5,130                      |    | —                      |   |
| Intangible assets, net of accumulated amortization  of $14,470 and $5,037, respectively                                             |   | 111,313                    |    | 7,887                       |   |
| Goodwill                                                                                                                            |   | 78,787                     |    | 11,780                      |   |
| Other assets, net                                                                                                                   |   | 18,219                     |    | 12,839                      |   |
| Total assets                                                                                                                        |   | $                          | 830,968 |                        | $      | 555,191 |   |
|                                                                                                                                |   |                       |    |                        |   |
| **Liabilities and  Stockholders’ Equity**                                                                                      |   |                       |    |                        |   |
| Current liabilities:                                                                                                                |   |                       |    |                        |   |
| Accounts payable                                                                                                                    |   | $                          | 16,532  |                        | $      | 16,530 |   |
| Accrued liabilities                                                                                                                 |   | 51,547                     |    | 37,779                      |   |
| Securities lending collateral payable                                                                                               |   | 126,681                    |    | —                      |   |
| Current portion of deferred revenue                                                                                                 |   | 19,775                     |    | 7,337                       |   |
| Income taxes payable                                                                                                                |   | 1,783                      |    | 2,782                       |   |
| Current portion of obligations under notes payable                                                                                  |   | 1,408                      |    | —                      |   |
| Current portion of obligations under capital  leases                                                                                |   | 1,377                      |    | 1,604                       |   |
| Total current liabilities                                                                                                           |   | 219,103                    |    | 66,032                      |   |
| Obligations under notes payable, less current  portion                                                                              |   | 201                        |    | —                      |   |
| Obligations under capital leases, less current  portion                                                                             |   | 890                        |    | 1,540                       |   |
| Deferred revenue, less current portion                                                                                              |   | 20,632                     |    | 13,114                      |   |
| Interest rate swap                                                                                                                  |   | 349                        |    | —                      |   |
| Convertible subordinated debt                                                                                                       |   | 172,151                    |    | —                      |   |
| Total liabilities                                                                                                                   |   | 413,326                    |    | 80,686                      |   |
| Commitments and contingencies (Note 13)                                                                                        |   |                       |    |                        |   |
| Stockholders’ Equity:                                                                                                          |   |                       |    |                        |   |
| Preferred stock, $0.01 par value, 25,000,000  shares authorized, no shares issued or outstanding                                    |   | —                     |    | —                      |   |
| Common stock, Class A, $0.01 par value,  250,000,000 shares authorized, 81,000,000 shares issued                               |   | 810                        |    | 810                         |   |
| Common stock, Class B, $0.01 par value,  200,000,000 shares authorized, 36,051,473 and 32,962,212 shares issued,  respectively |   | 361                        |    | 330                         |   |
| Additional paid-in-capital                                                                                                          |   | 476,993                    |    | 474,609                     |   |
| Treasury stock, at cost, 975,730 shares at  January 31, 2004                                                                   |   | (8,752                     | )       | —                      |   |
| Deferred compensation                                                                                                               |   | (10,375                    | )       | (6,812                      | )      |
| Accumulated other comprehensive income                                                                                              |   | 403                        |    | 773                         |   |
| Retained earnings (deficit)                                                                                                         |   | (41,798                    | )       | 4,795                       |   |
| Total stockholders’ equity                                                                                                     |   | 417,642                    |    | 474,505                     |   |
| Total liabilities and stockholders’ equity                                                                                     |   | $                          | 830,968 |                        | $      | 555,191 |   |

The accompanying notes are an integral partof these consolidated financial statements.

 

F-3

----

 

**McDATACORPORATIONCONSOLIDATED INCOME STATEMENTS(in thousands, except per share data)**

 
|                                                                                                                                                             |   | **Year Ended  January 31,** |    | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|---------|-------------------------------------|--------|------------------------------------|--------|
|                                                                                                                                                             |   | **2004**                         |    | **2002**                            |   | **2001**                           |   | **2003** |   |
|                                                                                                                                                             |   |                             |    |                                |   |                               |   |   |   |
| Revenue                                                                                                                                                          |   | $                                | 418,860 |                                | $      | 328,279                            |   | $ | 344,406 |   | $ | 17,045 |   |
| Cost of revenue                                                                                                                                                  |   | 177,329                          |    | 178,114                             |   | 215,751                            |   | 8,475 |   |
| Gross profit                                                                                                                                                     |   | 241,531                          |    | 150,165                             |   | 128,655                            |   | 8,570 |   |
| Operating expenses:                                                                                                                                              |   |                             |    |                                |   |                               |   |   |   |
| Research and development                                                                                                                                         |   | 88,826                           |    | 59,324                              |   | 49,166                             |   | 5,068 |   |
| Selling and marketing                                                                                                                                            |   | 95,820                           |    | 75,213                              |   | 70,489                             |   | 5,837 |   |
| General and administrative                                                                                                                                       |   | 39,057                           |    | 29,495                              |   | 20,337                             |   | 2,424 |   |
| Acquired in-process research and  development and other acquisition-related costs                                                                                |   | 11,410                           |    | —                              |   | 9,327                              |   | — |   |
| Amortization of deferred compensation  (excludes amortization of deferred compensation included in cost of revenue  of $739, $601, $1,437 and $50, respectively) |   | 11,969                           |    | 8,280                               |   | 7,259                              |   | 575 |   |
| Restructuring charges                                                                                                                                            |   | 2,258                            |    | —                              |   | —                             |   | — |   |
| Operating expenses                                                                                                                                               |   | 249,340                          |    | 172,312                             |   | 156,578                            |   | 13,904 |   |
| Loss from operations                                                                                                                                             |   | (7,809                           | )       | (22,147                             | )      | (27,923                            | )      | (5,334 | ) |
| Interest and other income                                                                                                                                        |   | 6,832                            |    | 6,924                               |   | 14,532                             |   | 28 |   |
| Interest expense                                                                                                                                                 |   | (2,760                           | )       | (293                                | )      | (349                               | )      | (17 | ) |
| Loss before income taxes                                                                                                                                         |   | (3,737                           | )       | (15,516                             | )      | (13,740                            | )      | (5,323 | ) |
| Income tax expense (benefit)                                                                                                                                     |   | 38,412                           |    | (5,529                              | )      | (5,084                             | )      | (1,863 | ) |
| Loss before equity in net loss of  affiliated company                                                                                                            |   | (42,149                          | )       | (9,987                              | )      | (8,656                             | )      | (3,460 | ) |
| Equity in net loss of affiliated company                                                                                                                         |   | (984                             | )       | —                              |   | —                             |   | — |   |
| Net loss                                                                                                                                                         |   | $                                | (43,133 | )                                   | $      | (9,987                             | )      | $ | (8,656 | ) | $ | (3,460 | ) |
|                                                                                                                                                             |   |                             |    |                                |   |                               |   |   |   |
| Basic net loss per share                                                                                                                                         |   | $                                | (0.38   | )                                   | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
| Shares used in computing basic net loss per  share                                                                                                               |   | 114,682                          |    | 113,185                             |   | 111,475                            |   | 114,000 |   |
|                                                                                                                                                             |   |                             |    |                                |   |                               |   |   |   |
| Diluted net loss per share                                                                                                                                       |   | $                                | (0.38   | )                                   | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
| Shares used in computing diluted net loss  per share                                                                                                             |   | 114,682                          |    | 113,185                             |   | 111,475                            |   | 114,000 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-4

----

 

**McDATACORPORATIONCONSOLIDATED STATEMENTS OF CHANGESIN STOCKHOLDERS’ EQUITY(in thousands)**

 
|                                               |   |              |   |             |   |        |   |         |   |              |   |             |    | **Accumulated** |   |                   |   |          |   |       |   |
|----------------------------------------------------|--------|-------------------|--------|------------------|--------|-------------|--------|--------------|--------|-------------------|--------|------------------|---------|-----------------|--------|------------------------|--------|---------------|--------|------------|--------|
|                                               |   | **Common  Stock** |   | **Additional**   |   |        |   | **Other**    |   |              |   | **Retained**     |    | **Total**       |   |
|                                               |   | **Class A**  |   | **Class B** |   | **Paid-In** |   | **Deferred** |   | **Comprehensive** |   | **Treasury**     |    | **Earnings**    |   | **Stockholders’** |   |
|                                               |   | **Shares**        |   | **Amount**       |   | **Shares**  |   | **Amount**   |   | **Capital**       |   | **Compensation** |    | **Income**      |   | **Stock**              |   | **(Deficit)** |   | **Equity** |   |
|                                               |   |              |   |             |   |        |   |         |   |              |   |             |    |            |   |                   |   |          |   |       |   |
| Balances at December 31, 2000                 |   | 81,000            |   | $                | 810    |        | 28,908 |         | $      | 289               |   | $                | 454,009 |            | $      | (24,850                | )      | $             | 117    |       | $      | — |   | $ | 23,438 |   | $ | 453,813 |   |
| Shares issued                                      |   | —            |   | —           |   | 2,654       |   | 27           |   | 6,797             |   | (1,896           | )       | —          |   | —                 |   | —        |   | 4,928      |   |
| Forfeitures of deferred compensation               |   | —            |   | —           |   | —      |   | —       |   | (3,280            | )      | 3,280            |    | —          |   | —                 |   | —        |   | —     |   |
| Compensation expense                               |   | —            |   | —           |   | —      |   | —       |   | —            |   | 8,696            |    | —          |   | —                 |   | —        |   | 8,696      |   |
| Tax benefit of stock options                       |   | —            |   | —           |   | —      |   | —       |   | 10,607            |   | —           |    | —          |   | —                 |   | —        |   | 10,607     |   |
| Comprehensive income (loss):                       |   |              |   |             |   |        |   |         |   |              |   |             |    |            |   |                   |   |          |   |       |   |
| Net loss                                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | (8,656        | )      | (8,656     | )      |
| Unrealized gain on investments, net of tax of $234 |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | 403             |   | —                 |   | —        |   | 403        |   |
| Total comprehensive loss                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   |          |   | (8,253     | )      |
| Balances at December 31, 2001                 |   | 81,000            |   | 810              |   | 31,562      |   | 316          |   | 468,133           |   | (14,770          | )       | 520             |   | —                 |   | 14,782        |   | 469,791    |   |
| Shares issued                                      |   | —            |   | —           |   | 1,407       |   | 14           |   | 4,274             |   | (1,867           | )       | —          |   | —                 |   | —        |   | 2,421      |   |
| Forfeitures of deferred compensation               |   | —            |   | —           |   | (7          | )      | —       |   | (944              | )      | 944              |    | —          |   | —                 |   | —        |   | —     |   |
| Compensation expense                               |   | —            |   | —           |   | —      |   | —       |   | —            |   | 8,881            |    | —          |   | —                 |   | —        |   | 8,881      |   |
| Tax benefit of stock options                       |   | —            |   | —           |   | —      |   | —       |   | 3,146             |   | —           |    | —          |   | —                 |   | —        |   | 3,146      |   |
| Comprehensive income (loss):                       |   | —            |   |             |   |        |   |         |   |              |   |             |    |            |   |                   |   |          |   |       |   |
| Net loss                                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | (9,987        | )      | (9,987     | )      |
| Unrealized gain on investments, net of tax of $188 |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | 253             |   | —                 |   | —        |   | 253        |   |
| Total comprehensive loss                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | —        |   | (9,734     | )      |
| Balances at December 31, 2002                 |   | 81,000            |   | 810              |   | 32,962      |   | 330          |   | 474,609           |   | (6,812           | )       | 773             |   | —                 |   | 4,795         |   | 474,505    |   |
| Shares issued                                      |   | —            |   | —           |   | 321         |   | 3            |   | 1,327             |   | (747             | )       | —          |   | —                 |   | —        |   | 583        |   |
| Compensation expense                               |   | —            |   | —           |   | —      |   | —       |   | —            |   | 625              |    | —          |   | —                 |   | —        |   | 625        |   |
| Tax benefit of stock options                       |   | —            |   | —           |   | —      |   | —       |   | 39                |   | —           |    | —          |   | —                 |   | —        |   | 39         |   |
| Comprehensive income (loss):                       |   |              |   |             |   |        |   |         |   |              |   |             |    |            |   |                   |   |          |   |       |   |
| Net loss                                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | (3,460        | )      | (3,460     | )      |
| Unrealized loss on investments,net of tax of $40   |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | (62             | )      | —                 |   | —        |   | (62        | )      |
| Total comprehensive loss                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | —        |   | (3,522     | )      |
| Balances at January 31, 2003                  |   | 81,000            |   | 810              |   | 33,283      |   | 333          |   | 475,975           |   | (6,934           | )       | 711             |   | —                 |   | 1,335         |   | 472,230    |   |
| Shares issued                                      |   | —            |   | —           |   | 2,880       |   | 29           |   | 23,155            |   | (17,357          | )       | —          |   | —                 |   | —        |   | 5,827      |   |
| Forfeitures of deferred compensation               |   | —            |   | —           |   | (112        | )      | (1           | )      | (1,207            | )      | 1,208            |    | —          |   | —                 |   | —        |   | —     |   |
| Purchase of call options, net                      |   | —            |   | —           |   | —      |   | —       |   | (20,510           | )      | —           |    | —          |   | —                 |   | —        |   | (20,510    | )      |
| Compensation expense                               |   | —            |   | —           |   | —      |   | —       |   | —            |   | 12,708           |    | —          |   | —                 |   | —        |   | 12,708     |   |
| Tax benefit (expense) of stock options             |   | —            |   | —           |   | —      |   | —       |   | (420              | )      | —           |    | —          |   | —                 |   | —        |   | (420       | )      |
| Acquisition of treasury stock                      |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | (8,752                 | )      | —        |   | (8,752     | )      |
| Comprehensive income (loss):                       |   |              |   |             |   |        |   |         |   |              |   |             |    |            |   |                   |   |          |   |       |   |
| Net loss                                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | (43,133       | )      | (43,133    | )      |
| Unrealized loss on investments,net of tax of $453  |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | (308            | )      | —                 |   | —        |   | (308       | )      |
| Total comprehensive loss                           |   | —            |   | —           |   | —      |   | —       |   | —            |   | —           |    | —          |   | —                 |   | —        |   | (43,441    | )      |
| Balances at January 31, 2004                  |   | 81,000            |   | $                | 810    |        | 36,051 |         | $      | 361               |   | $                | 476,993 |            | $      | (10,375                | )      | $             | 403    |       | $      | (8,752 | ) | $ | (41,798 | ) | $ | 417,642 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-5

----

 

**McDATACORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

 

 
|                                                                        |   | **Year Ended  January 31** |    | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|-----------------------------------------------------------------------------|--------|---------------------------------|---------|-------------------------------------|--------|------------------------------------|--------|
|                                                                        |   | **2004**                        |    | **2002**                            |   | **2001**                           |   | **2003** |   |
|                                                                        |   |                            |    |                                |   |                               |   |   |   |
| **Cash flows from  operating activities:**                                  |   |                            |    |                                |   |                               |   |   |   |
| Net loss                                                                    |   | $                               | (43,133 | )                                   | $      | (9,987                             | )      | $ | (8,656 | ) | $ | (3,460 | ) |
| Adjustments to reconcile net loss to cash  flows from operating activities  |   |                            |    |                                |   |                               |   |   |   |
| Depreciation and amortization                                               |   | 44,589                          |    | 25,524                              |   | 16,383                             |   | 2,527 |   |
| Bad debt provision                                                          |   | (474                            | )       | 525                                 |   | 707                                |   | 25 |   |
| Loss from write-off of collateralized lease  costs                          |   | —                          |    | 1,256                               |   | —                             |   | — |   |
| Equity in net loss of affiliate                                             |   | 984                             |    | —                              |   | —                             |   | — |   |
| Net realized and unrealized (gain)/loss on  investments                     |   | 48                              |    | 723                                 |   | (262                               | )      | 17 |   |
| Net loss on retirement of assets                                            |   | 400                             |    | 1,196                               |   | 102                                |   | 77 |   |
| Acquired in-process research and  development                               |   | 11,410                          |    | —                              |   | 7,200                              |   | — |   |
| Inventory and inventory commitment  provisions                              |   | 2,608                           |    | 15,199                              |   | 26,788                             |   | 384 |   |
| Non-cash compensation expense                                               |   | 12,708                          |    | 8,881                               |   | 8,696                              |   | 625 |   |
| Deferred tax asset                                                          |   | 38,815                          |    | (11,560                             | )      | (14,715                            | )      | (1,902 | ) |
| Tax benefit (expense) from stock options  exercised                         |   | (420                            | )       | 3,146                               |   | 10,607                             |   | 39 |   |
| Changes in net assets and liabilities, net  of acquired amounts:            |   |                            |    |                                |   |                               |   |   |   |
| Accounts receivable                                                         |   | (26,105                         | )       | (30,587                             | )      | 14,452                             |   | 38,740 |   |
| Inventories                                                                 |   | (6,150                          | )       | 2,870                               |   | (33,244                            | )      | 418 |   |
| Prepaid expenses and other current assets                                   |   | 29                              |    | 400                                 |   | (1,632                             | )      | (488 | ) |
| Other assets, net                                                           |   | (7,682                          | )       | (10,929                             | )      | (970                               | )      | (1,092 | ) |
| Accounts payable                                                            |   | 7,091                           |    | 4,986                               |   | (8,714                             | )      | (9,548 | ) |
| Accrued liabilities                                                         |   | 9,621                           |    | 8,338                               |   | 6,717                              |   | (1,083 | ) |
| Deferred revenue                                                            |   | 17,782                          |    | 12,997                              |   | (324                               | )      | 92 |   |
| Accrued income taxes                                                        |   | (1,061                          | )       | 7,478                               |   | (14,799                            | )      | — |   |
| Net cash provided by operating activities                                   |   | 61,060                          |    | 30,456                              |   | 8,336                              |   | 25,371 |   |
| **Cash flows from  investing activities:**                                  |   |                            |    |                                |   |                               |   |   |   |
| Acquisitions, net of cash acquired                                          |   | (171,421                        | )       | —                              |   | (29,750                            | )      | — |   |
| Purchase of equity investment in Aarohi                                     |   | (6,000                          | )       | —                              |   | —                             |   | — |   |
| Purchases of property and equipment                                         |   | (17,999                         | )       | (71,937                             | )      | (21,473                            | )      | (371 | ) |
| Payment of collateralized lease costs                                       |   | —                          |    | (1,256                              | )      | —                             |   | — |   |
| Restricted cash related to interest rate  swap                              |   | (5,130                          | )       | —                              |   | —                             |   | — |   |
| Purchases of investments                                                    |   | (654,238                        | )       | (481,078                            | )      | (614,064                           | )      | (11,600 | ) |
| Maturities of investments                                                   |   | 509,444                         |    | 403,123                             |   | 446,929                            |   | 21,970 |   |
| Sales of investments                                                        |   | 101,085                         |    | 124,109                             |   | 102,670                            |   | — |   |
| Net cash provided (used) in investing  activities                           |   | (244,259                        | )       | (27,039                             | )      | (115,688                           | )      | 9,999 |   |
| **Cash flows from  financing activities:**                                  |   |                            |    |                                |   |                               |   |   |   |
| Proceeds from issuance of convertible  subordinated debt                    |   | 172,500                         |    | —                              |   | —                             |   | — |   |
| Costs of debt issuance                                                      |   | (5,567                          | )       | —                              |   | —                             |   | — |   |
| Purchase of call options                                                    |   | (53,455                         | )       | —                              |   | —                             |   | — |   |
| Sale of call options                                                        |   | 32,945                          |    | —                              |   | —                             |   | — |   |
| Purchase of treasury stock                                                  |   | (8,752                          | )       | —                              |   | —                             |   | — |   |
| Payment of notes payable                                                    |   | (15,469                         | )       | —                              |   | —                             |   | — |   |
| Payment of obligations under capital leases                                 |   | (2,697                          | )       | (2,712                              | )      | (2,921                             | )      | (196 | ) |
| Proceeds from the issuance of stock                                         |   | 5,827                           |    | 2,421                               |   | 4,928                              |   | 583 |   |
| Net cash provided by (used in) financing  activities                        |   | 125,332                         |    | (291                                | )      | 2,007                              |   | 387 |   |
|                                                                        |   |                            |    |                                |   |                               |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                       |   | (57,867                         | )       | 3,126                               |   | (105,345                           | )      | 35,757 |   |
| Cash and cash equivalents, beginning of  period                             |   | 108,168                         |    | 69,285                              |   | 174,630                            |   | 72,411 |   |
| Cash and cash equivalents, end of period                                    |   | $                               | 50,301  |                                | $      | 72,411                             |   | $ | 69,285 |   | $ | 108,168 |   |
| **Supplemental Disclosure of Non-cash Investing  and Financing Activities** |   |                            |    |                                |   |                               |   |   |   |
| Interest paid                                                               |   | $                               | 2,325   |                                | $      | 293                                |   | $ | 350 |   | $ | — |   |
| Income taxes paid (received)                                                |   | 1,095                           |    | (3,285                              | )      | 13,505                             |   | (59 | ) |
| Capital lease obligations incurred, net of  trade-ins                       |   | 1,783                           |    | 4,634                               |   | 1,574                              |   | 186 |   |
| Transfer of inventory to fixed assets                                       |   | 1,859                           |    | 5,679                               |   | 4,549                              |   | 614 |   |
| Fixed assets exchanged for capital leases                                   |   | (1,364                          | )       | (1,501                              | )      | —                             |   | — |   |
| Restricted stock grant                                                      |   | 17,357                          |    | 1,867                               |   | 1,896                              |   | 747 |   |
| Unrealized gain (loss) on investments                                       |   | (761                            | )       | 441                                 |   | 637                                |   | (102) |   |

The accompanying notes are an integral partof these consolidated financial statements.

 

F-6

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**McDATA CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**(tabular amounts in thousands, except pershare data)**

 

##### ***NOTE 1 OVERVIEWAND BASIS OF PRESENTATION***

##### *** ***

McDATACorporation (McDATA or the Company) provides Multi-Capable Storage NetworkSolutionsTM (integrating multiple platforms, networks,protocols and locations) that enables end-customers around the world to betterutilize their storage infrastructure, easily manage the storage network andimplement best-in-class business continuance solutions allowing them to be moreefficient and effective. McDATA solutions are an integral part of data servicesinfrastructures sold by most major storage and system vendors, including DellProducts L.P (Dell), EMC Corporation (EMC), Hewlett-Packard (HP), Hitachi DataSystems (HDS), International Business Machines Corporation (IBM),StorageTechnology Corporation (STK) and Sun Microsystems, Inc. (Sun).

 

**Prior to February 7, 2001, McDATA was a majority-ownedsubsidiary of EMC. On February 7, 2001, EMC distributed all of the sharesit held of McDATA Class A common stock to EMC’s shareholders of record asof January 24, 2001 (the Distribution). EMC has received a ruling from theInternal Revenue Service that the Distribution to EMC stockholders was tax freefor U.S. federal income tax purposes. The Company continues to believe that thedistribution of its Class A common stock by EMC was tax-free. As a resultof the Distribution, EMC no longer has any ownership in or voting power overMcDATA and, therefore, is no longer considered a related party.**

** **

On January 15, 2003, the Company changed itsfiscal year end to January 31, from December 31. The Company believesthat the twelve months ended December 31, 2002 and 2001 provide ameaningful comparison to the twelve months ended January 31, 2004. Thereare no factors, of which the Company is aware, seasonal or otherwise, thatwould impact the comparability of information or trends, if results for thetwelve months ended January 31, 2003 and 2002 were presented in lieu ofresults for the twelve months ended December 31, 2002 and 2001. Referencesin these footnotes to 2003 represent the twelve months ended January 31,2004. References to 2002 and 2001 represent the twelve months endedDecember 31, 2002 and 2001.

 

##### ***NOTE 2SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES***

##### *** ***

*Principles of Consolidation*

 

The consolidated financial statements include the assets, liabilities,results of operations, cash flows and changes in stockholders’ equity of theCompany and its wholly-owned subsidiaries. The equity method of accounting isused for investments in affiliates in which we have significant influence.  All material intercompany transactions andbalances have been eliminated.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that effect the reported amountsof assets, liabilities, revenues and expenses and disclosure of contingentassets and liabilities. Actual results could differ from these estimates.

 

*Cash and Cash Equivalents*

 

Cash equivalents are short-term, highly liquid investments that arereadily convertible to cash and have remaining maturities of ninety daysor less at date of purchase.

 

F-7

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*Valuation of Accounts Receivable*

 

Accounts receivable are reviewed to determine which are doubtful ofcollection. Estimates are also made for potential future product returns. Inmaking the determination of the appropriate allowance for doubtful accounts andproduct returns, the Company considers specific accounts, analysis of accountsreceivable agings, changes in customer payment terms, historical write-offs andreturns, changes in customer demand and relationships, concentrations of creditrisk and customer credit worthiness. 

 

*Inventories*

 

Inventories, which include material, labor, factory overhead andpurchased finished goods, are stated using standard costs which approximate thelower of cost (first-in, first-out method) or market. The Company evaluates theneed for reserves associated with obsolete, slow-moving and non-salableinventory by reviewing net realizable values on a quarterly basis. TheCompany’s inventories do not include materials purchased and held by theCompany’s component subcontractors, as the Company does not own this inventory.

 

*Investments*

 

The Company’s short- and long-term investments consist primarily ofmarketable debt and equity securities, all of which are classified asavailable-for-sale and recorded at fair value. Fair values are determined usingquoted market prices. Unrealized holding gains and losses are recorded, net ofany tax effect, as a separate component of accumulated other comprehensiveincome. Securities with stated maturities of one year or less at time ofpurchase are classified as short-term investments. Securities with remainingmaturities longer than one year are classified as long-term investments.

 

Included in investment balances are certain derivatives used asfair-value hedges against positions held in certain marketable equitysecurities.  Any ineffectiveness inthese hedged instruments or the loss of hedge-accounting treatment could resultin significant fluctuations to earnings.

 

*Fair Value of Financial Instruments*

 

The carrying value of financial instruments, including cashequivalents, accounts receivable, accounts payable and accrued liabilities,approximate fair value due to their short maturities. Based upon borrowingrates currently available to the Company, with similar terms, the carryingvalues of the capital lease obligations approximate their fair values. The fairvalues of the Company’s investments and convertible debt are determined usingquoted market prices for those securities. The Company recognizes all derivatives as either assets or liabilitiesin the statement of financial position and measures those instruments at fairvalue.

 

# ***Interest Rate Swaps***

# ** **

The Company has entered into an interest rate swap to address interestrate market risk exposure. The interest rate swap is designated and qualifiesas a fair value hedge under Statement of Financial Standards (SFAS) No. 133,“Accounting for Derivative Instruments and Hedging Activities.” For derivativeinstruments that are designated and qualify as a fair value hedge, the gainsand losses on the derivative instrument, as well as the offsetting gain or losson the hedged item attributable to the hedged risk, are recognized in currentearnings during the period of change in fair values. If the change in the valueof the hedging instrument offsets the change in the value of the hedged item,the hedge is considered perfectly effective. The accounting for hedgeeffectiveness is measured at least quarterly based on the relative change infair value between the derivative contract and the hedged item over time. Anychange in fair value resulting from ineffectiveness, the amount by which thechange in the value of the hedge does not exactly offset the change in thevalue of the hedged item, is recognized immediately in earnings. The Company’sinterest rate swap qualifies as a perfectly effective fair value hedge. Assuch, there is no ineffective portion to the hedge recognized in earnings.Adjustments to the fair value of the interest rate swap agreement are recordedas either an other asset or long-term liability. The differential to be paid orreceived under these agreements is accrued consistently with the terms of theagreements and is recognized in interest expense over the term of the relateddebt. The related amounts payable to or receivable from counterparties are

 

F-8

----

 

included in accounts receivable or accrued liabilities. 

 

*Property and Equipment*

 

Property and equipment is stated at cost less accumulated depreciation.Expenditures that substantially extend the useful life of an asset arecapitalized. Ordinary repair and maintenance expenditures are expensed asincurred. For financial reporting purposes, depreciation is recordedprincipally on a straight-line method over the estimated useful lives of theasset as follows:

 
| Building                |   | 39 years                                                  |
|-------------------------|--------|----------------------------------------------------------------|
| Building equipment      |   | 5-39 years                                                |
| Equipment and furniture |   | 3-5 years                                                 |
| Computer software       |   | 2-5 years                                                 |
| Capital lease equipment |   | The shorter of the useful life of 3-5 years or lease term |
| Leasehold improvements  |   | The shorter of the useful life of 3-5 years or lease term |

 

Depreciation expense was approximately $26,933,000, $18,648,000,$14,297,000 and $1,979,000 in 2003, 2002, 2001 and for the month endedJanuary 31, 2003, respectively. Equipment and furniture atJanuary 31, 2004 and December 31, 2002 includes assets under capitalizedleases of $8,361,000 and $10,679,000, respectively, with related accumulatedamortization of approximately $4,627,000 and $6,436,000, respectively.

 

In accordance with American Institute of Certified Public Accountants(AICPA) Statement of Position (SOP) 98-1, “Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use,” certain costs incurred inconnection with the application development state of internal-use softwareprojects are capitalized and amortized over the estimated useful life of theasset.  Amortization expense related tothese costs are included in depreciation expense.

 

*Long-Lived Assets, Including Goodwill andOther Acquired Intangible Assets*

 

The Company periodically evaluates the carrying value of long-livedassets, excluding goodwill, for impairment when events and circumstancesindicate the carrying amount of an asset may not be recoverable. The carryingvalue of a long-lived asset is considered impaired when the anticipatedundiscounted cash flows from such asset (or asset group) are separatelyidentifiable and less than the asset’s (or asset group’s) carrying value. Inthat event, a loss is recognized to the extent that the carrying value exceedsthe fair value of the long-lived asset. Fair value is determined primarily usingthe anticipated cash flows discounted at a rate commensurate with the riskinvolved.  For the three years ended2003, 2002, 2001 and the month ended January 31, 2003, the Company hasmade no material adjustments to its long-lived assets.

 

The Company has adopted SFAS No. 142, “Goodwill and OtherIntangible Assets” for the year ended December 31, 2002. As the Company’sgoodwill at that time resulted from acquisitions subsequent to July 1,2001, no significant amortization was incurred in 2001.  See Note 5 – Acquisitions and IntangibleAssets.  Under SFAS No. 142,goodwill and other indefinite lived intangible assets are not subject toamortization, but are subject to an impairment test upon adoption and at leastannually thereafter. The Company completed its annual impairment analysis ofgoodwill in the first quarter of 2003 and found no impairment.  SFAS No. 142 also requires that intangibleassets with definite lives be amortized over their estimated useful lives andreviewed for impairment in accordance with SFAS No. 144, “Accounting for theImpairment of Long-Lived Assets to Be Disposed Of.”  The Company is currently amortizing its acquired intangibleassets with definite lives over periods ranging from one to six years. 

 

*Revenue Recognition*

 

The Company recognizes revenue when (a) persuasive evidence of anarrangement exists (b) products are delivered or services rendered(c) the sales price is fixed or determinable and (d) collectibilityis assured. Revenue from product sales to our resellers and end-user customersis recognized when title and risk of loss transfer to the customer, generallyat the time the product is delivered. Revenue from product sales to ourOEMs and distributors is recognized when title and risk of loss transferto the customer in accordance with the master agreement, generally uponsell-through

 

F-9

----

 

to the end-user. Revenue is reduced for estimated customer returns,price protection, rebates, and other offerings that occur under sales programsestablished with the Company’s OEMs, distributors and resellers. The Companyaccrues for warranty costs and sales returns at the time of shipment based onits experience. Revenue from support or maintenance contracts is recognizedratably over the contractual period. Amounts invoiced to customers in excess ofrevenue recognized on these contracts are recorded as deferred revenue untilall revenue recognition criteria are met. Revenue from software is comprised ofsoftware licensing and post-contract customer support. Software revenue isallocated to the license and support elements using vendor specific objectiveevidence of fair value (VSOE). Revenue allocated to software licenses isrecognized when the four basic criteria above have been met. Revenue allocatedto post-contract support is recognized ratably over the term of the supportcontract, assuming the four basic criteria are met.

 

In transactions that include multiple products, services and/orsoftware, the Company allocates the revenue to each element based on theirrelative fair value (or in the absence of fair value, the residual method) andrecognizes the associated revenue when all revenue recognition criteria havebeen met for each element.

 

*Research and Development*

 

Research and development (R&D) costs are expensed as incurred.R&D costs consist primarily of salaries and related expenses of personnelengaged in engineering and R&D activities; fees paid to consultants andoutside service providers; nonrecurring engineering charges; prototypingexpenses related to the design, development, testing and enhancement of ourproducts; depreciation related to engineering and test equipment; and IT andfacilities expenses.

 

*Software Development Costs*

 

The Company capitalizes eligible computer software development costsupon the establishment of technological feasibility, which it has defined ascompletion of designing, coding and testing activities or the completion of aworking model as defined by our software and hardware engineering developmentprocesses. Costs incurred prior to the establishment of technologicalfeasibility are expensed to research and development. The establishment oftechnological feasibility and the ongoing assessment of recoverability ofcapitalized software development costs require considerable judgment bymanagement with respect to certain external factors, including, but not limitedto, anticipated future revenues, estimated economic life and changes insoftware and hardware technologies. Upon the general release of the softwareproduct to customers, capitalization ceases and such costs are amortized (usingthe straight-line method) on a product-by-product basis over the estimatedlife, which is generally one to three years. Capitalized software costsand accumulated amortization included in other assets at January 31, 2004,were approximately $15,079,000 and $7,312,000, respectively. Capitalizedsoftware costs and accumulated amortization included in other assets atDecember 31, 2002, were approximately $9,220,000 and $1,546,000,respectively. Capitalized software amortization expense for 2003, 2002 and 2001were approximately $5,506,000, $1,520,000 and $27,000, respectively.  Capitalized software amortization expensefor the month ended January 31, 2003 was approximately $260,000.

 

*Advertising*

 

The Company expenses advertising costs as incurred. Advertisingexpenses for 2003, 2002, and 2001 were approximately $3,225,000, $6,222,000,and $6,941,000, respectively. Advertising expenses for the month ended January 31, 2003 wereapproximately $556,000.

 

# ***Restructuring Charges***

# ** **

In July 2002, the Financial Accounting Standards Board (FASB)issued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities.” SFAS No. 146 supercedes Emerging Issues Task Force (EITF)Issue No. 94-3, “Liability Recognition for Certain Employee TerminationBenefits and Other Costs to Exit an Activity (including Certain Costs Incurredin a Restructuring)” and requires that costs related to exiting an activity orto a restructuring not be recognized until the liability is incurred as opposedto when management commits to an exit plan. This statement was effective forexit or disposal activities initiated after December 31, 2002.  The provisions of SFAS No. 146 were requiredto be applied prospectively after the adoption date to newly initiated exitactivities.  See Note 4 for

 

F-10

----

 

discussion of 2003 restructuring activities.

 

*Earnings Per Share*

 

Basicnet income (loss) per share excludes dilution and is computed by dividingincome available to common stockholders by the weighted-average number ofcommon shares outstanding for the period. Diluted net income (loss) per shareis based on the weighted-average number of shares outstanding during eachperiod and the assumed exercise of dilutive stock options less the number oftreasury shares assumed to be purchased from the proceeds using the averagemarket price of the Company’s common stock for each of the periods presented.No dilutive effect has been included for the convertible subordinated debtissued February 7, 2003 (see Note 8) because the Company currently has theability and intent to settle the conversion in cash. Additionally, no dilutiveeffect has been included for the share options sold in relation to theconvertible subordinated debt because the exercise price was higher than theaverage stock price for the period.

 

Following is a reconciliation between basic and diluted earnings pershare:

 
|                                                                                            |   | **Year  Ended  January 31,** |    | **Years Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|-------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|------------------------------------|--------|------------------------------------|--------|
|                                                                                            |   | **2004**                          |    | **2002**                           |   | **2001**                           |   | **2003** |   |
|                                                                                            |   |                              |    |                               |   |                               |   |   |   |
| Net loss                                                                                        |   | $                                 | (43,133 | )                                  | $      | (9,987                             | )      | $ | (8,656 | ) | $ | (3,460 | ) |
| Weighted average shares of common stock  outstanding used in computing basic net loss per share |   | 114,682                           |    | 113,185                            |   | 111,475                            |   | 114,000 |   |
| Net effect of dilutive stock options                                                            |   | —                            |    | —                             |   | —                             |   | — |   |
| Weighted average shares of common stock  used in computing diluted net loss per share           |   | 114,682                           |    | 113,185                            |   | 111,475                            |   | 114,000 |   |
|                                                                                            |   |                              |    |                               |   |                               |   |   |   |
| Basic net loss per share                                                                        |   | $                                 | (0.38   | )                                  | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
| Diluted net loss per share                                                                      |   | $                                 | (0.38   | )                                  | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
|                                                                                            |   |                              |    |                               |   |                               |   |   |   |
| Options not included in diluted share base  because of the exercise prices                      |   | 8,459                             |    | 4,840                              |   | 1,344                              |   | 6,092 |   |
| Options and restricted stock not included  in diluted share because of net loss                 |   | 6,422                             |    | 6,984                              |   | 9,520                              |   | 6,401 |   |

 

*Stock-Based Compensation*

 

At January 31, 2004, the Company has stock-based employeecompensation and employee purchase plans, which are described more fully inNote 9. The Company accounts for these plans according to AccountingPrinciples Board Opinion No. 25, Accounting for Stock Issues to Employees(APB 25), and related interpretations and has adopted the disclosure-onlyalternative of SFAS No. 123, “Accounting for Stock-Based Compensation”(SFASNo. 123), as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure an amendment of FASB Statement No.123” (SFAS No. 148). Any deferred stock compensation calculated pursuant to APB25 is amortized ratably over the vesting period of the individual options,generally two to four years. The following table illustrates the effect onnet loss and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123.

 

F-11

----

 
|                                                                                                                                                     |   | **Year  Ended  January 31,** |    | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|-------------------------------------|--------|------------------------------------|--------|
|                                                                                                                                                     |   | **2004**                          |    | **2002**                            |   | **2001**                           |   | **2003** |   |
|                                                                                                                                                     |   |                              |    |                                |   |                               |   |   |   |
| Net loss, as reported                                                                                                                                    |   | $                                 | (43,133 | )                                   | $      | (9,987                             | )      | $ | (8,656 | ) | $ | (3,460 | ) |
| Add: Total stock-based employee  compensation expense included in net income as determined under the intrinsic  value method, net of related tax effects |   | 12,708                            |    | 5,542                               |   | 5,426                              |   | 406 |   |
| Deduct: Total stock-based employee  compensation expense determined under the fair value based method for all  awards, net of related tax effects        |   | (34,050                           | )       | (16,879                             | )      | (15,894                            | )      | (1,481 | ) |
| Pro forma net loss                                                                                                                                       |   | $                                 | (64,475 | )                                   | $      | (21,324                            | )      | $ | (19,124 | ) | $ | (4,535 | ) |
|                                                                                                                                                     |   |                              |    |                                |   |                               |   |   |   |
| Loss per share:                                                                                                                                          |   |                              |    |                                |   |                               |   |   |   |
| Basic-as reported                                                                                                                                        |   | $                                 | (0.38   | )                                   | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
| Basic-pro forma                                                                                                                                          |   | $                                 | (0.56   | )                                   | $      | (0.19                              | )      | $ | (0.17 | ) | $ | (0.04 | ) |
|                                                                                                                                                     |   |                              |    |                                |   |                               |   |   |   |
| Diluted-as reported                                                                                                                                      |   | $                                 | (0.38   | )                                   | $      | (0.09                              | )      | $ | (0.08 | ) | $ | (0.03 | ) |
| Diluted-pro forma                                                                                                                                        |   | $                                 | (0.56   | )                                   | $      | (0.19                              | )      | $ | (0.17 | ) | $ | (0.04 | ) |

 

The fair value of each option granted during 2003, 2002, 2001, and themonth ended January 31, 2003 is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions:

 
|                         |   | **Year  Ended  January 31,** |   | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|------------------------------|--------|-----------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                         |   | **2004**                          |   | **2002**                            |   | **2001**                           |   | **2003** |   |
|                         |   |                              |   |                                |   |                               |   |   |   |
| Dividend yield               |   | —                            | %      | —                              | %      | —                             | %      | — | % |
| Expected volatility          |   | 90                                | %      | 90                                  | %      | 125                                | %      | 90 | % |
| Risk-free interest rate      |   | 2.1%-3.5                          | %      | 2.5%-4.9                            | %      | 3.7%-5.0                           | %      | 3.0%-3.1 | % |
| Expected life, in years |   | 2.0 – 4.0                    |   | 2.0 - 4.0                           |   | 4.0                                |   | 2.0 - 4.0 |   |

 

*Comprehensive Income (Loss)*

 

Comprehensive income (loss) includes net earnings as well as additionalother comprehensive income. McDATA’s other comprehensive income consists ofunrealized gains and losses on available-for-sale securities, recorded net ofany related tax, that are recorded as changes in equity and not an element ofthe Company’s income statement.

 

*Reclassifications*

 

Certain prior year amounts have been reclassified to conform to the2003 presentation.

 

*Recent Accounting Pronouncements*

 

TheFASB issued Interpretation No. 46 (FIN 46), “Consolidation of Variable InterestEntities” in January 2003, and a revised interpretation of FIN 46 (FIN46-R) in December 2003. FIN 46 provides guidance on how to identify avariable interest entity (VIE) and determine when the assets, liabilities, andresults of operations of a VIE need to be included in a company’s consolidatedfinancial statements. FIN 46 also requires additional disclosures by primarybeneficiaries and other significant variable interest holders in a VIE. FIN46-Rapplies at different dates to different types of enterprises and entities, andspecial provisions apply to enterprises that have fully or partially appliedFIN 46 prior to issuance of FIN 46-R. Generally, application of FIN 46-R is required in financial statementsof public entities that have interest in variable interest entities orpotential variable interest entities commonly referred to as special-purposeentities for periods ending after December 15, 2003.  Application by public entities for all othertypes of entities is required in

 

F-12

----

 

financial statements forperiods ending after March 15, 2004. The adoption of FIN 46 and FIN 46-R did not have a material impact onthe Company’s results of operations or financial condition.

 

InApril 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities.” SFAS No. 149 amends andclarifies financial accounting and reporting for derivative instruments,including certain derivative instruments embedded in other contracts and forhedging activities under SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities.” SFAS No. 149 is generally effective for contracts enteredinto or modified after June 30, 2003, and for hedging relationshipsdesignated after June 30, 2003. The adoption of SFAS No. 149 did not havea significant impact on the Company’s financial position or results ofoperations.

 

In October 2003, the Emerging Issues Task Force (EITF) reached aconsensus on its tentative conclusions for EITF 03-05, “Applicability of SOP97-2 to Non-Software Deliverables in an Arrangement Containing More-ThanIncidental Software” (EITF 03-05). EITF 03-05 discusses that softwaredeliverables are within the scope of SOP 97-2 as are non-software deliverables.The Company is required to adopt this consensus for fiscal periods beginningafter August 2003. The Company believes the adoption of EITF 03-05 willnot have an impact on the Company’s consolidated financial statements.

 

In December 2003, the Staff of the Securities and ExchangeCommission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, “RevenueRecognition,” which supercedes SAB No. 101, “Revenue Recognition in FinancialStatements.”  SAB No. 104’s primarypurpose is to rescind accounting guidance contained in SAB No. 101 related tomultiple-element revenue arrangements and to rescind the SEC’s “RevenueRecognition in Financial Statements Frequently Asked Questions and Answers”(FAQ) issued with SAB No. 101.  Selectedportions of the FAQ have been incorporated into SAB No. 104.  The adoption of SAB No. 104 did not have amaterial impact on the Company’s revenue recognition policies.

 

##### ***NOTE 3COMPONENTS OF SELECTED BALANCE SHEET ACCOUNTS***

 
|                                                      |   | **Year Ended  January 31,** |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------------|--------|----------------------------------|--------|-----------------------------------|--------|
|                                                      |   | **2004**                         |   | **2002**                          |   |
| Inventories:                                              |   |                             |   |                              |   |
| Raw materials                                             |   | $                                | 7,037  |                              | $      | 8,070 |   |
| Work-in-progress                                          |   | 920                              |   | 1,123                             |   |
| Finished goods                                            |   | 7,883                            |   | 6,316                             |   |
| Total inventories at cost                                 |   | 15,840                           |   | 15,509                            |   |
| Less reserves (1)                                         |   | (4,476                           | )      | (7,412                            | )      |
| Total inventories, net                                    |   | $                                | 11,364 |                              | $      | 8,097 |   |
|                                                      |   |                             |   |                              |   |
| Property and equipment:                                   |   |                             |   |                              |   |
| Land                                                      |   | $                                | 16,091 |                              | $      | 16,091 |   |
| Building                                                  |   | 32,410                           |   | 29,712                            |   |
| Equipment and furniture                                   |   | 85,680                           |   | 74,608                            |   |
| Computer software for internal use                        |   | 25,492                           |   | 18,877                            |   |
| Leasehold improvements                                    |   | 3,271                            |   | 4,805                             |   |
| Construction in progress                                  |   | 958                              |   | 2,361                             |   |
|                                                      |   | 163,902                          |   | 146,454                           |   |
| Less accumulated depreciation and  amortization           |   | (64,677                          | )      | (46,527                           | )      |
|                                                      |   | $                                | 99,225 |                              | $      | 99,927 |   |
|                                                      |   |                             |   |                              |   |
| Accrued liabilities:                                      |   |                             |   |                              |   |
| Wages and employee benefits                               |   | $                                | 17,489 |                              | $      | 16,643 |   |
| Purchase commitments and other supply  obligations (1)(2) |   | 7,829                            |   | 12,022                            |   |
| Warranty reserves (3)                                     |   | 4,522                            |   | 3,461                             |   |
| Taxes, other than income tax                              |   | 2,534                            |   | 1,050                             |   |
| Interest payable                                          |   | 1,773                            |   | —                            |   |
| Customer obligations                                      |   | 4,729                            |   | 349                               |   |
| ESCON agency funds                                        |   | 8,373                            |   | 2,366                             |   |
| Other accrued liabilities                                 |   | 4,298                            |   | 1,888                             |   |
|                                                      |   | $                                | 51,547 |                              | $      | 37,779 |   |

 

F-13

----

 

----

(1)                                  During the year endedDecember 31, 2002, the Company recorded net inventory-related charges of$9.5 million, primarily for excess 1 gigabit (Gb) components used in theCompany’s director-class products. The excess inventory resulted primarily fromthe Company’s introduction of 2 Gb products in the second quarter of 2002 andthe unanticipated reduction in demand for the 1 Gb product orders prior to thenew product release.  These charges werein excess of the routine excess and obsolete reserves recorded by the Companyduring the year.

 

(2)                                  During the fiscal 2003 year, the Companyreleased recorded obligations of approximately $1.3 million relating to theexpiration of certain customer sales obligations which were provided for infiscal 2001.

 

(3)                                  Activity in thewarranty reserves is as follows:

 
|                              |   | **Year Ended**       |        | **One Month  Ended**  |       |
|-----------------------------------|--------|----------------------|-------------|-----------------------|------------|
|                              |   | **January 31,** |        | **December 31,** |       | **January 31,** |   |
|                              |   | **2004**             |        | **2002**              | ** ** | **2003** | ** ** |
| Balance at beginning of period    |   | $                    | 3,485       |                  | $          | 2,174 |   | $ | 3,461 |   |
| Warranty expense                  |   | 2,104                |        | 1,853                 |       | 24 |   |
| Warranty claims                   |   | (1,294               | )           | (566                  | )          | — |   |
| Acquisition of warranty liability |   | 227                  |        | —                |       | — |   |
| Balance at end of period          |   | $                    |  4,522 |                  | $          |  3,461 |   | $ |  3,485 |   |

 

##### ***NOTE 4RESTRUCTURING CHARGES***

##### *** ***

In January 2004, the Company announced that it was taking certaincost improvement actions, which included a workforce reduction and facilityconsolidation. As a result, in the fiscal fourth quarter of 2003, the Companyrecorded to accrued liabilities an approximate $2.3 million restructuringcharge related to the reduction in workforce. The reduction in workforcerepresented approximately nine percent primarily in the engineering, sales andmarketing organizations. In addition, the Company announced the anticipatedfirst quarter 2004 closure of its Canadian leased engineering facility. All ofthese charges are to be paid in fiscal year 2004.  In addition, the Company expects to incur an approximate $2.2million restructuring charge in its fiscal first quarter 2004, primarilyrelated to the facilities closure, as well as additional severance costs.** **

 

**NOTE 5 ACQUISITIONS AND INTANGIBLE ASSETS**

 

*Nishan Systems, Inc.*

 

On September 19, 2003, the Company completed its acquisition ofthe stock of Nishan Systems, Inc. (Nishan), a provider of next generationnative IP storage solutions that builds open storage networking products basedon IP and

 

F-14

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Ethernet, the international networking standards. The Nishantransaction is intended to accelerate McDATA’s delivery of inter-networkingcapabilities that scale data center storage networks and extend storage networkbenefits across the enterprise. Nishan’s comprehensive family of IP storageswitching products allows customers to leverage their fibre channel storagenetwork infrastructure and their IP networks to consolidate storageinfrastructures across the campus, the enterprise and geographies. Thesesolutions allow for integrated disaster recovery architectures, and costeffective integration of low-end servers and applications into the storagenetwork. These factors contributed to a purchase price in excess of fair valueof Nishan’s net tangible and intangible assets acquired. As a result, theCompany has recorded goodwill in connection with this transaction. Theconsolidated financial statements include the operating results of Nishan fromthe date of the acquisition.

 

The total purchase price of approximately $69.3 million consisted of$65.0 million in cash consideration and direct transaction costs paid ofapproximately $4.3 million. Based on estimates and assumptions of management,the preliminary allocation of the purchase price to the assets acquired andliabilities assumed was as follows:

 

 
| Cash                                |   | $       | 668    |   |
|-------------------------------------|--------|---------|--------|--------|
| Other tangible assets               |   | 4,905   |   |
| Amortizable  intangible assets:     |   |    |   |
| Customer relationships              |   | 1,622   |   |
| Developed technology                |   | 8,337   |   |
| Customer backlog                    |   | 454     |   |
| Goodwill                            |   | 67,007  |   |
| Liabilities                         |   | (5,680  | )      |
| Debt                                |   | (15,816 | )      |
| In-process research and development |   | 7,774   |   |
| Total                               |   | $       | 69,271 |   |

 

Amortizable intangible assets consist of customer-related intangibleassets and developed technology. Customer relationships represent existing contracts that relateprimarily to customers such as Hitachi Data Systems, IBM, EMC, Tokyo Electron,Sun Microsystems, and Bell Microproducts. The Company is amortizing the fairvalue of these assets on a straight-line basis over an estimated useful life ofapproximately 3 years.  Developedtechnology, which consists of products that have reached technologicalfeasibility, includes products which support various protocols (iSCSI, iFCP andE_Port for trunking) to connect IP backbones to legacy Fibre Channel fabrics.The technology has a non-blocking architecture that supports Ethernet Layer 2switching, IP Layer 3 switching, and Fibre Channel switching over extendeddistances at full gigabit wire speed. These products also support standard IProuting protocols such as OSPF and DVMRP and can be fully integrated intoexisting IP networks. The Company is amortizing the developed technology andrelated patents on a straight-line basis over an estimated useful life ofapproximately 5 years.

 

A preliminary estimate of $67 million has been allocated to goodwill.Goodwill represents the excess of the purchase price over the fair value of thenet tangible and intangible assets acquired, and will not be deductible for taxpurposes. Goodwill will not be amortized and will be tested for impairment atleast annually. The preliminary purchase price allocation for Nishan is subjectto revision after a more detailed analysis is completed and additionalinformation on the fair value of assets and liabilities becomes available. Anychange in the fair value of the net assets of Nishan will change the amount ofthe purchase price allocable to goodwill. In addition, as this was the purchase of stock, the tax basis ofNishan’s assets and liabilities carry over resulting in temporary differencesand a net deferred tax asset of $35.1 million. In light of the Company’s tax position (see Note 12) a fullvaluation allowance of $35.1 million was recorded against the net acquireddeferred tax asset.  Pursuant to the provisions of SFAS No. 109,“Accounting for Income Taxes,” if this valuation allowance is released insubsequent periods, goodwill will be decreased by the amount released up to amaximum of $35.1 million.

 

Of the total purchase price, $7.8 million was allocated to IPR&Dand expensed in fiscal 2003. Projects that qualify as IPR&D represent thosethat have not yet reached technological feasibility and for which no futurealternative uses existed at the date of acquisition. Technological feasibilityis defined as being equivalent to a final working prototype or detailed programdesign in which there is no remaining risk relating to the development. ThreeIPR&D projects were identified

 

F-15

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relating to Nishan’s multiple-protocol switches.  The value assigned to IPR&D wasdetermined by evaluating the importance of each project to the overalldevelopment plan, estimating costs to develop the purchased IPR&D intocommercially viable products, and then estimating the resulting future revenuesand net cash flows from the projects when completed and discounting the netcash flows to their present value. The revenue estimates used to value thepurchased IPR&D were based on estimates of the relevant market sizes andgrowth factors, expected trends in technology and the nature and expectedtiming of new product introductions by the Company and its competitors.

 

Overall, the IPR&D projects were determined to be approximately 70%complete with estimated full completion in the first half of 2004, at whichtime the Company is expected to begin generating economic benefits. In total,costs to complete the IPR&D are expected to be approximately $5.2 million.The rates utilized to discount the net cash flows to their present values were basedon an industry weighted average cost of capital adjusted to reflect thedifficulties and uncertainties in completing each project and risks related tothe impact of potential changes in future target markets. Based on thesefactors, discount rates that range from 21% - 23% were used to value theIPR&D. The estimates used in valuing IPR&D were based upon assumptionsbelieved to be reasonable but which are inherently uncertain and unpredictable.As a result, actual results may differ from such estimates.

 

The nature of the efforts to develop the acquired technologies intocommercially viable products consist principally of designing and testingactivities, including qualification. Failure to bring these products to marketin a timely manner could result in a loss of market share or a lost opportunityto capitalize on emerging markets and could have a material adverse impact onour business and operating results.

 

*Sanera Systems, Inc.*

 

On September 30, 2003, the Company completed its acquisition ofthe stock of Sanera Systems, Inc. (Sanera), a producer of next generationintelligent switching platform technologies. The company was formed in order tobring to market multi-protocol, high performance, highly scaleable switchesdelivering storage services over the network infrastructure. The acquisition ofSanera, when combined with McDATA technologies, extends the Company’s Multi-CapableStorage Network SolutionsTM platform and believe it will accelerate its vision ofdelivering a real-time storage services infrastructure. The technology acquiredfrom Sanera will help McDATA extend its reach at the core of the data center,and integrated with McDATA’s products and technology, will create a productthat allows enterprises to securely consolidate their separate SAN networks andintegrate intelligent storage utility services on one platform, significantlylowering storage networking costs and simplifying SAN management. These factorscontributed to a purchase price in excess of the fair value of the Sanera nettangible and intangible assets acquired. The condensed consolidated financialstatements include the operating results of Sanera from the date of theacquisition.

 

The total purchase price of approximately $113.2 million consisted of$110.2 million in cash consideration and direct transaction costs paid ofapproximately $3.0 million.

 

As of the acquisition date, Sanera was a development stage company withno recognized revenue and no established customer base. Sanera hadsubstantially completed all the planning, designing, coding and testingactivities necessary to establish that the technology underlying the developedproducts could be utilized to meet the design specifications intended. TheCompany currently believes that revenues related to this product will commenceduring fiscal year 2004. Based upon these factors, the Company concluded that,for accounting purposes, it was not purchasing a business with an existingrevenue stream, but rather a group of assets related to a developed technologythat the Company believes will ultimately be developed into a scalable product.

 

The purchase price was allocated to the assets acquired and liabilitiesassumed based on their respective fair values. The excess of purchase priceover the fair value of net assets received was allocated to the acquirednon-monetary assets.  The preliminarypurchase price allocation for Sanera is subject to revision after a moredetailed analysis is completed and additional information on the fair value ofassets and liabilities becomes available. Any change in the fair value of thenet assets of Sanera will change the amount of the purchase price allocable tointangible assets.  The following tablesummarizes the allocation of purchase price for the acquisition of Sanera:

 

F-16

----

 
|                            |   | **Fair Value  of Assets and  Liabilities** |    | **Allocation  of  Excess Purchase  Price** |   | **Allocated  Fair  Value of Assets**

**and  Liabilities** |   |
|---------------------------------|--------|--------------------------------------------|---------|--------------------------------------------|--------|------------------------------------------------------------|--------|
|                            |   |                                       |    |                                       |   |                                                       |   |
| Cash                            |   | $                                          | 10,547  |                                       | $      | —                                                     |   | $ | 10,547 |   |
| Other tangible assets           |   | 4,492                                      |    | —                                     |   | 4,492                                                      |   |
| Amortizable  intangible assets: |   |                                       |    |                                       |   |                                                       |   |
| Developed technology            |   | 48,098                                     |    | 49,833                                     |   | 97,931                                                     |   |
| Customer Relationships          |   | 1,399                                      |    | —                                     |   | 1,399                                                      |   |
| Patents pending                 |   | 434                                        |    | 450                                        |   | 884                                                        |   |
| Assembled workforce             |   | 1,104                                      |    | 1,144                                      |   | 2,248                                                      |   |
| Liabilities assumed             |   | (4,272                                     | )       | —                                     |   | (4,272                                                     | )      |
| Excess purchase price           |   | 51,427                                     |    | (51,427                                    | )      | —                                                     |   |
| Total purchase price            |   | $                                          | 113,229 |                                       | $      | —                                                     |   | $ | 113,229 |   |

 

Amortizable intangible assets consist of customer relationships,patents pending, an assembled workforce and developed technology.  Customer relationships represent an existingcontract that relates primarily to an outstanding purchase order for futureproduct, when and if available. The Company is amortizing the fair value ofthis asset on a straight-line basis over an estimated useful life ofapproximately three years.  Developedtechnology represents next-generation intelligent switching platformtechnologies and consists of products that have reached technologicalfeasibility. The Company is amortizing the developed technology on astraight-line basis over an estimated useful life of approximately sixyears.  Patents pending and theassembled workforce intangible assets are being amortized over lives of six andtwo years, respectively.

 

*Consolidation of Facilities*

 

In conjunction with the acquisitions of Nishan and Sanera, managementcompleted a facilities consolidation plan during the fourth quarter of2003.  In accordance with the provisionsof EITF95-3 “Recognition of Liabilities in Connection With a Purchase BusinessCombination,” a liability of $1.2 million has been recorded as part of purchaseaccounting to reflect the estimated obligation related to uncancellable leasesfor both Nishan and Sanera through the expected cease-use date. The Companyestimates that the consolidation will be completed by the third quarter of2004.

 

*Purchase of SANavigator, Inc.*

 

On September 21, 2001, the Company acquired the assets ofSANavigator, Inc. (SANavigator) for a cash purchase price of$29.75 million. In addition, one-time costs associated with theacquisition were approximately $2.1 million. The results of SANavigator’soperations have been included in the consolidated financial statements sincethat date. SANavigator is a software company that designs and develops ascalable and stable SAN management tool that manages entry-level through complexSAN environments utilizing vendor- and platform-independent software. As aresult of the acquisition, the Company is expected to be in a leading positionin offering storage network management software that provides visibility anddiscovery in a multi-vendor fabric environment.

 

The estimated excess of the purchase price over the fair value of thetangible net assets acquired was valued at $29.2 million. Of this excess,$10.5 million was allocated to developed technology (5 year averageuseful life), $7.2 million was allocated to in-process research anddevelopment (IPR&D), and the remaining $11.5 million was allocated togoodwill. Of the total goodwill amount, $11.5 million is deductible fortax purposes.  In conjunction with theacquisition, the Company issued approximately 192,000 shares of Class Bcommon stock, with a fair value of $1.9 million, for the completion ofongoing employment arrangements with certain SANavigator employees. The stockawards were contingent upon the continued employment of these employees. Assuch, these awards were recorded as deferred compensation and recognizedratably through the expiration date of the employee agreements. AtJanuary 31, 2004, all awards were fully vested.

 

The IPR&D was expensed at the time of purchase becausetechnological feasibility had not been established and no future alternativeuse existed. The IPR&D arose from SANavigator’s on-going development of thenext-generation of

 

F-17

----

 

SANavigator software. This software was intended to significantlyenhance the features of the current version of SANavigator software. The statusof the development at the acquisition date was dependent on several factorsincluding the complexity of working with diverse servers and storage devicesand integrating with other applications. Overall, SANavigator’s IPR&Dproject was estimated to be approximately 40% complete at the time ofacquisition and it was expected that the remaining 60% would be completedduring the Company’s 2002 fiscal year at a cost of approximately$2.1 million. The remaining efforts, which were completed during 2002,included completion of coding, finalizing user interface design anddevelopment, and testing. The amount allocated to in-process research anddevelopment was determined using the discounted cash flow method. This modelemployed cash flow projections for revenue based on the projected incrementalincrease in revenue that the Company expected to receive from the completedIPR&D. Estimated operating expenses, capital charges and applicable incometaxes were deducted to arrive at an estimated after-tax cash flow. The Companydiscounted the after-tax cash flow projections using a risk-adjusted rate ofreturn of 75%.

 

*Pro Forma Information*

 

The unaudited pro forma information presented below assumes that theacquisitions were completed at the beginning of the year acquired and theimmediate preceding year and includes the effect of amortization of identifiedintangibles and costs from those dates. The impact of charges for IPR&D hasbeen excluded. This is presented for informational purposes only and is notnecessarily indicative of the results of future operations or results thatwould have been achieved had the acquisition taken place at the beginning ofthe periods presented.

 

|                                |   | **Year Ended  January 31,** |     | **Years  Ended  December 31,** |   |
|-------------------------------------|--------|----------------------------------|----------|-------------------------------------|--------|
|                                |   | **2004**                         |     | **2002**                            |   | **2001** |   |
| Revenue                             |   | $                                | 426,959  |                                | $      | 344,106 |   | $ | 344,636 |   |
| Net income (loss)                   |   | $                                | (110,500 | )                                   | $      | (93,183 | ) | $ | (9,248 | ) |
| Basic net income (loss) per share   |   | $                                | (0.96    | )                                   | $      | (0.82 | ) | $ | (0.08 | ) |
| Diluted net income (loss) per share |   | $                                | (0.96    | )                                   | $      | (0.82 | ) | $ | (0.08 | ) |

 

# ***Goodwill and Other Intangible Assets***

 

Changes in the carrying amounts of goodwill are as follows:

 

| Goodwill as of December 31, 2001 and  2001 and January 31, 2003, net |   | $      | 11,780 |   |
|--------------------------------------------------------------------------------|--------|--------|--------|--------|
| Acquisitions (Note 5)                                                          |   | 67,007 |   |
| Goodwill as of January 31, 2004, net                                           |   | $      | 78,787 |   |

 

The Company is currently amortizing its acquired intangible assets withdefinite lives over periods ranging from 1 to 6 years.  The following table summarizes the componentsof gross and net intangible asset balances:

 
|                    |   | **January 31,  2004**  |    | **December 31,  2002**   |   |
|-------------------------|--------|-----------------------------|---------|-------------------------------|--------|
|                    |   | **Gross  Carrying  Amount** |    | **Accumulated  Amortization** |   | **Net  Carrying  Amount** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Net  Carrying  Amount** |   |
|                    |   |                        |    |                          |   |   |   |   |   |   |   |   |   |
| Developed technology    |   | $                           | 116,769 |                          | $      | 11,133 |   | $ | 105,636 |   | $ | 10,501 |   | $ | 2,666 |   | $ | 7,835 |   |
| Customer relationships  |   | 3,021                       |    | 340                           |   | 2,681 |   | — |   | — |   | — |   |
| Workforce               |   | 2,248                       |    | 375                           |   | 1,873 |   | — |   | — |   | — |   |
| Other                   |   | 3,745                       |    | 2,622                         |   | 1,123 |   | 2,423 |   | 2,371 |   | 52 |   |
| Total intangible assets |   | $                           | 125,783 |                          | $      | 14,470 |   | $ | 111,313 |   | $ | 12,924 |   | $ | 5,037 |   | $ | 7,887 |   |

 

Expected annual amortization expense related to acquired intangibleassets is as follows:

 

F-18

----

 
| Fiscal Years:                              |   |   |    |
|--------------------------------------------|--------|--------|---------|
| 2004                                       |   | $      | 22,995  |   |
| 2005                                       |   | 22,068 |    |
| 2006                                       |   | 19,781 |    |
| 2007                                       |   | 17,757 |    |
| 2008                                       |   | 17,421 |    |
| Thereafter                                 |   | 11,291 |    |
| Total expected annual amortization expense |   | $      | 111,313 |   |

 

Amortization expense related to acquired intangible assets was $9.4million, $2.1 million, $565,000 and $175,000 for 2003, 2002, 2001 and the monthended January 31, 2003, respectively.

 

##### ***NOTE 6 EQUITY INVESTMENT***

 

OnAugust 22, 2003, the Company purchased 13.6 million shares of preferredstock of Aarohi Communications (Aarohi) for $6 million cash. At January 31,2004, this represented approximately 17.3% of the total outstanding shares ofAarohi.  Aarohi is a privately ownedprovider of next-generation intelligent storage networking technology.  Asof the investment date, the purchase price paid by McDATA exceeded theCompany’s underlying proportionate equity in Aarohi’s net assets by $3.6million. Aarohi is a development stage company with no recognized productrevenue and a core ASIC technology that has not yet reached technicalfeasibility. Management of Aarohi currently believes that revenues related tothis technology will commence during fiscal year 2004. The Company hasconcluded that the $3.6 million difference between the purchase price of theinvestment and the underlying share of equity in the net assets of Aarohirepresents in-process research and development and, as such, has expensed thisamount during fiscal year 2003.

 

Inaddition to the equity investment, the Company has entered into a non-exclusivesupply arrangement with Aarohi to purchase their ASIC chip for inclusion in theCompany’s new product launches when, and if, Aarohi’s product becomes generallyavailable.

 

TheCompany has recorded its share of Aarohi’s net loss of approximately $984,000from the date of purchase through January 31, 2004. The remaining netequity investment of approximately $1.4 million is recorded as an Other Assetat January 31, 2004.

 

Summarizedfinancial information for Aarohi is as follows:

 
| Year Ended December 31, 2003      |   |   |    |
|----------------------------------------|--------|--------|---------|
| Net sales                              |   | $      | 126     |   |
| Gross profit                           |   | $      | 48      |   |
| Operating loss                         |   | $      | (10,231 | ) |
| Net loss                               |   | $      | (9,908  | ) |
|                                   |   |   |    |
| As of December 31, 2003           |   |   |    |
| Current assets                         |   | $      | 14,524  |   |
| Noncurrent assets                      |   | $      | 1,581   |   |
| Current liabilities                    |   | $      | 1,253   |   |
| Noncurrent liabilities                 |   | $      | 2,020   |   |
| Redeemable convertible preferred stock |   | $      | 34,249  |   |
| Stockholders’ deficit             |   | $      | (21,417 | ) |

 

##### ***NOTE 7INVESTMENTS***

 

Short and long-term investments consisted of the followingavailable-for-sale securities at January 31, 2004 and December 31,2003 (in thousands):

 

F-19

----

 
|                                   |   | **Amortized  Cost** |    | **Unrealized  Holding  Gains** |   | **Unrealized  Holding  Losses** |   | **Fair  Values** |    |
|----------------------------------------|--------|---------------------|---------|--------------------------------|--------|---------------------------------|--------|------------------|---------|
|                                   |   |                |    |                           |   |                            |   |             |    |
| **2003**                               |   |                |    |                           |   |                            |   |             |    |
| U.S. Government obligations            |   | $                   | 126,250 |                           | $      | 418                             |   | $                | 67      |   | $ | 126,601 |   |
| State and local government obligations |   | 48,459              |    | 18                             |   | —                          |   | 48,477           |    |
| Corporate obligations                  |   | 44,788              |    | 145                            |   | 4                               |   | 44,929           |    |
| U.S. Treasury options                  |   | 66                  |    | —                         |   | 34                              |   | 32               |    |
| Marketable equity securities           |   | 31,109              |    | —                         |   | 64                              |   | 31,045           |    |
| Fixed income mutual funds              |   | 10,246              |    | —                         |   | 107                             |   | 10,139           |    |
|                                   |   | $                   | 260,918 |                           | $      | 581                             |   | $                | 276     |   | $ | 261,223 |   |
| Reported as:                           |   |                |    |                           |   |                            |   |             |    |
| Short-term investments                 |   |                |    |                           |   |                            |   | $                | 157,740 |   |
| Long-term investments                  |   |                |    |                           |   |                            |   | 103,483          |    |
|                                   |   |                |    |                           |   |                            |   | $                | 261,223 |   |
| **2002**                               |   |                |    |                           |   |                            |   |             |    |
| U.S. Government obligations            |   | $                   | 87,570  |                           | $      | 1,026                           |   | $                | —  |   | $ | 88,596 |   |
| State and local government obligations |   | 89,614              |    | 118                            |   | —                          |   | 89,732           |    |
| Mutual funds                           |   | 18,954              |    | 127                            |   | —                          |   | 19,081           |    |
| Marketable equity securities           |   | 32,956              |    | —                         |   | 6                               |   | 32,950           |    |
|                                   |   | $                   | 229,094 |                           | $      | 1,271                           |   | $                | 6       |   | $ | 230,359 |   |
| Reported as:                           |   |                |    |                           |   |                            |   |             |    |
| Short-term investments                 |   |                |    |                           |   |                            |   | $                | 157,260 |   |
| Long-term investments                  |   |                |    |                           |   |                            |   | 73,099           |    |
|                                   |   |                |    |                           |   |                            |   | $                | 230,359 |   |

 

Amortized cost is determined based on specificidentification.  As of January 31,2004 and December 31, 2002, net unrealized holding gains of $403,000 and$1,265,000 million, respectively, were included in accumulated othercomprehensive income in the accompanying condensed consolidated balance sheets.For the fiscal year ended January 31, 2004, approximately $98,000 ofunrealized losses related to hedged securities were included in investmentincome. These unrealized losses represent the net ineffectiveness of afair-value hedge comprised of certain marketable equity securities and putoptions on U.S. Treasury futures. At January 31, 2004, the Company heldapproximately $32,000 of purchase put options for U.S. Treasury futures. Theseinvestments were purchased to hedge the interest rate risk related to aportfolio of preferred equity securities, included in marketable equitysecurities above, with a market value of approximately $8.2 million atJanuary 31, 2004.

 

**Realized gains and losses on sales of securities wererecorded as other income as follows:**

 
|                        |   | **Year  Ended  January 31,** |   | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|-----------------------------|--------|-----------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                        |   | **2004**                          |   | **2002**                            |   | **2001**                           |   | **2003** |   |
|                        |   |                              |   |                                |   |                               |   |   |   |
| Realized gains              |   | $                                 | 863    |                                | $      | 3                                  |   | $ | 396 |   | $ | — |   |
| Realized losses             |   | (834                              | )      | (343                                | )      | (134                               | )      | (6 | ) |
| Net realized gains (losses) |   | $                                 | 29     |                                | $      | (340                               | )      | $ | 262 |   | $ | (6 | ) |

 

The amortized cost and estimated fair value of debt securities held atJanuary 31, 2004, by contractual maturity, are shown below. Expectedmaturities will differ from contractual maturities because the issuers ofsecurities may have the right to repay obligations without prepaymentpenalties. Certain instruments, although possessing a contractual maturitygreater than a year, are classified as short-term investments based on methodsof trade and availability for current

 

F-20

----

 

operations.

 
|                                                 |   | **Amortized  Cost** |    | **Fair  Values** |   |
|------------------------------------------------------|--------|---------------------|---------|------------------|--------|
| Less than one year                                   |   | $                   | 65,037  |             | $      | 65,412 |   |
| Greater than one year through  five years       |   | 96,211              |    | 96,345           |   |
| Greater than five years through  ten years |   | 1,950               |    | 1,950            |   |
| Greater than ten years                          |   | 56,299              |    | 56,300           |   |
|                                                 |   | $                   | 219,497 |             | $      | 220,007 |   |

 

In fiscal year 2003, the Company began a securities lending programwhereby certain Company securities from the portfolio are loaned to otherinstitutions for short periods of time. The market value of the loanedsecurities is monitored on a daily basis, with additional collateral obtainedor refunded as the market value of the loaned securities changes. The Company’spolicy is to require initial cash collateral equal to 102 percent of the fairvalue of the loaned securities. Securities lending collateral is recordedseparately as a current asset and corresponding current liability. The Companymaintains ownership of the securities loaned, and continues to earn income onthem. The Company shares a portion of the interest earned on the collateralwith Wells Fargo Bank Minnesota, N.A. (the Lending Agent). In addition, theCompany has the ability to sell the securities while they are on loan. TheCompany has an indemnification agreement with the lending agents in the event aborrower becomes insolvent or fails to return securities.  At January 31, 2004, the amount ofsecurities on loan equaled $124.5 million.

 

Financial instruments that potentially subject the Company toconcentrations of credit risk are cash equivalents, short and long-terminvestments and accounts receivable. The Company maintains cash and cashequivalents and short- and long-term investments with various financialinstitutions. These financial institutions are geographically dispersed andcompany policy restricts investments and limits the amount invested with anysingle financial institution. The Company has not sustained material creditlosses from instruments held at financial institutions.

 

##### ***NOTE 8 CONVERTIBLE SUBORDINATED DEBT***

##### *** ***

OnFebruary 7, 2003, the Company sold $172.5 million of 2.25% convertiblesubordinated notes (the “Notes”) due February 15, 2010, raising netproceeds of approximately $167 million. The Notes are convertible into Class Acommon stock at a conversion rate of 93.3986 shares per $1,000 principal amountof notes (aggregate of approximately 16.1 million shares) at any time prior toFebruary 15, 2010, subject to adjustments. In addition, holders of theNotes may require the Company to purchase all or a portion of the Notes upon achange in control of the Company. Upon a conversion, the Company may choose todeliver, in lieu of shares of Class A common stock, cash or a combination ofcash and Class A common stock. The Notes do not contain any restrictivecovenants.  The notes are not listed onany securities exchange or included in any automated quotation system; however,the notes are eligible for trading on the PortalSM Market. On January 31, 2004, the approximate bid price of ournotes was $116.0 and the approximate ask price of our notes was $116.5,resulting in an aggregate fair value of between $200.1 million and $201.0million. Our Class A common stock is quoted on the NASDAQ National Market underthe symbol, “MCDTA.”

 

Concurrentwith the issuance of the Notes, the Company entered into share optiontransactions using approximately $20.5 million of net proceeds. As part ofthese share option transactions, the Company purchased options that coverapproximately 16.1 million shares of Class A common stock, at a strike price of$10.71. The Company also sold options that cover approximately 16.9 millionshares of Class A common stock, at a strike price of $15.08. The net cost ofthe share option transactions was recorded against additional paid in capital.These share option transactions are intended to give the Company the ability tosignificantly mitigate dilution as a result of the Notes being converted tocommon shares up to the $15.08 price per common share and mitigate dilution ifthe share price exceeds $15.08 at that time. Should there be an early unwind ofeither of the share option transactions, the amount of cash or net sharespotentially received or paid by the Company will be dependent on then existingoverall market conditions, the stock price, the volatility of the stock, andthe amount of time remaining until expiration of the options.

 

F-21

----

 

InJuly 2003, the Company entered into an interest-rate swap agreement with anotional amount of $155.3 million that has the economic effect of modifyingthat dollar portion of the fixed interest obligations associated with the Notesso that the interest payable effectively becomes variable based on the sixmonth London Interbank Offered Rate (LIBOR) minus 152 basis points. The resetdates of the swap are February 15 and August 15 of each year untilmaturity on February 15, 2010. At January 31, 2004, the six-monthLIBOR setting for the swap was 1.1283%, creating a rate of approximately minus0.39%, which was effective until February 15, 2004.  On February 15, 2004, the six-monthLIBOR setting was reset to 1.175%, resulting in a rate of approximately minus0.345%, which is effective until August 15, 2004.  The swap was designated as a fair valuehedge and, as such, the gain or loss on the swap, as well as the fullyoffsetting gain or loss on the Notes attributable to the hedged risk, wererecognized in earnings. At January 31, 2004, the fair value of theinterest rate swap had decreased from inception to $349,000 and is included inother long-term liabilities. Corresponding to this change, the carrying valueof the Notes has decreased by $349,000. As part of the agreement, the Companyis also required to post collateral based on changes in the fair value of theinterest rate swap. This collateral, in the form of restricted cash, was $5.1million at January 31, 2004.

 

##### ***NOTE 9STOCKHOLDERS’ EQUITY***

##### *** ***

The Company has both Class A and Class B common stock.Holders of Class A and Class B common stock have voting rights equalto one vote and one-tenth vote, respectively, for each share held. Holders ofClass A and Class B common stock share equal rights as to dividends.No dividends attributable to common stock were declared or paid during 2003,2002, 2001 or the month ended January 31, 2003.

 

The Board of Directors is authorized to issue preferred stock withvoting, conversion and other rights and preferences that may differ from theClass A and Class B common stock. At January 31, 2004, there isno outstanding preferred stock.

 

*Stock Repurchase Plan*

 

InMay 2003, the Company’s Board of Directors authorized a plan for the Company torepurchase up to $50 million of its common stock (Class A, Class B or acombination thereof). This repurchase plan does not obligate the Company toacquire any specific number of shares or acquire shares over any specifiedperiod of time. At January 31, 2004, approximately 976,000 shares have beenrepurchased under the plan with a total cost at $8.8 million.

 

*Stockholders’ Rights Plan*

 

Effective June 5, 2001, the Company’s Board of Directors approveda Stockholder Rights Plan in which preferred stock purchase rights weredistributed as a dividend. Each Right, expiring June 5, 2011, represents aright to buy from the Company one ten-thousandth (1/10,000) of a share ofSeries A Junior Participating Preferred Stock, $0.01 par value, at a priceof $200 per Right. This dividend distribution of the Rights was not taxable tothe Company or its stockholders.

 

Separate certificates for Rights will not be distributed, nor will theRights be exercisable, unless a person or group acquires 15 percent ormore, or announces an offer that could result in acquiring 15 percent ormore, of the aggregate number of votes entitled to be cast by all thenoutstanding shares of Common Stock (a Stock Acquisition). Following a StockAcquisition, each Right holder, except the 15 percent or more stockholder,has the right to receive, upon exercise, common shares valued at twice the thenapplicable exercise price of the Right (or, under certain circumstances, cash,property or other Company securities), unless the 15 percent or morestockholder has offered to acquire all of the outstanding shares of the Companyunder terms that a majority of the independent directors of the Company havedetermined to be fair and in the best interest of the Company and itsstockholders. Similarly, unless certain conditions are met, if the Company engagesin a merger or other business combination following a Stock Acquisition whereit does not survive or survives with a change or exchange of its common sharesor if 50 percent or more of its assets, earning power, or cash flow issold or transferred, the Rights will become exercisable for shares of theacquirer’s stock having a value of twice the exercise price (or under certaincircumstances, cash or property). The Rights are not exercisable, however,until the Company’s right of redemption described below has expired. Generally,Rights

 

F-22

----

 

may be redeemed for $0.01 each (in cash, common shares or otherconsideration the Company deems appropriate) until the earlier of (i) thetenth day following public announcement that a 15 percent or greaterposition has been acquired in the Company’s stock or (ii) the finalexpiration of the Rights. Until exercise, a Right holder, as such, has norights as a stockholder of the Company.

 

*Stock Options*

 

The Company maintains a stock option and restricted stock plan known asthe 2001 McDATA Equity Incentive Plan (the 2001 Plan) which provides for thegrant of Class B stock options, restricted stock and other stock based awardsto directors, officers, other employees, and consultants as determined by thecompensation committee of the Board of Directors. A maximum of 30,000,000shares of common stock were issuable under the terms of the 2001 Plan as ofJanuary 31, 2004, of which no more than 3,000,000 shares may be issued asrestricted stock or other stock based awards. On August 27, 2003, theCompany’s stockholders approved the addition of 6,000,000 shares to the 2001Plan (included in the maximum amount noted above).

 

In August 2003 and in connection with theacquisitions of Nishan and Sanera, the Company adopted the 2003 McDATAAcquisition Equity Incentive Plan (the 2003 Plan). The 2003 Plan is a limitedpurpose plan that allows for the issuance of inducement grants of restrictedand unrestricted Class B common stock to new employees in connection with amerger or acquisition of a company or business by McDATA. Stock awards may onlybe granted to new employees resulting from a merger or acquisition by theCompany. A maximum of 3,000,000 shares of common stock are issuable under theterms of the 2003 Plan. Approximately 1,300,000 restricted stock shares wereissued under this 2003 Plan in connection with the acquisitions discussed inNote 5.  As of January 31, 2004,there were approximately 8.3 million shares of common stock available forfuture grants under these plans.

 

All stock option grants under the plans since August 2000 havebeen granted at an exercise price equal to the fair market value of theCompany’s stock. Prior to 2001, in connection with the grant of certain stockoptions to employees, the Company recorded deferred stock-based compensation,net of forfeitures, of $36,110,000, representing the difference between theexercise price and the deemed fair market value of the Company’s common stockon the dates these stock options were granted. Deferred compensation related tothese grants is included as a reduction of stockholders’ equity and is beingamortized on a straight-line basis over the vesting periods of the relatedoptions, which is generally four years. During 2003, 2002, 2001, and themonth ended January 31, 2003, the Company recorded amortization expenserelated to these grants of approximately $4,279,000, $7,218,000, $8,195,000,and $572,000, respectively (of which $377,000, $584,000, $1,437,000, and $44,000is included in the cost of revenue for 2003, 2002, 2001, and the month endedJanuary 31, 2003, respectively).

 

The following summarizes stock option transactions for the period fromJanuary 1, 2001 to January 31, 2004:

 
|                                                                                              |   | **Year Ended  January 31,** |   | **Years Ended  December 31,**     |   | **Month  Ended  January 31,** |   |
|---------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|----------------------------------------|--------|------------------------------------|--------|
|                                                                                              |   | **2004**                         |   | **2002**                               |   | **2001**                           |   | **2003** |   |
| **Options**                                                                                       |   | **Shares**                       |   | **Weighted  Average  Exercise  Price** |   | **Shares**                         |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at beginning of period                                                                |   | 12,324                           |   | $                                      | 11.43  |                               | 10,672 |   | $ | 11.32 |   | 11,891 |   | $ | 7.41 |   | 11,654 |   | $ | 11.56 |   |
| Granted                                                                                           |   | 3,683                            |   | 10.47                                  |   | 3,296                              |   | 11.44 |   | 2,526 |   | 19.29 |   | 1,073 |   | 8.24 |   |
| Exercised                                                                                         |   | (805                             | )      | 2.75                                   |   | (1,234                             | )      | 1.97 |   | (2,462 | ) | 2.00 |   | (238 | ) | 2.45 |   |
| Forfeited or expired                                                                              |   | (1,554                           | )      | 14.17                                  |   | (1,080                             | )      | 19.89 |   | (1,283 | ) | 8.64 |   | (165 | ) | 12.41 |   |
| Outstanding end of period                                                                         |   | 13,648                           |   | $                                      | 11.38  |                               | 11,654 |   | $ | 11.56 |   | 10,672 |   | $ | 11.32 |   | 12,324 |   | $ | 11.43 |   |
|                                                                                              |   |                             |   |                                   |   | 5,194                              |   | $ | 8.17 |   | 4,377 |   | $ | 4.70 |   | 5,061 |   | $ | 8.95 |   |
| Exercisable at end of period                                                                      |   | 6,602                            |   | $                                      | 10.76  |                               |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted-average fair value of options  granted with an exercise price equal to fair market value |   |                             |   | $                                      | 6.84   |                               |   |   | $ | 7.52 |   |   |   | $ | 15.55 |   |   |   | $ | 5.39 |   |

 

F-23

----

 

The status of total stock options outstanding and exercisable atJanuary 31, 2004 was as follows:

 
|                |   | **Options  Outstanding** |   | **Options  Exercisable**                                    |   |
|---------------------|--------|--------------------------|--------|-------------------------------------------------------------|--------|
| **Exercise Prices** |   | **Number of  Shares**    |   | **Weighted  Average  Remaining  Contractual  Life (Years)** |   | **Weighted  Average  Exercise  Price** |   | **Number  of  Shares** |   | **Weighted  Average  Exercise Price** |   |
|                |   |                     |   |                                                        |   |   |   |   |   |   |   |
| $1.00—$9.99    |   | 6,831                    |   | 6.9                                                         |   | $ | 5.35 |   | 3,697 |   | $ | 2.74 |   |
| $10.00—$19.99  |   | 5,281                    |   | 8.0                                                         |   | 12.44 |   | 1,906 |   | 13.15 |   |
| $20.00—$29.99  |   | 1,177                    |   | 7.1                                                         |   | 26.41 |   | 748 |   | 26.71 |   |
| $30.00—$39.99  |   | 79                       |   | 7.3                                                         |   | 34.99 |   | 41 |   | 34.98 |   |
| $40.00—$49.99  |   | 47                       |   | 6.9                                                         |   | 45.60 |   | 35 |   | 45.60 |   |
| $50.00—$59.99  |   | 13                       |   | 7.0                                                         |   | 54.43 |   | 7 |   | 54.21 |   |
| $60.00—$69.99  |   | 44                       |   | 6.9                                                         |   | 63.51 |   | 33 |   | 63.51 |   |
| $70.00—$79.99  |   | 168                      |   | 6.8                                                         |   | 76.01 |   | 129 |   | 76.04 |   |
| $80.00—$93.36  |   | 8                        |   | 6.6                                                         |   | 93.36 |   | 6 |   | 93.36 |   |
|                |   | 13,648                   |   | 7.4                                                         |   | $ | 11.38 |   | 6,602 |   | $ | 10.76 |   |

 

*Restricted Stock*

 

Restricted stock issued under the plans are recorded at fair marketvalue on the date of the grant and generally vest over a one to four yearperiod. Vesting for some grants may be accelerated if certain performancecriteria are achieved. Compensation expense is recognized over the applicablevesting period. During the years ended January 31, 2004, andDecember 31, 2002, and 2001, and the month ended January 31, 2003 theCompany issued approximately 1,532,000, 182,000, 192,000 and 107,000 ofrestricted shares, respectively, having an aggregate fair market value of$17,357,000, $1,867,000, $1,896,000 and $747,000, respectively. Compensationexpense recognized for restricted shares in 2003, 2002 and 2001 and the monthended January 31, 2003 was $8,429,000, $1,663,000, $501,000, and $53,000,respectively.

 

*Employee Stock Purchase Plan*

 

On August 1, 2002, the Board of Directors approved the 2002Employee Stock Purchase Plan (the Purchase Plan). The Purchase Plan allowseligible employees an opportunity to purchase an aggregate of 1,200,000 sharesof the Company’s Class B common stock at a price per share equal to 85% ofthe lesser of the fair market value of the Company’s common stock at thebeginning or the end of each six-month purchase period. Under the terms of thePurchase Plan, no participant may acquire more than more than $25,000 inaggregate fair market value of common stock during any one-year calendarperiod. As of December 31, 2002 and January 31, 2004, 0 and 521,000shares had been issued under the plan.

 

##### ***NOTE 10OTHER COMPREHENSIVE INCOME***

 

Other comprehensive income consisted solely of unrealized gains(losses) on investments. The changes in the components of other comprehensiveincome, net of taxes were as follows:

 

F-24

----

 
|                                                                                                                                                                          |   | **Year  Ended  January 31,** |   | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                                                                                                                                                                          |   | **2004**                          |   | **2002**                            |   | **2001**                           |   | **2003** |   |
| Change in net unrealized gains (losses) on  investments, net of related income tax expense (benefit) of $(401), $(94),  $331,and $(42), respectively                          |   | $                                 | (227   | )                                   | $      | (189                               | )      | $ | 570 |   | $ | (66 | ) |
| Reclassification adjustment for net  realized (gains) losses included in net income, net of related income tax  (expense) benefit of $(52), $282, $(97), and $2, respectively |   | (81                               | )      | 442                                 |   | (167                               | )      | 4 |   |
|                                                                                                                                                                          |   | $                                 | (308   | )                                   | $      | 253                                |   | $ | 403 |   | $ | (62 | ) |

 

**NOTE 11 EMPLOYEE BENEFIT PLANS**

 

*Defined Contribution Plan*

 

The Company has a defined contribution plan (the McDATA RetirementSavings Plan) that covers eligible employees. The Company matches 50% of anemployee’s contribution up to 6% of annual eligible compensation, subject torestrictions of such plans. Such Company contributions are made in cash, andamounted to approximately $2,049,000, $1,803,000, and $1,359,000 in 2003, 2002and 2001, respectively.  Contributionsfor the month ended January 31, 2003 totaled $313,000.

 

*Profit Sharing and Bonus Plans*

 

The Company has various employee bonus plans. A profit sharing planprovides for the contribution of a portion of each year’s profits to a profitsharing pool that is distributed to all employees not eligible for otherperformance-based incentive plans. The profit sharing amount is determinedannually by the Board of Directors and is paid in cash. Other bonus plans awardquarterly bonuses to the Company’s executives and other members of managementbased on the achievement of pre-defined performance measures and other specificperformance criteria. Compensation charges related to these plans were approximately$3,046,000, $2,991,000, and $981,000 for 2003, 2002, and 2001,respectively.  Compensation charges forthe month ended January 31, 2003 were immaterial.

 

##### ***NOTE 12INCOME TAXES***

 

Income (loss) before income taxes consisted of the following:

 
|     |   | **Year Ended  January 31,** |   | **Years  Ended December 31,** |   | **Month  Ended  January 31,** |   |
|----------|--------|----------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|     |   | **2004**                         |   | **2002**                           |   | **2001**                           |   | **2003** |   |
|     |   |                             |   |                               |   |                               |   |   |   |
| Domestic |   | $                                | (5,526 | )                                  | $      | (16,620                            | )      | $ | (14,270 | ) | $ | (5,445 | ) |
| Foreign  |   | 1,789                            |   | 1,104                              |   | 530                                |   | 122 |   |
|     |   | $                                | (3,737 | )                                  | $      | (15,516                            | )      | $ | (13,740 | ) | $ | (5,323 | ) |

 

 

Income tax expense (benefit) consisted of the following:

 
|                    |   | **Year Ended  January 31,** |   | **Year Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|-------------------------|--------|----------------------------------|--------|-----------------------------------|--------|------------------------------------|--------|
|                    |   | **2004**                         |   | **2002**                          |   | **2001**                           |   | **2003** |   |
|                    |   |                             |   |                              |   |                               |   |   |   |
| **Current:**            |   |                             |   |                              |   |                               |   |   |   |
| Federal                 |   | $                                | (974   | )                                 | $      | 3,190                              |   | $ | 8,894 |   | $ | — |   |
| State                   |   | (39                              | )      | 442                               |   | 508                                |   | — |   |
| Foreign                 |   | 610                              |   | 185                               |   | —                             |   | — |   |
|                    |   | (403                             | )      | 3,817                             |   | 9,402                              |   | — |   |
| **Deferred:**           |   |                             |   |                              |   |                               |   |   |   |
| Federal                 |   | 34,943                           |   | (8,328                            | )      | (13,423                            | )      | (1,716 | ) |
| State                   |   | 3,872                            |   | (1,018                            | )      | (1,063                             | )      | (147 | ) |
|                    |   | 38,815                           |   | (9,346                            | )      | (14,486                            | )      | (1,863 | ) |
| Total expense (benefit) |   | $                                | 38,412 |                              | $      | (5,529                             | )      | $ | (5,084 | ) | $ | (1,863 | ) |

 

F-25

----

 

The total income tax expense (benefit) differs from the amount computedusing the federal income tax rate of 35% for the following reasons:

 
|                                                    |   | **Year Ended  January 31,** |   | **Years  Ended December 31,** |   | **Month  Ended  January 31,** |   |
|---------------------------------------------------------|--------|----------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                                    |   | **2004**                         |   | **2002**                           |   | **2001**                           |   | **2003** |   |
|                                                    |   |                             |   |                               |   |                               |   |   |   |
| Federal income tax expense (benefit) at  statutory rate |   | $                                | (1,308 | )                                  | $      | (5,430                             | )      | $ | (4,809 | ) | $ | (1,863 | ) |
| Research and development credit                         |   | (1,400                           | )      | (1,970                             | )      | —                             |   | (100 | ) |
| State taxes, net of federal benefit                     |   | (131                             | )      | (373                               | )      | (346                               | )      | (147 | ) |
| Foreign taxes                                           |   | 126                              |   | 185                                |   | —                             |   | 33 |   |
| Convertible debt discount                               |   | (2,028                           | )      | —                             |   | —                             |   | — |   |
| Stock-based compensation                                |   | 1,083                            |   | 2,958                              |   | 1,803                              |   | 267 |   |
| Write-off of acquired in-process R&D                |   | 1,273                            |   | —                             |   | —                             |   | — |   |
| Benefit from export sales                               |   | (158                             | )      | (247                               | )      | (305                               | )      | (13 | ) |
| Municipal interest income                               |   | (140                             | )      | (872                               | )      | (1,625                             | )      | (53 | ) |
| Increase in valuation allowance                         |   | 41,332                           |   | —                             |   | —                             |   | — |   |
| Other                                                   |   | (237                             | )      | 220                                |   | 198                                |   | 13 |   |
| Income tax expense (benefit)                            |   | $                                | 38,412 |                               | $      | (5,529                             | )      | $ | (5,084 | ) | $ | (1,863 | ) |

 

Deferred income taxes reflect the tax effect of temporary differencesbetween the amount of assets and liabilities for financial reporting purposesand income tax purposes. The tax effects of each type of temporary differencethat give rise to significant portions of the net deferred tax assets are asfollows:

 
|                                                |   | **Year Ended  January 31  2004** |   | **Year Ended  December 31,  2002** |   |
|-----------------------------------------------------|--------|---------------------------------------|--------|-----------------------------------------|--------|
|                                                |   |                                  |   |                                    |   |
| **Current deferred  tax assets (liabilities):**     |   |                                  |   |                                    |   |
| Inventory reserves and costs                        |   | $                                     | 6,931  |                                    | $      | 10,726 |   |
| Revenue recognition                                 |   | 8,743                                 |   | 10,368                                  |   |
| Net operating loss carry forward                    |   | 12,323                                |   | 7,373                                   |   |
| Warranty reserves                                   |   | 1,727                                 |   | 1,321                                   |   |
| Reserves related to employee benefits               |   | 2,140                                 |   | 1,993                                   |   |
| Stock-based compensation                            |   | 1,253                                 |   | 1,544                                   |   |
| Restructuring reserves                              |   | 855                                   |   | —                                  |   |
| Other                                               |   | (149                                  | )      | —                                  |   |
|                                                |   | 33,823                                |   | 33,325                                  |   |
| **Non-current  deferred tax assets (liabilities):** |   |                                  |   |                                    |   |
| Capitalized research expenditures                   |   | 40,999                                |   | —                                  |   |
| Capitalized acquired intangible assets              |   | (40,381                               | )      | —                                  |   |
| Tax credit carry forward                            |   | 16,796                                |   | 3,537                                   |   |
| Revenue recognition                                 |   | 8,005                                 |   | —                                  |   |
| Stock compensation                                  |   | 1,476                                 |   | —                                  |   |
| Difference between book and tax  depreciation       |   | 4,994                                 |   | 2,485                                   |   |
| Capitalized software, net of amortization           |   | (2,966                                | )      | (2,930                                  | )      |
| Foreign earnings                                    |   | (1,374                                | )      | —                                  |   |
| Net operating loss carry forward                    |   | 15,769                                |   | —                                  |   |
| Other                                               |   | 229                                   |   | —                                  |   |
|                                                |   | 43,547                                |   | 3,092                                   |   |
|                                                |   | 77,370                                |   | 36,417                                  |   |
| Valuation allowance                                 |   | (77,370                               | )      | —                                  |   |
| Total deferred tax asset, net                       |   | $                                     | — |                                    | $      | 36,417 |   |

 

F-26

----

 

The $77.4 million valuation allowance was recorded against deferred taxassets as follows:

 
| Opening balance of deferred tax asset at  February 1, 2003                                  |   | $      | 38,815 |   |
|--------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Additional deferred tax asset arising  during 2003                                               |   | 2,517  |   |
| Acquired deferred tax assets                                                                     |   | 35,070 |   |
| Deferred tax asset for stock-based  compensation in 2003 (net of alternative minimum tax effect) |   | 968    |   |
|                                                                                             |   | $      | 77,370 |   |

 

Gross operating loss carry forwards and tax credit carry forwards willexpire as follows:

 
| **Year of Expiration** |   | **Federal  Net Operating  Loss Carry  Forward** |   | **Research  & Development  Tax Credit  Carry Forward** |   |
|------------------------|--------|-------------------------------------------------|--------|------------------------------------------------------------|--------|
|                   |   |                                            |   |                                                       |   |
| 2019                   |   | $                                               | 99     |                                                       | $      | 104 |   |
| 2020                   |   | —                                          |   | 1,074                                                      |   |
| 2021                   |   | 11,718                                          |   | 4,579                                                      |   |
| 2022                   |   | 22,686                                          |   | 3,540                                                      |   |
| 2023                   |   | 41,501                                          |   | 4,358                                                      |   |
| 2024                   |   | —                                          |   | 1,400                                                      |   |
|                   |   | $                                               | 76,004 |                                                       | $      | 15,055 |   |

 

Approximately $51 million of the net operating loss carryforward and$10 million of the research and development tax credit carry forward aresubject to annual limitations on the amount that can be utilized in theCompany’s tax returns, pursuant to Internal Revenue Code Section 382, as theseamounts were accumulated in the tax returns of Nishan Systems and SaneraSystems for tax periods prior to the date those companies were acquired byMcDATA.

 

Infiscal 2003, the Company recorded an income tax provision of $38.4 million,which included a non-cash charge of $38.8 million related to recording of avaluation allowance against the deferred tax assets. In evaluating the abilityto realize the benefits of the recorded deferred tax assets, managementconsiders all available positive and negative evidence including past operatingresults, the existence of cumulative losses in the most recent fiscal years andforecasts of future taxable income. In determining future taxable income,management is responsible for assumptions utilized including the amount ofstate, federal and international pre-tax operating income, the reversal oftemporary differences and the implementation of feasible and prudent taxplanning strategies. These assumptions require significant judgment about theforecasts of future taxable income and are consistent with the plans andestimates used to manage the underlying businesses.

 

Inperforming the analysis of the realizability of the recorded deferred taxassets, the specific evidence considered by management included cumulativeaccounting losses over the past three years, tax net operating lossespreviously reported, net operating losses acquired, estimated future taxableincome, ongoing prudent and feasible tax planning strategies, progress againstthe forecast of operating results, and continuing market uncertainties. Throughthis analysis, management assessed the likelihood that the net deferred taxassets will be recovered against future taxable income. After considering allof the evidence and applying the provisions of SFAS No. 109, “Accounting forIncome Taxes” (SFAS

 

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109), management concludedthat it was not more likely than not that the deferred tax assets would berealized and that a valuation allowance for the entire deferred tax asset wasrequired.

 

The Company is subject to audit by federal, state and foreign taxauthorities.  These audits may result inadditional tax liabilities.  The Companyaccounts for such contingent liabilities in accordance with SFAS No. 5,“Accounting for Contingencies”, and believes that it has appropriately providedfor taxes for all years.  Severalfactors drive the calculation of the tax reserves including (i) the expirationof statutes of limitations, (ii) changes in tax law and regulations, and (iii)settlements with tax authorities. Changes in any of these factors may result in adjustments to thesereserves which could impact our reported financial results.

 

Prior to the initial public offering on August 9, 2000, theCompany was included in a consolidated Federal income tax return with EMC.  As of the Distribution, the Company is nolonger eligible to be included in EMC’s consolidated tax returns and hasconsequently filed separate income tax returns for the tax periods, which beganimmediately following the Distribution. Under the terms of a tax sharing agreement between the Company and EMC,the Company is obligated to indemnify EMC for any taxes arising out of thefailure of the Distribution to be tax free if that failure results from, amongother things, (i) any act or omission by the Company that would cause suchDistribution to fail to qualify as a tax free distribution under the InternalRevenue Code of 1986, as amended; (ii) any act or omission by the Company thatis inconsistent with any representation made to the Internal Revenue Service inconnection with the request for a private letter ruling regarding the tax-freenature of the Distribution; (iii) any acquisition by a third party of theCompany’s stock or assets; or (iv) any issuance by the Company of stock or anychange in ownership of the Company’s stock. If the distribution of the Company’s Class A common stock fails toqualify as a tax-free distribution, EMC would incur tax liability as if theCompany’s Class A common stock that was distributed by EMC had been sold by EMCfor its fair market value in a taxable transaction.  In the event that the Company is required to indemnify EMCbecause the distribution of the Company’s Class A common stock fails to qualifyas a tax-free distribution, the Company’s liability could exceed 35% of thevalue of the Company’s Class A common stock distributed by EMC as determined onthe date of the distribution.

 

Although the Company is no longer a member of EMC’s consolidated taxgroup, the tax sharing agreement between the Company and EMC continues toaffect the Company.  If a taxingauthority effects a change to the EMC consolidated return, the Company isrequired to reimburse EMC for the tax of any Company-related unfavorableadjustment.  Conversely, the Company isentitled to any refund for any Company-related favorable adjustment.  Second, the Company is required to remit toEMC any tax savings generated by the tax deductions, if any, related to theissuance or sale of EMC stock upon the exercise of options held by Companyemployees.  Included in the Company’s2001 federal tax return was a stock-based compensation deduction of $25 millionrelated to the issuance or sale of EMC stock. Subsequent to the receipt of its IRS refund of its 2001 net operatingloss carry back into 2000, the Company remitted to EMC $9.5 million pursuant tothe tax sharing agreement.

 

##### ***NOTE 13COMMITMENTS AND CONTINGENCIES***

 

*Operating and Capital Leases*

 

The Company had various operating and capital leases in effect atJanuary 31, 2004 for certain buildings, office space and machinery andequipment. Future minimum lease payments under non-cancelable capital andoperating leases with terms of one year or more are as follows atJanuary 31, 2004:

 
|                               |   | **Capital  Leases** |   | **Operating  Leases** |   |
|------------------------------------|--------|---------------------|--------|-----------------------|--------|
| 2004                               |   | $                   | 1,453  |                  | $      | 8,097 |   |
| 2005                               |   | 739                 |   | 5,655                 |   |
| 2006                               |   | 184                 |   | 2,554                 |   |
| 2007                               |   | —              |   | 1,359                 |   |
| 2008                               |   | —              |   | 1,250                 |   |
| Thereafter                         |   | —              |   | 1,380                 |   |
| Total minimum lease payments       |   | 2,376               |   | $                     | 20,295 |   |
| Less portion representing interest |   | 109                 |   |                  |   |
|                               |   | 2,267               |   |                  |   |
| Less: current portion              |   | 1,377               |   |                  |   |
|                               |   | $                   | 890    |                  |   |   |

 

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Operating rent expense in 2003, 2002, 2001 and the month endedJanuary 31, 2003 totaled approximately $10,414,000, $8,946,000,$7,671,000, and $771,000, respectively.

 

As part of the Company’s move to the new office and engineeringbuilding in 2002, the Company performed a review of its real estate facilityrequirements and identified excess leased facility space, which was offered forsublease. Based upon the results of this analysis, the Company recorded acharge of $83,000 and $941,000 included in selling and marketing expenserelated to facility lease losses for the years ended December 31,2002 and 2001, respectively. In determining the anticipated lease losses,various assumptions were made, including, the time period over which the excessspace will be under contract; expected sublease terms; and expected subleaserates and anticipated recoveries from sublease income. The new office andengineering building was completed in July 2002. Lease charges of$589,000, $341,000 and $57,000 were recorded against the loss accrual duringthe years ended January 31, 2004 and December 31, 2002 and the monthended January 31, 2003, respectively. As of January 31, 2004, the balance of this accrual was $0.

 

*Collateralized Lease*

 

On February 9, 2001, the Company entered into an operating leaseand associated agreements with Deutsche Bank AG, New York Branch (“DeutscheBank”) for the lease of an approximately 167,000 square foot multi-story officeand engineering building to be constructed on a 106 acre parcel of land locatedin Broomfield, Colorado. Construction of the building commenced in the firsthalf of 2001 and was completed in July 2002, at which time lease paymentswere scheduled to commence. As part of the transaction, the Company guaranteeda residual value of the facility to Deutsche Bank of approximately 89% duringthe construction period and 85% thereafter of the $60 million totaloriginal cost and agreed to restrict up to $63 million of its investmentsecurities as collateral for specified obligations under the lease. During thefirst quarter of 2002, the Company elected to terminate the lease under theprovisions of the agreements. On May 9, 2002, the Company entered into a TerminationAgreement with Deutsche Bank and recorded approximately $39 million inconstruction costs as property and equipment. $41 million in restrictedassets were used to pay off the lease obligation and construction costs. Inaddition, a loss of $1.25 million was recorded during the first quarter of2002 to reflect the write-off of certain lease costs that could not becapitalized.

 

*Manufacturing and Purchase Commitments*

 

TheCompany has contracted with Sanmina SCI Systems, Inc. (SSCI) and Solectron Corporation(Solectron) (collectively, Contract Manufacturers) for the manufacture ofprinted circuit boards and box build assembly and configuration for specificmulti-protocol directors and switches. The agreements require the Company tosubmit purchasing forecasts and place orders sixty calendar days in advance ofdelivery.  At January 31,2004, the Company’s commitment with the Contract Manufacturers for purchasesover the next sixty days totaled $48.1 million. The Company may be liable for materials that theContract Manufacturers purchase on McDATA’s behalf if the Company’s actualrequirements do not meet or exceed its forecasts and those materials cannot beredirected to other uses. At January 31, 2004, the Company had recordedobligations of approximately $8 million (See Note 3) primarily related tomaterials purchased by the Contract Manufacturers for certain end-of-life andobsolete material. Management does not expect the remaining commitments underthese agreements to have a material adverse effect on the Company’s business,results of operations, financial position or cash flows.

 

The Company has various other commitments for sales and purchases inthe ordinary course of business. In the aggregate, such commitments do notdiffer significantly from current market prices or anticipated usagerequirements.

 

*Litigation*

 

**Class Action Laddering Lawsuits**

** **

TheCompany, Mr. John F. McDonnell, the former Chairman of the board of directors,Mrs. Dee J. Perry, a former officer and Mr. Thomas O. McGimpsey a currentofficer were named as defendants in purported securities class-action lawsuitsfiled in the United States District Court, Southern District of New York. Thefirst of these lawsuits, filed on July 20, 2001, is captioned Gutner v.McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch,

 

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Pierce Fenner & SmithIncorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens etal., No. 01 CIV. 6627. Three other similar suits were filed against the Companyand the individuals. The complaints are substantially identical to numerousother complaints filed against other companies that went public in 1999 and2000. These lawsuits generally allege, among other things, that theregistration statements and prospectus filed with the SEC by such companieswere materially false and misleading because they failed to disclose (a) thatcertain underwriters had allegedly solicited and received excessive andundisclosed commissions from certain investors in exchange for which theunderwriters allocated to those investors material portions of shares inconnection with the initial public offerings, or IPOs, and (b) that certain ofthe underwriters had allegedly entered into agreements with customers wherebythe underwriters agreed to allocate IPO shares in exchange for which thecustomers agreed to purchase additional company shares in the aftermarket atpre-determined prices. The complaints allege claims against the Company, thenamed individuals, and CSFB, the lead underwriter of the Company’sAugust 9, 2000 initial public offering, under Sections 11 and 15 of theSecurities Act. The complaints also allege claims solely against CSFB and theother underwriter defendants under Section 12(a)(2) of the Securities Act,and claims against the individual defendants under Section 10(b) of theSecurities Exchange Act. Although management believes that all of the lawsuitsare without legal merit and they intend to defend against them vigorously,there is no assurance that the Company will prevail.

 

InSeptember 2002, plaintiffs’ counsel in the above-mentioned lawsuitsoffered to individual defendants of many of the public companies being sued,including the Company, the opportunity to enter into a Reservation of Rightsand Tolling Agreement that would dismiss without prejudice and without costsall claims against such persons if the company itself had entity coverageinsurance. This agreement was signed by Mr. John F. McDonnell, the formerCompany Chairman, Mrs. Dee J. Perry, the former chief financial officer, andMr. Thomas O. McGimpsey, the current Vice President and General Counsel and theplaintiffs’ executive committee. Under the Reservation of Rights and TollingAgreement, the plaintiffs dismissed the claims against such individuals.

 

OnFebruary 19, 2003, the court in the above-mentioned lawsuits entered aruling on the pending motions to dismiss, which dismissed some, but not all, ofthe plaintiffs’ claims against the Company. These lawsuits have been consolidatedas part of In Re Initial Public Offering Securities Litigation (SDNY). TheCompany has considered and agreed to enter into a proposed settlement offerwith representatives of the plaintiffs in the consolidated proceeding, and webelieve that any liability on behalf of the Company that may accrue under thatsettlement offer would be covered by our insurance policies. Until thatsettlement is fully effective, Management intends to defend against theconsolidated proceeding vigorously.

 

Patent Infringement Lawsuit

 

OnFebruary 14, 2002, the Company filed a patent infringement lawsuit againstBrocade in the United States District Court for the District of Coloradoalleging that Brocade’s Frame Filtering feature in their products infringed theCompany’s U.S. Patent No. 6,233,236 “Method and apparatus for measuring trafficwithin a switch.” On March 5, 2002, the Company filed for a preliminaryinjunction against Brocade to immediately stop infringing the patent afterBrocade announced another product containing its advanced performancemonitoring feature. On April 8, 2002, Brocade filed an answer to themotion for preliminary injunction generally alleging that Brocade has notinfringed and is not infringing the patent. Brocade alleged variouscounterclaims in its answer including a claim that the patent is invalid andunenforceable, and that the Company misappropriated trade secret informationfrom Brocade under prior agreements and that a 1999 OEM agreement contained acovenant not to sue. The United States District Court for the District ofColorado on December 6, 2002 denied the Company’s motion for a preliminaryinjunction. The Company filed documents on December 23, 2002 with theAmerican Arbitration Association to initiate an arbitration proceeding toresolve contract and patent issues relating to the 1999 OEM agreement withBrocade. On January 24, 2003, Brocade, in response to the initiation ofthe arbitration proceeding, filed an answer and counterclaim with the AmericanArbitration Association that objected to the inclusion of the patentinfringement claims in the arbitration, claims the patent is invalid andunenforceable and claims the Company misappropriated trade secret informationfrom Brocade.

 

On March 5, 2004, the Company and Brocade entered into a confidentialsettlement agreement whereby both parties agreed to dismiss without prejudicetheir respective claims against each other in the pending infringement case inthe United States District Court for the District of Colorado entitled *McDATA Corp. v. Brocade CommunicationsSystems, Inc.*, Civil Action No. 02-K-303 and the relatedarbitration proceedings before the

 

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AmericanArbitration Association entitled *McDATACorp. v. Brocade Communications Systems, Inc.*, Case No. 74133 00025 03 SAT. Under the confidential settlement agreement both partiespreserved their respective rights, no licenses were granted and they agreed toa three-year standstill during which neither party may initiate litigation againstthe other party with respect to their respective patents

 

Raytheon Lawsuit

 

OnMay 5, 2003, the Company was added as the ninth defendant to aJanuary 2003 patent infringement lawsuit that was filed by RaytheonCompany (Raytheon) in the United States District Court for the Eastern Districtof Texas—Marshall Division (Civil Action No. 2:03CV13). The complaint allegedthat the our products infringed and/or we actively induced the infringement ofRaytheon’s United States Patent No. 5,412,791, entitled “Mass Data StorageLibrary.” On January 8, 2004, we settled this lawsuit with Raytheon andthe parties agreed to dismiss with prejudice their respective claims andcounterclaims against each other.

 

Nishan Acquisition RelatedLawsuit

 

Inconnection with the Company’s acquisition of Nishan, the Company was namedalong with Nishan, various investors of Nishan, CSFB and former board membersand officers of Nishan in a lawsuit brought by Aamer Latif, a former boardmember and ex-CEO of Nishan, in the Superior Court of California, County ofSanta Clara on September 11, 2003 (as amended on October 10, 2003 andMarch 24, 2004) entitled *Aamer Latif v.Nishan Systems, Inc. et al (103 CV 004 939)*. The Complaint makesvarious allegations against the other defendants such as fraud, directors’breach of the duty of care, shareholders’ breach of fiduciary duty, unjustenrichment, and conspiracy to commit unjust enrichment. The allegations madeagainst the Company are vote buying, unjust enrichment, and conspiracy tocommit unjust enrichment. The allegation made against Nishan is breach ofSection 1602 of the California Corporations Code (a provision dealing withbooks and records inspection). The complaint primarily seeks compensatorydamages of approximately $11.5 million and other relief. The defendants haveagreed that lawsuit expenses are covered by indemnification under the mergeragreement from the selling shareholders of Nishan. The defendants filed ademurer to dismiss this action, which was denied by the Court in January 2004.  After significant review of the allegationsmade by the plaintiff, the Company strongly believes that the lawsuit is whollywithout legal merit and the Company intends to vigorously defend against thisaction.

 

*Indemnifications and Guarantees*

 

During its normal course of business, the Company may enter intoagreements with, among others, customers, resellers, OEMs, systems integratorsand distributors.  These agreementstypically require the Company to indemnify the other party against third party claimsor product infringements on patents or copyrights.  The Company provides indemnifications of varying scope and sizeto certain customers against claims of intellectual property infringement madeby third parties arising for the use of our products.

 

The Company has also indemnified its former parent, EMC, for any incometaxes arising out of the Distribution as discussed in Note 12.

 

In addition, the majority of these indemnities, commitments andguarantees do not provide for any limitation of the maximum potential futurepayments the Company could be obligated to make.  The Company evaluates and estimates losses from suchindemnification under SFAS 5, Accounting for Contingencies, as interpreted byFIN 45.  To date, the Company has notincurred any material costs as a result of such obligations and has not accruedany liabilities related to such indemnification and guarantees in our financialstatements.

 

**NOTE 14 RELATED PARTY TRANSACTIONS**

 

InJanuary 2004, the Company entered into a three-year litigation support andconsulting agreement with John F. McDonnell, the Company’s former Chairman,pursuant to which Mr. McDonnell will render litigation support and consultingservices to McDATA. Under the agreement, the Company is assured on-demandaccess to Mr. McDonnell at a

 

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rate of $250 per hour and the reimbursement of out-of-pocket expenses.The agreement was reviewed and approved by a committee of independent directorsof the Board of Directors. As of January 31, 2004, there was no liability orrelated expense recorded from this agreement.

 

InFebruary 2004, the Company entered into a six-month standard lab servicesagreement with JRBM Incorporated (JRBM), a company partially owned by John F.McDonnell, the Company’s former Chairman. Under this arrangement, the Companyleases approximately 155 square feet of unused lab space and equipment to JRBMat an arms-length market rate, and JRBM may purchase McDATA products under ourstandard OpenReadyTM equipment discount program. The arrangement was reviewedand approved by a committee of independent directors of the Board of Directors.JRBM also made a business proposal to McDATA to review the SANavigator®software, over a nine month period, for the purpose of potentially reselling,licensing or utilizing certain features or modules of SANavigator®and potentially developing application program interfaces. The agreementevidencing such an arrangement was signed on February 25, 2004 (with aFebruary 27, 2004 effective date) by both parties after review andapproval by a committee of independent directors of the Board of Directors.

 

##### ***NOTE 15SEGMENT INFORMATION***

 

The Company has one reporting segment relating to the design,development, manufacture and sales of open storage networking solutions thatprovide highly available, scalable and centrally managed storage area networks(SANs).  The Company’s Chief OperatingDecision Makers, as defined by SFAS 131, “Disclosures about Segments of anEnterprise and Related Information,” allocate resources and assess theperformance of the Company based on revenue and overall profitability.

 

For the year ended January 31, 2004, the Company had threecustomers who each contributed greater than 10% of the Company’s totalrevenues.  For the fiscal years endedDecember 31, 2002 and 2001, and the one-month ended January 31, 2003,the Company had two customers each who contributed greater than 10% of theCompany’s total revenues as follows:

 
|   |   | **Year Ended  January 31,** |   | **Years  Ended  December 31,** |   | **Month  Ended  January 31,** |   |
|--------|--------|----------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|   |   | **2004**                         |   | **2002**                            |   | **2001**                           |   | **2003** |   |
|   |   |                             |   |                                |   |                               |   |   |   |
| EMC    |   | 56                               | %      | 54                                  | %      | 69                                 | %      | 54 | % |
| IBM    |   | 21                               | %      | 25                                  | %      | 17                                 | %      | 21 | % |
| HDS    |   | 10                               | %      | <10                              | %      | <10                             | %      | <10 | % |

 

At January 31, 2004 and December 31, 2002, 73% and 80% ofaccounts receivable were concentrated with our two largest customers, EMC andIBM. The Company performs ongoing evaluations of its customers’ financialcondition and, generally, requires no collateral from its customers.  The level of sales to any single customermay vary and the loss of any one of these customers, or a decrease in the levelof sales to any one of these customers, could have a material impact on theCompany’s financial condition or results of operations

 

The Company’s operations are conducted in the United States with salesoffices throughout the European Community and Asia Pacific, none of which areindividually significant to the Company’s overall operations.  The Company has not incurred any foreigncurrency translation adjustments as all of its sales are settled in U.S.dollars.

 

Certain information related to the Company’s operations by geographicarea is presented below.  The Company’srevenues are attributed to the geographic areas according to the location ofthe customers.  Long-lived assetsinclude property and equipment and other non-current assets.

 

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|                                     |   | **Net Sales** |    | **Long-Lived  Assets** |   |
|------------------------------------------|--------|---------------|---------|------------------------|--------|
|                                     |   |          |    |                   |   |
| **2003**                                 |   |          |    |                   |   |
| United States                            |   | $             | 282,503 |                   | $      | 115,450 |   |
| Foreign countries                        |   | 136,357       |    | 1,994                  |   |
| Total                                    |   | $             | 418,860 |                   | $      | 117,444 |   |
|                                     |   |          |    |                   |   |
| **2002**                                 |   |          |    |                   |   |
| United States                            |   | $             | 207,015 |                   | $      | 111,479 |   |
| Foreign countries                        |   | 121,264       |    | 1,287                  |   |
| Total                                    |   | $             | 328,279 |                   | $      | 112,766 |   |
|                                     |   |          |    |                   |   |
| **2001**                                 |   |          |    |                   |   |
| United States                            |   | $             | 263,416 |                   |   |   |
| Foreign countries                        |   | 80,990        |    |                   |   |
| Total                                    |   | $             | 344,406 |                   |   |   |
|                                     |   |          |    |                   |   |
| ***Month  Ended January 31, 2003*** |   |          |    |                   |   |
| United States                            |   | $             | 12,582  |                   | — |   |
| Foreign countries                        |   | 4,463         |    |                   |   |
| Total                                    |   | $             | 17,045  |                   |   |   |

 

**NOTE 16 SELECTED QUARTERLY FINANCIAL DATA(UNAUDITED)**

 

The following summarizes selected financial information for each of thetwo years in the period ended January 31, 2004:

 
|                                |   | **Q1**  |    | **Q2** |   | **Q3(6)** |   | **Q4(6)** |   | **Total** |   |
|-------------------------------------|--------|---------|---------|--------|--------|-----------|--------|-----------|--------|-----------|--------|
|                                |   |    |    |   |   |      |   |      |   |      |   |
| **2003(1)**                         |   |    |    |   |   |      |   |      |   |      |   |
| Total revenue(2)                    |   | $       | 103,179 |   | $      | 107,014   |   | $         | 94,659 |      | $      | 114,008 |   | $ | 418,860 |   |
| Gross profit                        |   | 58,591  |    | 63,307 |   | 54,647    |   | 64,986    |   | 241,531   |   |
| Net income (loss)(3)                |   | 5,312   |    | 9,133  |   | (50,048   | )      | (7,530    | )      | (43,133   | )      |
| Basic net income (loss) per share   |   | $       | 0.05    |   | $      | 0.08      |   | $         | (0.44  | )         | $      | (0.07 | ) | $ | (0.38 | ) |
| Diluted net income (loss) per share |   | $       | 0.05    |   | $      | 0.08      |   | $         | (0.44  | )         | $      | (0.07 | ) | $ | (0.38 | ) |
|                                |   |    |    |   |   |      |   |      |   |      |   |
| **2002**                            |   |    |    |   |   |      |   |      |   |      |   |
| Total revenue                       |   | $       | 64,543  |   | $      | 77,254    |   | $         | 80,941 |      | $      | 105,541 |   | $ | 328,279 |   |
| Gross profit(4)                     |   | 13,890  |    | 35,091 |   | 42,580    |   | 58,604    |   | 150,165   |   |
| Net income (loss)(4)(5)             |   | (17,071 | )       | (3,858 | )      | 2,343     |   | 8,599     |   | (9,987    | )      |
| Basic net income (loss) per share   |   | $       | (0.15   | )      | $      | (0.03     | )      | $         | 0.02   |      | $      | 0.08 |   | $ | (0.09 | ) |
| Diluted net income (loss) per share |   | $       | (0.15   | )      | $      | (0.03     | )      | $         | 0.02   |      | $      | 0.07 |   | $ | (0.09 | ) |

 

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(1)           On January 15, 2003, we changed ourfiscal year end to January 31, rather than December 31.

(2)           Revenuesfor the quarter ended October 31, 2003, were significantly impacted by adecline in sales to our largest customer, EMC. This revenue decline was drivenby an inability to reach an agreement in a timely manner, which reduced theshipment of products during the quarter.

(3)           Net income for the quarter endedOctober 31, 2003 includes the impacts of a $38.8 million valuationallowance recorded against the deferred tax asset and a $11.4 million chargefor IPR&D related to the equity acquisitions of Nishan and Aarohi.

(4)           Gross profit and net loss for the quarterended March 31, 2002 includes the impact of a $14.0 million charge to costof revenues primarily as a result of identified excesses 1 Gb components userin the Director-class products.  Duringthe quarters ended June 30, 2002, September 30, 2002 andDecember 31, 2002, approximately $1.1 million, $2.5 million and $0.9million, respectively, of these reserves were reversed as the Companyexperienced higher-than-expected sales of discontinued 1 Gb products and, therefore,realized 100% margins for these product sales.

(5)           Net loss for the quarter endedMarch 31, 2002 includes the impact of a $1.25 million charge to generaland

 

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administrated expenses associated with thetermination of the collateralized lease with Deutsche Bank.

(6)           Total revenue, gross profit and net incomefor the third and fourth quarters of 2003 reflect our acquisitions of Nishanand Sanera on September 19, 2003 and September 30, 2003,respectively.

 

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**MCDATA CORPORATION**

 

**SCHEDULE II****—VALUATION AND QUALIFYING ACCOUNTS**

**(IN THOUSANDS)**

 

 
|                                   |   | **Balance at  Beginning  of Period** |   | **Charged to  Costs and  Expenses** |   | **Deductions** |   | **Other** |   | **Balance at  End of  Period** |   |
|----------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|----------------|--------|-----------|--------|--------------------------------|--------|
|                                   |   |                                 |   |                                |   |           |   |      |   |                           |   |
| **Year ended  December 31, 2001** |   |                                 |   |                                |   |           |   |      |   |                           |   |
| Allowance for doubtful accounts        |   | $                                    | 284    |                                | $      | 707            |   | $         | (208)  | (a)                            | $      | — |   | $ | 783 |   |
| Inventory reserves                     |   | 4,315                                |   | 29,919                              |   | (15,269)       | (b)    | —    |   | 18,965                         |   |
| **Year ended  December 31, 2002** |   |                                 |   |                                |   |           |   |      |   |                           |   |
| Allowance for doubtful accounts        |   | $                                    | 783    |                                | $      | 25             |   | $         | 43)    | (a)                            | $      | — |   | $ | 1,265 |   |
| Inventory reserves                     |   | 18,965                               |   | 11,332                              |   | (22,885)       | (b)    | —    |   | 7,412                          |   |
| **Month ended  January 31, 2003** |   |                                 |   |                                |   |           |   |      |   |                           |   |
| Allowance for doubtful accounts        |   | $                                    | 1,265  |                                | $      | 25             |   | $         | — | (a)                            | $      | — |   | $ | 1,290 |   |
| Inventory reserves                     |   | 7,412                                |   | 316                                 |   | (613)          | (b)    | —    |   | 7,115                          |   |
| **Year ended  January 31, 2004**  |   |                                 |   |                                |   |           |   |      |   |                           |   |
| Allowance for doubtful accounts        |   | $                                    | 1,290  |                                | $      | (474           | )      | $         | (64)   | (a)                            | $      | 174 | (c) | $ | 926 |   |
| Inventory reserves                     |   | 7,115                                |   | 1,923                               |   | (5,870)        | (b)    | 1,308     | (c)    | 4,476                          |   |

 

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(a) Reflects uncollectible amounts written-off, net of recoveries.

 

(b) Reflects disposals of obsolete inventory and reductions tolower-of-cost or market reserves.

 

(c) Reflects the acquisition of Nishan in fiscal year 2003.

 

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