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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 Form 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007
 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 NUMBER: 000-24647
 TERAYON COMMUNICATION SYSTEMS, INC.
 (Exact Name of Registrant as Specified in Its Charter)
 Delaware
    
    77-0328533(State or Other Jurisdiction of
    
    (IRS EmployerIncorporation or Organization)
    
    Identification No.)
 2450 WALSH AVENUE
SANTA CLARA, CALIFORNIA 95051
(408) 235-5500  (Address, Including Zip Code, and Telephone Number, Including Area Code, of
the Registrants Principal Executive Offices)
 
 þ o
  o þ o
 o þ
 APPLICABLE ONLY TO CORPORATE ISSUERS:




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##### 



INDEX
 TERAYON COMMUNICATION SYSTEMS, INC.
 PageNo.PART I. FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    3Condensed Consolidated Balance Sheets as of March 31, 2007 (unaudited) and December
31, 2006
    
    
    3Condensed Consolidated Statements of Operations for the three months ended March 31,
2007 and 2006 (unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the three months ended March
31, 2007 and 2006 (unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements as of March 31, 2007 (unaudited)
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4.
    
    Controls and Procedures
    
    
    29PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    34Item 1A.
    
    Risk Factors
    
    
    37Item 2.
    
    Unregistered Sale of Equity Securities and Use of Proceeds
    
    
    38Item 3.
    
    Defaults Upon Senior Securities
    
    
    38Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    38Item 5.
    
    Other Information
    
    
    38Item 6.
    
    Exhibits
    
    
    39EXHIBIT 10.32EXHIBIT 10.33EXHIBIT 10.34EXHIBIT 10.35EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 TERAYON COMMUNICATION SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
 March 31,
    
    
    December 31,2007
    
    
    2006(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,547
    
    
    $
    8,362Short-term investments
    
    
    7,975
    
    
    
    11,951Accounts receivable, net of allowance for doubtful accounts
    
    
    8,073
    
    
    
    10,914Other current receivables
    
    
    1,515
    
    
    
    1,296Inventory, net
    
    
    2,816
    
    
    
    2,324Deferred cost of goods sold
    
    
    2,267
    
    
    
    2,289Deposits
    
    
    1,442
    
    
    
    8,248Other current assets
    
    
    1,110
    
    
    
    1,532Total current assets
    
    
    37,745
    
    
    
    46,916Property and equipment, net
    
    
    3,141
    
    
    
    3,309Restricted cash
    
    
    380
    
    
    
    395Long-term deferred cost of goods sold
    
    
    784
    
    
    
    1,338Other assets, net
    
    
    12
    
    
    
    12Total assets
    
    $
    42,062
    
    
    $
    51,970LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    4,434
    
    
    $
    5,495Accrued payroll and related expenses
    
    
    3,683
    
    
    
    3,650Deferred revenues
    
    
    9,351
    
    
    
    9,329Accrued warranty expenses
    
    
    1,143
    
    
    
    1,246Accrued restructuring and executive severance
    
    
    143
    
    
    
    149Accrued vendor cancellation charges
    
    
    10
    
    
    
    124Accrued other liabilities
    
    
    3,752
    
    
    
    4,071Total current liabilities
    
    
    22,516
    
    
    
    24,064Long-term obligations
    
    
    1,208
    
    
    
    1,399Accrued restructuring and executive severance
    
    
    160
    
    
    
    193Long-term deferred revenue
    
    
    5,077
    
    
    
    6,492Total liabilities
    
    
    28,961
    
    
    
    32,148Contingencies (Note 3)Stockholders equity:Preferred stock, $0.001 par value: 5,000,000 shares authorized;
no shares issued and outstanding
    
    
    
    
    
    
    Common stock: $0.001 par value, 200,000,000 shares authorized
issued  77,793,844 shares issued; 77,637,177 shares outstanding
    
    
    78
    
    
    
    78Additional paid-in capital
    
    
    1,089,632
    
    
    
    1,089,278Accumulated deficit
    
    
    (1,073,251
    )
    
    
    (1,066,269
    )Treasury stock, at cost; 156,009 shares
    
    
    (773
    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,585
    )
    
    
    (2,492
    )Total stockholders equity
    
    
    13,101
    
    
    
    19,822Total liabilities and stockholders equity
    
    $
    42,062
    
    
    $
    51,970
  3




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TERAYON COMMUNICATION SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 Three Months EndedMarch 31,2007
    
    
    2006Revenues
    
    $
    12,776
    
    
    $
    21,490Cost of goods sold
    
    
    4,580
    
    
    
    10,716Gross profit
    
    
    8,196
    
    
    
    10,774Operating expenses:Research and development
    
    
    3,005
    
    
    
    4,069Sales and marketing
    
    
    3,323
    
    
    
    5,184General and administrative
    
    
    8,149
    
    
    
    5,150Restructuring charges, executive severance and asset write-offs
    
    
    
    
    
    
    34Total operating expenses
    
    
    14,477
    
    
    
    14,437Loss from operations
    
    
    (6,281
    )
    
    
    (3,663
    )Interest income, net
    
    
    215
    
    
    
    301Other income (expense), net
    
    
    (895
    )
    
    
    (553
    )Loss before income tax expense
    
    
    (6,961
    )
    
    
    (3,915
    )Income tax expense
    
    
    (21
    )
    
    
    (29
    )Net loss
    
    $
    (6,982
    )
    
    $
    (3,944
    )Basic and diluted net loss per share
    
    $
    (0.09
    )
    
    $
    (0.05
    )Shares used in computing basic and diluted net loss per share
    
    
    77,637
    
    
    
    77,637
  4




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TERAYON COMMUNICATION SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 Three Months EndedMarch 31,2007
    
    
    2006Cash flows from operating activities:Net loss
    
    $
    (6,982
    )
    
    $
    (3,944
    )Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Depreciation and amortization
    
    
    450
    
    
    
    487Stock based compensation
    
    
    354
    
    
    
    792Amortization of subordinated convertible notes premium
    
    
    
    
    
    
    (286
    )Accretion of discounts on short-term investments
    
    
    
    
    
    
    (126
    )Inventory provision
    
    
    134
    
    
    
    2,399Provision for doubtful accounts
    
    
    (90
    )
    
    
    50Restructuring provision
    
    
    
    
    
    
    34Write-off of fixed assets
    
    
    
    
    
    
    41Warranty provision
    
    
    462
    
    
    
    149Vendor cancellation provision
    
    
    34
    
    
    
    (1,040
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    2,712
    
    
    
    446Inventory
    
    
    (626
    )
    
    
    (761
    )Other current assets
    
    
    7,250
    
    
    
    (5,311
    )Long-term deferred cost of goods sold
    
    
    554
    
    
    
    637Other assets
    
    
    15
    
    
    
    7,526Accounts payable
    
    
    (1,061
    )
    
    
    (695
    )Accrued payroll and related expenses
    
    
    33
    
    
    
    (209
    )Deferred revenues
    
    
    (1,393
    )
    
    
    (4,658
    )Accrued warranty expense
    
    
    (565
    )
    
    
    (535
    )Accrued restructuring charges
    
    
    (39
    )
    
    
    (506
    )Accrued vendor cancellation charges
    
    
    (148
    )
    
    
    (124
    )Other accrued liabilities
    
    
    (510
    )
    
    
    (2,333
    )Net cash provided by (used in) operating activities
    
    
    584
    
    
    
    (7,967
    )Cash flows from investing activities:Proceeds from sales and maturities of short-term investments
    
    
    4,000
    
    
    
    54,033Purchases of property and equipment
    
    
    (282
    )
    
    
    (170
    )Net cash provided by investing activities
    
    
    3,718
    
    
    
    53,863Cash flows from financing activity:Debt extinguishment of convertible debt
    
    
    
    
    
    
    (65,081
    )Net cash used in financing activity
    
    
    
    
    
    
    (65,081
    )Effect of foreign currency exchange rate changes
    
    
    (117
    )
    
    
    34Net increase (decrease) in cash and cash equivalents
    
    
    4,185
    
    
    
    (19,151
    )Cash and cash equivalents at beginning of period
    
    
    8,362
    
    
    
    28,867Cash and cash equivalents at end of period
    
    $
    12,547
    
    
    $
    9,716Supplemental disclosures of cash flow information:Cash paid for income taxes
    
    $
    27
    
    
    $
    28Cash paid for interest
    
    $
    
    
    
    $
    461
  5




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TERAYON COMMUNICATION SYSTEMS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 1. Organization
 Description of Business
       2. Summary of Significant Accounting Policies
 Basis of Presentation
   Basis of Consolidation
  6




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Use of Estimates
  Fair Value of Financial Instruments
  Revenue Recognition
      7




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Deferred Revenue, Deferred Cost of Goods Sold
  Stock-Based Compensation
      8




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Accounts Receivable, Net of Allowance for Doubtful Accounts
  Inventory
  March 31,
    
    
    December 31,2007
    
    
    2006(unaudited)Raw materials
    
    $
    176
    
    
    $
    203Finished goods
    
    
    2,640
    
    
    
    2,121Inventory, net
    
    $
    2,816
    
    
    $
    2,324
 Purchase Obligation
  Net Loss Per Share
  Three Months EndedMarch 31,2007
    
    
    2006Net loss
    
    $
    (6,982
    )
    
    $
    (3,944
    )Shares used in computing basic and diluted
net loss per share
    
    
    77,637
    
    
    
    77,637Basic and diluted net loss per share
    
    $
    (0.09
    )
    
    $
    (0.05
    )
  Comprehensive Loss
   Three months endedMarch 31,2007
    
    
    2006Net Loss
    
    $
    (6,982
    )
    
    $
    (3,944
    )Change in cumulative translation adjustments, net
    
    
    (117
    )
    
    
    34Change in unrealized gain on available-for-sale investments, net
    
    
    24
    
    
    
    249Total comprehensive loss
    
    $
    (7,075
    )
    
    $
    (3,661
    )
   March 31,
    
    
    December 31,2007
    
    
    2006(unaudited)Cumulative translation adjustments
    
    $
    (2,560
    )
    
    $
    (2,443
    )Unrealized gain on available- for-sale investments
    
    
    (25
    )
    
    
    (49
    )Total accumulated other comprehensive loss
    
    $
    (2,585
    )
    
    $
    (2,492
    )
 9




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Impact of Recently Issued Accounting Standards
          10




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3. Contingencies
 Litigation
  Bertram v. Terayon Communication Systems, Inc.
  11




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12




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13




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4. Employee Equity Incentive Plans
 Stock Option Program Description
    14




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General Option Information
  Options OutstandingOptions
    
    
    
    
    
    
    WeightedAvailable
    
    
    Number of
    
    
    Averagefor Grant
    
    
    Shares
    
    
    Exercise PriceDecember 31, 2006
    
    
    9,421,592
    
    
    
    12,136,816
    
    
    $
    4.58Authorized
    
    
    
    
    
    
    
    
    
    
    Granted
    
    
    
    
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    
    
    
    
    Cancelled
    
    
    26,200
    
    
    
    (26,200
    )
    
    $
    2.72Expired
    
    
    (7,495,347
    )
    
    
    
    
    
    
    March 31, 2007
    
    
    1,952,445
    
    
    
    12,110,616
    
    
    $
    4.79
 Valuation and Expense Information under SFAS 123(R)
  Three Months Ended March 31,2007
    
    
    2006Cost of goods sold
    
    $
    61
    
    
    $
    84Research and development
    
    
    73
    
    
    
    176Sales and marketing
    
    
    48
    
    
    
    327General and administrative
    
    
    172
    
    
    
    205Share-based compensation effect in income before taxes
    
    $
    354
    
    
    $
    792Income taxes
    
    
    
    
    
    
    Net share-based compensation effect in net loss
    
    $
    354
    
    
    $
    792Impact on net loss per share:Basic and diluted
    
    $
    0.00
    
    
    $
    0.01Shares outstanding
    
    
    77,637
    
    
    
    77,637
   Three Months Ended March 31,2007
    
    2006Weighted average estimated
fair value of grant (1)
    
    
    N/A
    
    
    $
    0.90Expected life (in years)
    
    
    2.2
    
    
    
    2.2Risk-free interest rate
    
    
    4.68
    %
    
    
    4.40
    %Volatility
    
    
    76.45
    %
    
    
    72.60
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
 
 (1)
    
    There were no options granted during the three months ended March 31, 2007. If the Company
had granted options during the quarter ended March 31, 2007, these variables would have been
used to calculate the fair value of the options.   WeightedAverageWeighted
    
    
    Remaining
    
    
    AggregateNumber of
    
    
    Average
    
    
    Contractual
    
    
    IntrinsicShares
    
    
    Exercise Price
    
    
    Life (in years)
    
    
    Value(1)Vested
    
    
    10,521,324
    
    
    $
    5.11
    
    
    
    5.13
    
    
    $
    82,274Expected to vest
    
    
    1,387,824
    
    
    $
    2.66
    
    
    
    5.85
    
    
    
    22,539Total
    
    
    11,909,148
    
    
    $
    4.83
    
    
    
    5.21
    
    
    $
    104,813
 
 (1)
    
    These amounts represent the differences between the exercise price and $1.75, the closing
price of the Companys stock on March 30, 2007 as reported on the Pink Sheets, for all
in-the-money options outstanding. 5. Operating Segment Information
  15




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6. Restructuring Charges and Asset Write-offs
 Restructuring
 
 2004 Restructurings
    16




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##### Table of Contents



Excess LeasedFacilitiesBalance at December 31, 2006
    
    $
    343Charges
    
    
    Cash payments
    
    
    (39
    )Charges in estimate
    
    
    Balance at March 31, 2007
    
    $
    304
 7. Product Warranty
  8. Corporate Aircraft
   9. RGB Litigation Settlement
  10. Director Compensation
  11. Subsequent Events
 Merger Agreement with Motorola
  17




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Dolby Settlement and License
 .
 18




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 Forward-Looking Statements
  Executive Overview
 ®
    19




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Merger Agreement with Motorola
     Critical Accounting Policies and Estimates
   Revenue Recognition
  20




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Deferred Revenue, Deferred Cost of Goods Sold
  Stock-Based Compensation
  21




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Accounts Receivable, Net of Allowance for Doubtful Accounts
  22




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Results of Operations
 Comparison of Three Months Ended March 31, 2007 and March 31, 2006
 Revenues
  Revenues by Groups of Similar Products
  Three months endedMarch 31,
    
    
    Variance in
    
    
    Variance in2007
    
    
    2006
    
    
    Dollars
    
    
    PercentRevenues by product:DVS
    
    $
    12,414
    
    
    $
    14,824
    
    
    $
    (2,410
    )
    
    
    (16.3
    )%CMTS
    
    
    346
    
    
    
    1,713
    
    
    
    (1,367
    )
    
    
    (79.8
    )%HAS
    
    
    16
    
    
    
    4,953
    
    
    
    (4,937
    )
    
    
    (99.7
    )%Total revenues
    
    $
    12,776
    
    
    $
    21,490
    
    
    $
    (8,714
    )
    
    
    (40.5
    )%
    Three Months EndedMarch 31,
    
    
    Variance in
    
    
    Variance in2007
    
    
    2006
    
    
    Dollars
    
    
    PercentDVS product revenue invoiced and recognized in
current period:Total invoiced in current period
    
    $
    10.6
    
    
    $
    9.5
    
    
    $
    1.1
    
    
    
    11.6
    %Less: Invoiced in current period and recognized in
future periods
    
    
    1.2
    
    
    
    1.1
    
    
    
    0.1
    
    
    
    9.1
    %Total invoiced and recognized in current period
    
    $
    9.4
    
    
    $
    8.4
    
    
    $
    1.0
    
    
    
    11.9
    %DVS product revenue invoiced in prior fiscal years
and recognized in current period
    
    
    3.0
    
    
    
    6.4
    
    
    
    (3.4
    )
    
    
    (53.1
    )%Total DVS product revenue recognized in current period
    
    $
    12.4
    
    
    $
    14.8
    
    
    $
    (2.4
    )
    
    
    (16.2
    )%
   Revenues by Geographic Region
  Three months endedMarch 31,
    
    
    Variance in
    
    
    Variance in2007
    
    
    2006
    
    
    Dollars
    
    
    PercentRevenues:United States
    
    $
    11,200
    
    
    $
    14,416
    
    
    $
    (3,216
    )
    
    
    (22.3
    )%Americas, excluding United States
    
    
    268
    
    
    
    782
    
    
    
    (514
    )
    
    
    (65.7
    )%Europe, Middle East and Africa, (EMEA), excluding Israel
    
    
    846
    
    
    
    3,659
    
    
    
    (2,813
    )
    
    
    (76.9
    )%Israel
    
    
    
    
    
    
    653
    
    
    
    (653
    )
    
    
    (100.0
    )%Asia excluding Japan
    
    
    155
    
    
    
    1,606
    
    
    
    (1,451
    )
    
    
    (90.3
    )%Japan
    
    
    307
    
    
    
    374
    
    
    
    (67
    )
    
    
    (17.9
    )%Total
    
    $
    12,776
    
    
    $
    21,490
    
    
    $
    (8,714
    )
    
    
    (40.5
    )%
  23




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Significant Customers
   Cost of Goods Sold and Gross Profit
      Three Months EndedMarch 31,
    
    
    Variance in
    
    
    Variance in2007
    
    
    2006
    
    
    Dollars
    
    
    PercentDVS product cost of goods sold invoiced and
recognized in current period:Total invoiced in current period
    
    $
    2.2
    
    
    $
    2.2
    
    
    $
    0.0
    
    
    
    0.0
    %Less: invoiced in current period and recognized
in future periods
    
    
    0.0
    
    
    
    
    
    
    
    0.0Total invoiced and recognized in current period
    
    $
    2.2
    
    
    $
    2.2
    
    
    $
    0.0
    
    
    
    0.0
    %DVS product cost of goods sold invoiced in prior
fiscal years and recognized in current period
    
    
    0.7
    
    
    
    1.4
    
    
    
    (0.7
    )
    
    
    (50.0
    )%Total cost of goods sold related to DVS product
recognized in current period
    
    $
    2.9
    
    
    $
    3.6
    
    
    $
    (0.7
    )
    
    
    (19.4
    )%
    24




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##### Table of Contents



Operating Expenses
  Three months endedMarch 31,
    
    Variance in
    
    Variance in2007
    
    2006
    
    Dollars
    
    PercentResearch and development
    
    $
    3,005
    
    
    $
    4,069
    
    
    $
    (1,064
    )
    
    
    (26.1
    )%Sales and marketing
    
    $
    3,323
    
    
    $
    5,184
    
    
    $
    (1,861
    )
    
    
    (35.9
    )%General and administrative
    
    $
    8,149
    
    
    $
    5,150
    
    
    $
    2,999
    
    
    
    58.2
    %Restructuring charges, executive severance and asset write-offs
    
    
    
    
    
    $
    34
    
    
    $
    (34
    )
    
    
    (100.0
    )%
 Research and Development.
 Sales and Marketing.
 General and Administrative.
 Restructuring Charges, Executive Severance and Asset Write-offs.
   Non-Operating Expenses
  Three months endedMarch 31,
    
    Variance in
    
    Variance in2007
    
    2006
    
    Dollars
    
    PercentInterest income, net
    
    $
    215
    
    
    $
    301
    
    
    $
    (86
    )
    
    
    (28.6
    )%Other income (expense), net
    
    $
    (895
    )
    
    $
    (553
    )
    
    $
    (342
    )
    
    
    (62.0
    )%
  25




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##### Table of Contents



Income Tax Expense
     Stock-Based Compensation
    Litigation
  Off-Balance Sheet Financings and Liabilities
  Liquidity and Capital Resources
   26




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##### Table of Contents



Contractual Obligations
  Payments Due by PeriodLess than
    
    
    1-3
    
    
    4-5
    
    
    After 5Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    yearsUnconditional Purchase Obligations
    
    $
    6.7
    
    
    $
    6.7
    
    
    $
    0.0
    
    
    $
    
    
    
    $
    Operating Lease Obligations
    
    
    10.0
    
    
    
    3.9
    
    
    
    6.1
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    16.7
    
    
    $
    10.6
    
    
    $
    6.1
    
    
    $
    
    
    
    $
    
    Amount of Commitment Experation Per PeriodTotalAmounts
    
    
    Less than 1
    
    
    
    
    
    
    
    
    
    
    After 5Commited
    
    
    year
    
    
    1-3 years
    
    
    4-5 years
    
    
    yearsDeposits
    
    $
    0.7
    
    
    $
    0.7
    
    
    $
    
    
    
    $
    
    
    
    $
    Standby Letters of Credit
    
    
    0.4
    
    
    
    
    
    
    
    0.4
    
    
    
    
    
    
    
    Total Commercial Commitments
    
    $
    1.1
    
    
    $
    0.7
    
    
    $
    0.4
    
    
    $
    
    
    
    $
    
  27




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##### Table of Contents



Impact of Recently Issued Accounting Standards
          28




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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk
 Interest Rate Risk.
 Foreign Currency Risk.
 
 Item 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
    Communication of Financial Information.
 Lack of Technical Accounting Expertise and Qualified Accounting Personnel
 The Use of Estimates.
 29




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##### Table of Contents



Inadequate Controls over Documentation and Record Keeping.
 
    
    The Company did not have sufficient controls in place to ensure the proper
authorization and review of manual journal entries and the associated support
documentation.
    
    The Company did not have sufficient controls to address the amendment of sales orders
with its customers. Sales orders could be amended through the amendment of the sales
orders, purchase orders and agreements. When sales were amended through sales or
purchase orders, the person processing the amendments would exercise discretion in
inputting the revised terms and conditions and there was no consistent policy requiring
the accounting and finance department to approve such amendments or even informing the
accounting and finance department of such amendments.
    
    The Company did not keep adequate documentation related to the analysis and
reconciliation of certain general ledger accounts.
    
    The Company did not retain certain corporate records in connection with the sale of
certain subsidiaries to third parties.
  Remediation of Previously Disclosed Material Weakness
  Revenue Recognition.
   Remediation Steps:
 
    
    The Company engaged the services of experienced accounting consultants to review
the Companys books and close procedures on a monthly basis to assist management in
ensuring that the Companys financial statements are being recorded in accordance with
GAAP.
 30




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##### Table of Contents




    
    During the quarter ended September 30, 2006, the Company established a process where
all significant accruals must be reviewed and approved by the Corporate Controller.
    
    During the first three quarters of 2006, the Companys accounting and finance
department, with the assistance of outside consultants, implemented procedures to
recognize sales of its video products under the software accounting rules under SOP 97-2
in accordance with GAAP.
    
    In 2006, the Company established pricing guidelines and internal procedures to ensure
consistent pricing to allow for the establishment of VSOE of fair value for sales made
with multiple element arrangements.
    
    During the second and third quarters of 2005, the accounting and finance department
established procedures surrounding the month-end close process to ensure that the
information and estimates necessary for recognizing revenue in accordance with SOP 97-2
were available.
    
    The Company provided its accounting staff with training on revenue recognition,
including software accounting and project accounting, and GAAP, including attending
seminars and conferences. Additional training will be provided on a regular and periodic
basis and updated as considered necessary.
    
    During the quarter ended March 31, 2006, the Company hired an experienced revenue
accountant to review all revenue transactions and to ensure that revenues, cost of goods
sold, deferred revenue and deferred cost of goods sold are properly accounted for in
accordance with GAAP and the Companys policies.
 Remediation Steps to Address Continuing Material Weaknesses
  Communication of Financial Information.
 
    
    During the quarter ended June 30, 2005, the Company established procedures to
document the review of press releases to account for transactions in a complete and
timely manner.
    
    During the quarter ended June 30, 2005, the Company also improved the internal
process of drafting and reviewing periodic reports by implementing additional management
and external legal counsel review prior to their submission to the Companys independent
registered public accounting firm.
    
    Continue to monitor the communication channels between the Companys senior
management and the Companys accounting and finance department and take prompt action,
as necessary, to further strengthen these communication channels;
    
    Implement training procedures for new employees and/or consultants in the accounting
and finance department on the Companys disclosure procedures and controls, the Company
and the Companys actions in previous reporting periods; and
    
    Take steps to ensure that the Company senior management has timely access to all
material financial and non-financial information concerning our business.
 31




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##### Table of Contents



Use of Estimates.
 
    
    The Company has engaged the services of experienced accounting consultants to review
the Companys books and close procedures on a monthly basis to assist management in
ensuring that the Companys financial statements are being recorded in accordance with
GAAP.
    
    The Company continues to engage the services of an outside tax accounting firm to
assist with the calculation of the Companys tax liabilities.
    
    During the quarter ended September 30, 2006, the Company established a process where
all significant accruals must be reviewed and approved by the Corporate Controller.
    
    During the quarter ended June 30, 2006, the Company implemented a process to obtain
and assess accruals for legal costs and expenses owed to third party vendors whereby the
Companys legal department obtains monthly estimates from the third party vendors and
reviews the amount reported by third party vendors for accuracy.
 Lack of Technical Accounting Expertise and Qualified Accounting Personnel.
 
    
    During the quarter ended June 30, 2006, the Company engaged experienced accounting
consultants to act as the VP Finance, Corporate Controller and Revenue Recognition
Accountant.
    
    During the second, third and fourth quarters of 2006, the Company engaged expert
accounting consultants to assist the Companys accounting and finance department with
the management and implementation of controls surrounding revenue recognition, the
administration of existing controls and procedures, the preparation of the Companys
periodic reports and the documentation of complex accounting transactions.
    
    The Company is increasing staffing in the accounting and finance department, and
re-allocating duties to persons within the accounting and finance organization to
maximize their skills and experience.
    
    The Company continues to take steps to recruit additional qualified senior accounting
personnel, including certified public accountants personnel with recent public
accounting firm experience. The Company is looking to hire an accountant with SEC
reporting experience.
 Inadequate Controls over Documentation and Record Keeping.
 
    
    During the quarter ended March 31, 2007, the Companys employees involved in order
entry received training regarding the controls and procedures surrounding the amendment
of sales orders. Additional training will be provided on a regular and periodic basis
and updated as necessary to reflect any changes in the Companys or its customers
business practices or activities.
    
    The Company has established policies and procedures for the review and approvals of
all manual journal entries.
    
    The Company has adopted a policy requiring it to retain a copy of all corporate
records in connection with dispositions of assets to third parties.
    
    Improve the review process that occurs prior to providing the initial draft of the
periodic report to our independent auditors for review.
    
    The Company has developed monthly close schedules which include the timeline for
completion and approval of reconciliations by the Corporate Controller.
    
    During the quarter ended June 30, 2006, the Company entered into agreements with
third parties that purchased assets from the Company in Israel. These agreements provide
the Company with access to the corporate records and require the third parties to retain
documents in accordance with Israeli law.
 32




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##### Table of Contents



Subsequent Changes in Internal Control over Financial Reporting
  33




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##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
 In re
Terayon Communication Systems, Inc. Securities Litigation.
 Bertram v. Terayon Communication Systems, Inc.
   34




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##### Table of Contents



35




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##### Table of Contents



36




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##### Table of Contents



Item 1A. Risk Factors
 The reader should carefully consider, in connection with the other information in this report,
the factors discussed in Part I, Item 1A  Risk Factors on pages 12 through 37 of our Annual
Report on Form 10-K for the year ended December 31, 2006, as amended (2006 Form 10-K ). These
factors could cause our actual results to differ materially from those stated in forward-looking
statements contained in this document and elsewhere. In addition to the factors included in the
2006 Form 10-K , the reader should also consider the following risk factors:
 Risks Related to the Proposed Acquisition by Motorola, Inc.
 Our business and results of operations are likely to be affected by our announced acquisition
by Motorola, Inc. (Motorola
    If the conditions to the proposed acquisition by Motorola set forth in the Merger Agreement
are not met, the acquisition may not occur.
  37




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##### Table of Contents



Failure to complete the proposed acquisition by Motorola would negatively affect our business,
financial condition, stock price and operating results.
  
    
    Activities relating to the acquisition and related uncertainties may lead to a loss of
revenue and market position that we may not be able to regain if the acquisition does not
occur;
    
    The price of our common stock may decline to the extent that the current market price
of the common stock reflects an assumption that the acquisition will be completed;
    
    We could be required to pay Motorola a termination fee of $5.25 million under the
circumstances described in the Merger Agreement;
    
    We would remain liable for our costs related to the acquisition, such as legal,
accounting, investment banking fees and related expenses in
connection with the merger;
    
    We may not be able to take advantage of alternative business opportunities or
effectively respond to competitive pressures;
    
    Our management and employees attention would have been diverted for which they will
have received little or no benefit;
    
    We may not be able to retain key employees;
    
    We may not be able to maintain effective internal control over financial reporting due to employee departures; and
    
    We would continue to be exposed to the general competitive pressures and risks
discussed in Item 1A. Risk Factors of our 2006 Form 10-K, which pressures and risks may
be increased if the acquisition is not completed.
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other Information
  38




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##### Table of Contents



Item 6. Exhibits
 ExhibitNumber
    
    Exhibit Description2.1
    
    Agreement and Plan of Merger, dated as of April 21, 2007 among Terayon Communication Systems, Inc., Motorola,
Inc., and Motorola GTG Subsidiary VI Corp.(7)3.1
    
    Amended and Restated Certificate of Incorporation of Terayon Communication Systems, Inc.(5)3.2
    
    Bylaws of Terayon Communication Systems, Inc.(5)3.3
    
    Certificate of Amendment to Amended and Restated Certificate of Incorporation of Terayon Communication Systems,
Inc.(5)3.4
    
    Certificate of Designation of Series A Junior Participating Preferred Stock.(4)4.1
    
    Specimen Common Stock Certificate.(2)4.2
    
    Amended and Restated Information and Registration Rights Agreement, dated April 6, 1998.(1)4.3
    
    Form of Security for Terayon Communication Systems, Inc.s 5% Convertible Subordinated Notes due August 1,
2007.(3)4.4
    
    Registration Rights Agreement, dated July 26, 2000, among Terayon Communication Systems, Inc. and Deutsche Bank
Securities, Inc. and Lehman Brothers, Inc.(3)4.5
    
    Indenture, dated July 26, 2000, between Terayon Communication Systems, Inc. and State Street Bank and Trust
Company of California, N.A.(3)4.6
    
    Rights Agreement, dated February 6, 2001, between Terayon Communication Systems, Inc. and Fleet National Bank.(4)4.7
    
    Rights Agreement Amendment, dated April 21, 2007 between Terayon Communication Systems, Inc. and Computershare
Trust Company, N.A. (as successor in interest to Fleet National Bank).(7)10.31
    
    Termination Agreement, effective as of March 22, 2007, between Terayon Communications Systems, Inc. and General
Electric Capital Corporation.(6)10.32
    
    2007 Executive Sales Commission Plan.10.33
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Matthew Aden.10.34
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Jerry Chase.10.35
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Mark Richman.31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Incorporated by reference to exhibits to our Registration Statement on Form S-1 filed on June 16, 1998 (File No.
333-56911).(2)
    
    Incorporated by reference to exhibits to our Registration Statement on Form S-1/A filed on July 31, 1998 (File No.
333-56911).(3)
    
    Incorporated by reference to our Registration Statement on Form S-3 filed on October 24, 2000 (File No. 333-48536).(4)
    
    Incorporated by reference to our Report on Form 8-K filed on February 9, 2001.(5)
    
    Incorporated by reference to our Report on Form 8-K filed on November 21, 2003.(6)
    
    Incorporated by reference to our Report on Form 10-K filed on April 2, 2007.(7)
    
    Incorporated by reference to our Report on Form 8-K filed on April 23, 2007. 39




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##### Table of Contents



SIGNATURES
  TERAYON COMMUNICATION SYSTEMS, INC.By:

/s/
Mark A. RichmanMark A. RichmanChief Financial Officer  40




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##### Table of Contents



EXHIBIT INDEX
 ExhibitNumber
    
    Exhibit Description2.1
    
    Agreement and Plan of Merger, dated as of April 21, 2007 among Terayon Communication Systems, Inc., Motorola,
Inc., and Motorola GTG Subsidiary VI Corp.(7)3.1
    
    Amended and Restated Certificate of Incorporation of Terayon Communication Systems, Inc.(5)3.2
    
    Bylaws of Terayon Communication Systems, Inc.(5)3.3
    
    Certificate of Amendment to Amended and Restated Certificate of Incorporation of Terayon Communication Systems,
Inc.(5)3.4
    
    Certificate of Designation of Series A Junior Participating Preferred Stock.(4)4.1
    
    Specimen Common Stock Certificate.(2)4.2
    
    Amended and Restated Information and Registration Rights Agreement, dated April 6, 1998.(1)4.3
    
    Form of Security for Terayon Communication Systems, Inc.s 5% Convertible Subordinated Notes due August 1,
2007.(3)4.4
    
    Registration Rights Agreement, dated July 26, 2000, among Terayon Communication Systems, Inc. and Deutsche Bank
Securities, Inc. and Lehman Brothers, Inc.(3)4.5
    
    Indenture, dated July 26, 2000, between Terayon Communication Systems, Inc. and State Street Bank and Trust
Company of California, N.A.(3)4.6
    
    Rights Agreement, dated February 6, 2001, between Terayon Communication Systems, Inc. and Fleet National Bank.(4)4.7
    
    Rights Agreement Amendment, dated April 21, 2007 between Terayon Communication Systems, Inc. and Computershare
Trust Company, N.A. (as successor in interest to Fleet National Bank).(7)10.31
    
    Termination Agreement, effective as of March 22, 2007, between Terayon Communications Systems, Inc. and General
Electric Capital Corporation.(6)10.32
    
    2007 Executive Sales Commission Plan.10.33
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Matthew Aden.10.34
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Jerry Chase.10.35
    
    Amendment to Employment Agreement, dated May 10, 2007, between Terayon Communication Systems,
Inc. and Mark Richman.31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 (1)
    
    Incorporated by reference to exhibits to our Registration Statement on Form S-1 filed on June 16, 1998 (File No.
333-56911).(2)
    
    Incorporated by reference to exhibits to our Registration Statement on Form S-1/A filed on July 31, 1998 (File No.
333-56911).(3)
    
    Incorporated by reference to our Registration Statement on Form S-3 filed on October 24, 2000 (File No. 333-48536).(4)
    
    Incorporated by reference to our Report on Form 8-K filed on February 9, 2001.(5)
    
    Incorporated by reference to our Report on Form 8-K filed on November 21, 2003.(6)
    
    Incorporated by reference to our Report on Form 10-K filed on April 2, 2007.(7)
    
    Incorporated by reference to our Report on Form 8-K filed on April 23, 2007.