** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-Q**

 

| (Mark One) |
|------------|
|       |   |   |
| **ý** | ** ** | **Quarterly report pursuant to Section 13 or 15(d) of the Securities  Exchange Act of 1934** |

 

Forthe quarterly period ended September 30, 2005.

 

**OR**

 

| **o** | ** ** | **Transition report pursuant to Section 13 or 15(d) of the Securities  Exchange Act of 1934** |
|-------|------------|-----------------------------------------------------------------------------------------------|

 

Forthe transition period from                    to

 

**Commission file number000-51560**

 

**MathStar, Inc.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                     | ** ** | **41-1881957**       |
|----------------------------------|------------|----------------------|
| (State  or other jurisdiction of |       | (I.R.S.  Employer    |
| incorporation  or organization)  |       | Identification  No.) |

 

| **5900 Green Oak Drive, Minnetonka, Minnesota** | ** ** | **55343**   |
|-------------------------------------------------|------------|-------------|
| (Address  of principal executive offices)       |       | (Zip  Code) |

 

**(952) 746-2200**

(Registrant’stelephone number, including area code)

 

**N/A**

(Formername, former address, and former fiscal year, if changed since last report)

 

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  o  Yes    ý  No

 

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

 

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

 

Shares outstanding of the Registrant’scommon stock:

 

| **Class**                      | ** ** | **Outstanding at  November 16, 2005** |
|--------------------------------|------------|--------------------------------------------|
|                           |       |                                       |
| Common  stock, $0.01 par value |       | 15,745,535                                 |

 

 

----

 
| ** **                         | **Page** |
|------------------------------------|----------|
| PART I  FINANCIAL INFORMATION |     |
|                               | Item 1.  | Financial  Statements (Unaudited) |   |
|                               |     | Condensed Balance Sheets as of December  31, 2004 and September 30, 2005 | 1 |
|                               |     | Condensed Statements of  Operations for the Three and Nine Months Ended September 30, 2004 and  September 30, 2005 and Cumulative for the period from Inception (April  14, 1997) through September 30, 2005 | 2 |
|                               |     | Condensed Statements of Cash  Flows for the Nine Months Ended September 30, 2004 and September 30, 2005 and  Cumulative for the period from Inception (April 14, 1997) through September  30, 2005 | 3 |
|                               |     | Notes to Condensed  Consolidated Financial Statements | 4 |
|                               | Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 9 |
|                               | Item 3.  | Quantitative  and Qualitative Disclosures about Market Risk | 14 |
|                               | Item 4.  | Controls and Procedures | 14 |
|                               |     |   |   |
| PART II  OTHER INFORMATION    | 16       |
|                               | Item 1.  | Legal Proceedings | 16 |
|                               | Item 2.  | Unregisterd  Sales of Equity Securities and Use of Proceeds | 16 |
|                               | Item 3.  | Defaults Upon  Senior Securities | 17 |
|                               | Item 4.  | Submission of  Matters to a Vote of Security Holders | 17 |
|                               | Item 5.  | Other Information | 17 |
|                               | Item 6.  | Exhibits | 17 |
|                               |     |   |   |
| SIGNATURES                         | 18       |

 

----

 

**MathStar, Inc.**

**(Adevelopment stage company)**

**CondensedBalance Sheets**

**(Unaudited)**

 
| ** **                                                                                                                                                                | ** ** | **December 31,**          | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                | ** ** | **2004**                       | ** ** | **2005**               | ** ** |
| ** **                                                                                                                                                                | ** ** | **(in thousands,**        | ** ** |
| ** **                                                                                                                                                                | ** ** | **except per share** | ** ** |
| ** **                                                                                                                                                                | ** ** | **amounts)**                   | ** ** |
| **Assets**                                                                                                                                                                |       |                           |       |                   |       |
| Current  assets                                                                                                                                                           |       |                           |       |                   |       |
| Cash and cash equivalents                                                                                                                                                 |       | $                              | 4,132      |                   | $          | 298 |   |
| Accounts receivable                                                                                                                                                       |       | 29                             |       | 88                     |       |
| Prepaid expenses and other current assets                                                                                                                                 |       | 230                            |       | 1,022                  |       |
| Total current assets                                                                                                                                                      |       | 4,391                          |       | 1,408                  |       |
| Property and  equipment, net                                                                                                                                              |       | 109                            |       | 60                     |       |
| Other assets                                                                                                                                                              |       | 4                              |       | 15                     |       |
| Total assets                                                                                                                                                              |       | $                              | 4,504      |                   | $          | 1,483 |   |
|                                                                                                                                                                      |       |                           |       |                   |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                            |       |                           |       |                   |       |
| Current  liabilities                                                                                                                                                      |       |                           |       |                   |       |
| Accounts payable                                                                                                                                                          |       | $                              | 251        |                   | $          | 1,079 |   |
| Accrued expenses                                                                                                                                                          |       | 236                            |       | 552                    |       |
| Convertible notes payable                                                                                                                                                 |       | —                         |       | 3,120                  |       |
| Total liabilities                                                                                                                                                         |       | 487                            |       | 4,751                  |       |
| Commitments  and contingencies                                                                                                                                            |       |                           |       |                   |       |
| Stockholders’ equity                                                                                                                                                 |       |                           |       |                   |       |
| Preferred stock, $0.01 par value; 10,000  shares authorized; no shares issued and outstanding                                                                             |       | —                         |       | —                 |       |
| Common stock, $0.01 par value; 90,000  shares authorized; 11,140 and 11,236 shares issued and outstanding at  December 31, 2004 and September 30, 2005, respectively |       | 111                            |       | 113                    |       |
| Additional paid-in capital                                                                                                                                                |       | 68,465                         |       | 72,861                 |       |
| Deficit accumulated during the development  stage                                                                                                                         |       | (64,559                        | )          | (76,242                | )          |
| Total stockholders’ equity (deficit)                                                                                                                                 |       | 4,017                          |       | (3,268                 | )          |
| Total liabilities and stockholders’ equity                                                                                                                           |       | $                              | 4,504      |                   | $          | 1,483 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

1

----

 

**MathStar, Inc.**

**(A development stage company)**

**Condensed Statements of Operations**

**(Unaudited)**

** **
| ** **                                             | ** ** | ** **                                | ** ** | ** **                                      | ** ** | ** **                      | ** ** | ** ** | ** ** | **Cumulative**                 | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | ** **                                | ** ** | ** **                                      | ** ** | ** **                      | ** ** | ** ** | ** ** | **for the Period**   | ** ** |
| ** **                                             | ** ** | ** **                                | ** ** | ** **                                      | ** ** | ** **                      | ** ** | ** ** | ** ** | **from Inception**        | ** ** |
| ** **                                             | ** ** | ** **                                | ** ** | ** **                                      | ** ** | ** **                      | ** ** | ** ** | ** ** | **(April 14, 1997)** | ** ** |
| ** **                                             | ** ** | **Three  Months Ended  September 30,**    | ** ** | **Nine  Months Ended  September 30,** | ** ** | **Through  September 30,** | ** ** |
| ** **                                             | ** ** | **2004**                                  | ** ** | **2005**                                        | ** ** | **2004**                        | ** ** | **2005**   | ** ** | **2005**                       | ** ** |
| ** **                                             | ** ** | (in thousands, except  per share amounts) | ** ** |
| Revenue                                                |       | $                                         | 100        |                                            | $          | 15                              |       | $          | 100        |                           | $          | 55 |   | $ | 801 |   |
| Cost of goods sold                                     |       | 45                                        |       | 45                                              |       | 15                              |       | 68         |       |                           |       |
| Gross margin                                           |       | 55                                        |       | 15                                              |       | 55                              |       | 40         |       | 733                            |       |
| Operating expenses:                                    |       |                                      |       |                                            |       |                            |       |       |       |                           |       |
| Research and development                               |       | 1,342                                     |       | 1,806                                           |       | 3,502                           |       | 6,384      |       | 27,617                         |       |
| Selling, general and administrative                    |       | 973                                       |       | 1,519                                           |       | 2,796                           |       | 3,977      |       | 17,193                         |       |
|                                                   |       | 2,315                                     |       | 3,325                                           |       | 6,298                           |       | 10,361     |       | 44,810                         |       |
| Operating loss                                         |       | (2,260                                    | )          | (3,290                                          | )          | (6,243                          | )          | (10,321    | )          | (44,077                        | )          |
| Interest income                                        |       | 14                                        |       | 7                                               |       | 47                              |       | 7          |       | 1,087                          |       |
| Interest expense                                       |       | —                                    |       | (900                                            | )          | —                          |       | (1,369     | )          | (1,369                         | )          |
| Other income, net                                      |       | —                                    |       | —                                          |       | —                          |       | —     |       | 17                             |       |
| Net loss from continuing operations                    |       | (2,246                                    | )          | (4,203                                          | )          | (6,196                          | )          | (11,683    | )          | (44,368                        | )          |
| Loss from discontinued operations                      |       | —                                    |       | —                                          |       | —                          |       | —     |       | (31,874                        | )          |
| Net loss                                               |       | $                                         | (2,246     | )                                               | $          | (4,203                          | )          | $          | (6,196     | )                              | $          | (11,683 | ) | $ | (76,242 | ) |
|                                                   |       |                                      |       |                                            |       |                            |       |       |       |                           |       |   |   |   |   |
| Basic and diluted net loss per share                   |       | $                                         | (0.24      | )                                               | $          | (0.37                           | )          | $          | (0.69      | )                              | $          | (1.04 | ) | — |   |
| Weighted average basic and diluted shares  outstanding |       | 9,469                                     |       | 11,233                                          |       | 8,968                           |       | 11,195     |       | —                         |       |

 

The accompanying notesare an integral part of these financial statements.

 

2

----

** **

**MathStar, Inc.**

**(Adevelopment stage company)**

**Condensed Statements of Cash Flows**

**(Unaudited)**

 
| ** **                                                                                                          |   |                            |   |                   |   | **Cumulative**                 |   |
|---------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|------------------------|--------|--------------------------------|--------|
| ** **                                                                                                          |   |                            |   |                   |   | **for the Period**   |   |
| ** **                                                                                                          |   |                            |   |                   |   | **from Inception**        |   |
| ** **                                                                                                          |   |                            |   |                   |   | **(April 14, 1997)** |   |
| ** **                                                                                                          |   | **Nine Months Ended** |   | **Through**            |   |
| ** **                                                                                                          |   | **September 30,**          |   | **September 30,** |   |
| ** **                                                                                                          |   | **2004**                        |   | **2005**               |   | **2005**                       |   |
| ** **                                                                                                          |   | **(in thousands)**              |   |
| **Cash flows from operating activities**                                                                            |   |                            |   |                   |   |                           |   |
| Net loss                                                                                                            |   | $                               | (6,196 | )                      | $      | (11,683                        | )      | $ | (76,242 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities Depreciation                            |   | 137                             |   | 49                     |   | 1,509                          |   |
| Amortization of convertible notes discount  - beneficial conversion feature and value of warrants issued with notes |   | —                          |   | 1,061                  |   | 1,061                          |   |
| Amortization of discount on  held-to-maturity securities                                                            |   | —                          |   |                   |   | (233                           | )      |
| Acquired in-process research and  development                                                                       |   | —                          |   |                   |   | 4,300                          |   |
| Stock-based compensation                                                                                            |   | —                          |   | 546                    |   | 1,610                          |   |
| Goodwill impairment                                                                                                 |   | —                          |   | —                 |   | 13,306                         |   |
| Change in operating assets and liabilities,  net of effects of acquisition                                     |   |                            |   |                   |   |                           |   |
| Accounts receivable                                                                                                 |   | (13                             | )      | (60                    | )      | 56                             |   |
| Prepaid expenses and other assets                                                                                   |   | 144                             |   | (803                   | )      | (898                           | )      |
| Accounts payable                                                                                                    |   | 19                              |   | 828                    |   | 931                            |   |
| Accrued expenses                                                                                                    |   | (576                            | )      | 505                    |   | 719                            |   |
| Net cash used in operating activities                                                                               |   | (6,485                          | )      | (9,557                 | )      | (53,882                        | )      |
| **Cash flows from investing activities**                                                                            |   |                            |   |                   |   |                           |   |
| Cash used in acquisition, net of cash  acquired                                                                     |   | —                          |   | —                 |   | (791                           | )      |
| Purchase of property and equipment                                                                                  |   | —                          |   | —                 |   | (1,408                         | )      |
| Proceeds from sale of discontinued  operations                                                                      |   | —                          |   | —                 |   | 1,752                          |   |
| Purchases of held-to-maturity securities                                                                            |   | —                          |   | —                 |   | (10,000                        | )      |
| Sales of held-to-maturity securities                                                                                |   | —                          |   | —                 |   | 10,233                         |   |
| Net cash used in investing activities                                                                               |   | —                          |   | —                 |   | (214                           | )      |
| **Cash flows from financing activities**                                                                            |   |                            |   |                   |   |                           |   |
| Proceeds from issuance of common stock, net  of offering costs                                                      |   | 7,533                           |   | —                 |   | 41,414                         |   |
| Proceeds from issuance of convertible notes                                                                         |   | —                          |   | 5,500                  |   | 5,500                          |   |
| Proceeds from issuance of warrants to  purchase common stock, net of offering costs                                 |   | 536                             |   | —                 |   | 5,304                          |   |
| Proceeds from exercise of warrants                                                                                  |   | —                          |   | 223                    |   | 2,896                          |   |
| Collection of subscription receivable                                                                               |   | —                          |   | —                 |   | 27                             |   |
| Proceeds from exercise of stock options                                                                             |   | —                          |   | —                 |   | 1                              |   |
| Principal payments on notes receivable from  stockholders                                                           |   | —                          |   | —                 |   | 245                            |   |
| Principal payments on notes payable to  stockholders                                                                |   | —                          |   | —                 |   | (250                           | )      |
| Repurchase of common stock                                                                                          |   | —                          |   | —                 |   | (257                           | )      |
| Payments on capital lease obligations                                                                               |   | —                          |   | —                 |   | (486                           | )      |
| Net cash provided by financing activities                                                                           |   | 8,069                           |   | 5,723                  |   | 54,394                         |   |
| Net (decrease) increase in cash and cash  equivalents                                                               |   | 1,584                           |   | (3,834                 | )      | 298                            |   |
| **Cash and cash equivalents**                                                                                       |   |                            |   |                   |   |                           |   |
| Beginning of period                                                                                                 |   | 2,805                           |   | 4,132                  |   | -0-                            |   |
| End of period                                                                                                       |   | $                               | 4,389  |                   | $      | 298                            |   | — |   |
|                                                                                                                     |        |                                 |        |                        |        |                                |        |  |  |  |

 

The accompanying notesare an integral part of these financial statements.

 

3

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** **

**MathStar, Inc.**

**(A development stagecompany)**

**Notes to FinancialStatements**

**(in thousands, exceptshare and per share amounts)**

** **

**1.**                                      Basis ofPresentation and Going Concern

 

The accompanying interimcondensed financial statements of MathStar, Inc. (“MathStar” or the “Company”)have been prepared in conformity with United States (U.S.) generally acceptedaccounting principles, consistent in all material respects with those appliedin the Company’s Registration Statement on Form S-1, as amended,which was declared effective on October 26, 2005.  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and the disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

The interim financialinformation is unaudited, but it reflects all normal adjustments that are, inthe opinion of management, necessary to provide a fair statement of results forthe interim periods presented.  Theinterim financial results are not necessarily indicative of results to beexpected in future interim or annual periods.  The interim financial statements should beread in conjunction with the financial statements in the Company’s RegistrationStatement on Form S-1, as amended, which was declared effective onOctober 26, 2005.

 

The Company wasincorporated as a Minnesota corporation in April 1997 and reincorporatedunder Delaware law in June 2005.  Sinceits inception, the Company has devoted substantially all of its efforts tobusiness planning, research and development, recruitment of management andtechnical staff, acquiring operating assets and raising capital.  The Company has generated only nominalrevenues from the sale of development kits that support customer development ofapplications for one of the Company’s products, the sale of product prototypesand contractual research and development services.  Accordingly, the Company is considered to bein the development stage as defined by Statement of Financial Accounting Standards(“SFAS”) No. 7, *Accounting andReporting by Development Stage Enterprises*.

 

The accompanyingfinancial statements have been prepared on a basis which assumes that theCompany will continue as a going concern and which contemplates the realizationof assets and the satisfaction of liabilities and commitments in the normalcourse of business.  The Company has alimited operating history and has incurred losses and negative cash flows fromoperations since inception.  The Companyexpects to incur additional losses at least through 2005.

 

On November 1,2005, the Company closed on its initial public offering of 4,000,000 shares ofits common stock at $6.00 per share, resulting in net proceeds to the Companyof approximately $22,100.

** **

4

----

 

**2.             New Accounting Pronouncements**

 

In November 2004,the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 151,*Inventory Cost*.  SFAS No. 151 amends the guidance inAccounting Research Bulletin (“ARB”) No. 43, Chapter 4, *Inventory Pricing*, to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs and wasted materialor spoilage.  Paragraph 5 of ARBNo. 43, Chapter 4, previously stated that “under some circumstances, itemssuch as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to require treatment as current periodcharges.”  SFAS No. 151 requiresthat those items be recognized as current period charges regardless of whetherthey meet the criterion of “so abnormal.” In addition, SFAS No. 151 requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities.  Theprovisions of SFAS No. 151 will be effective for the Company in the firstquarter of 2006, which begins January 1, 2006.  The Company does not expect adoption of SFASNo. 151 to have a material effect on its consolidated financialstatements.

 

In December 2004,the FASB issued SFAS No. 123R, *Share-Based Payment*.  SFAS No. 123R revised SFAS No. 123and supersedes Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB OpinionNo. 25”).  The revised statementaddresses the accounting for share-based payment transactions with employeesand other third parties, eliminates the ability to account for share-basedpayments using APB Opinion No. 25 and requires that the compensation costsrelating to such transactions be recognized in the statement of operationsbased upon the grant-date fair value of those instruments.  The revised statement is effective for theCompany in the first quarter of 2006 which begins on January 1, 2006.  The Company expects that adoption of SFASNo. 123R will result in additional charges to operations beginning in2006.  However, the Company has not yetdetermined the amount of such charges.

 

UnderSFAS No. 123R, the Company must determine the appropriate fair valuemodel to be used for valuing share-based payments, the amortization method forcompensation costs and the transition method to be used at the date ofadoption.  The transition methods includeprospective and retroactive adoption alternatives.  The Company expects to apply the prospectiveadoption method.  Because the Company hashistorically followed the “minimum value” method permitted by SFASNo. 123, the prospective method will require the Company to recordcompensation expense only for options issued after adoption of SFASNo. 123R.

** **

**3.             Stock-Based Compensation**

 

In accordance with SFASNo. 123, *Accounting for Stock-BasedCompensation*, the Company has elected to account for stock-basedcompensation to employees using the intrinsic value method prescribed inAccounting Principles Board Opinion No. 25, (“APB 25”), *Accounting for Stock Issued to Employees*,and related interpretations. Accordingly, compensation cost for stock options granted to employees ismeasured as the excess, if any, of the fair value of the Company’s stock at thedate of the grant over the amount an employee must pay to acquire thestock.  The Company accounts forstock-based compensation to nonemployees using the fair value method prescribedby SFAS No. 123.  Compensation costfor stock options granted to nonemployees is measured based on the fair valueof the option at the date of grant, with the unvested portion revalued at eachbalance sheet date.  Compensation costs,if any, are amortized over the underlying option vesting terms.

 

# **Restricted Stock**

 

In 2004, the Company issued83,570 shares of restricted stock to certain employees of the Company.  During the nine months endedSeptember 30, 2005, the Company issued 408,335 shares of restricted stockto certain employees.  The restrictedstock terms provided for vesting upon either a change of control (as defined bythe restricted stock agreement) of the Company or an initial public offering ofthe Company’s common stock. Notwithstanding the foregoing, the Company had the power to delay thevesting of the restricted stock up to one year after a change in control or aninitial public offering of the Company’s common stock.  During the quarter ended September 30,2005, the Company’s Board of Directors elected to delay vesting of all sharesof restricted stock until one year after the effectiveness of the Company’sregistration statement (which occurred on October 26, 2005).  In accordance with APB 25, the Company willrecord compensation expense of up to $2,740 related to these restricted sharesover a one-year vesting period of these shares, beginning on the November 1, 2005 closingdate of the Company’s initial public offering.

 

5

----

 

The following tablepresents the pro forma effect on net loss if the Company had applied the fairvalue recognition provisions for SFAS No. 123 (minimum value method) tostock-based employee compensation:

 
| ** **                                                                                                                | ** ** | ** **                       | ** ** | ** **            | ** ** | ** **             | ** ** | ** ** | ** ** | **Cumulative**                 | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|------------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                                                                                                | ** ** | ** **                       | ** ** | ** **            | ** ** | ** **             | ** ** | ** ** | ** ** | **for the Period**   | ** ** |
| ** **                                                                                                                | ** ** | ** **                       | ** ** | ** **            | ** ** | ** **             | ** ** | ** ** | ** ** | **from Inception**        | ** ** |
| ** **                                                                                                                | ** ** | ** **                       | ** ** | ** **            | ** ** | ** **             | ** ** | ** ** | ** ** | **(April 14, 1997)** | ** ** |
| ** **                                                                                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** | **Through**            | ** ** |
| ** **                                                                                                                | ** ** | **September 30,**           | ** ** | **September 30,**     | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                | ** ** | **2004**                         | ** ** | **2005**              | ** ** | **2004**               | ** ** | **2005**   | ** ** | **2005**                       | ** ** |
| ** **                                                                                                                | ** ** | ** **                       | ** ** |
| Net loss as reported                                                                                                      |       | $                                | (2,246     | )                     | $          | (4,203                 | )          | $          | (6,196     | )                              | $          | (11,683 | ) | $ | (76,242 | ) |
| Add: Total stock-based employee compensation expense  included in net loss, as reported                                   |       | —                           |       | (39                   | )          | —                 |       | 138        |       | 1,009                          |       |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all employee awards |       | (43                              | )          | (212                  | )          | (131                   | )          | (569       | )          | (2,354                         | )          |
| Pro forma net loss                                                                                                        |       | $                                | (2,289     | )                     | $          | (4,454                 | )          | $          | (6,327     | )                              | $          | (12,114 | ) | $ | (77,587 | ) |
| Basic and diluted loss per share:                                                                                         |       |                             |       |                  |       |                   |       |       |       |                           |       |
| As reported                                                                                                               |       | $                                | (0.24      | )                     | $          | (0.37                  | )          | $          | (0.69      | )                              | $          | (1.04 | ) |   |   |
| Pro forma                                                                                                                 |       | $                                | (0.24      | )                     | $          | (0.40                  | )          | $          | (0.71      | )                              | $          | (1.08 | ) |   |   |

** **

For the purpose of determining fair values using theminimum value method for employee grants as prescribed by SFAS No. 123,the Company used the Black-Scholes option pricing model with the followingweighted average assumptions:

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                  | ** ** | **2004**               | ** ** | **2005**              | ** ** | **2004** | ** ** | **2005** | ** ** |
|                        |       |                   |       |                  |       |   |   |   |   |
| Expected option term        |       | 5 Years                |       | 5 Years               |       | 5 Years |   | 5 Years |   |
| Expected volatility  factor |       | 0                      | %          | 0                     | %          | 0 | % | 0 | % |
| Expected dividend yield     |       | 0                      | %          | 0                     | %          | 0 | % | 0 | % |
| Risk free interest rate     |       | 3.61                   | %          | 4.04                  | %          | 3.52 | % | 3.93 | % |

 

The Company used the Black-Scholes option pricingmodel with the minimum value method for measuring the fair value of options priorto completion of its initial public offering. The minimum value method assumes no volatility in the application of theBlack-Scholes model.  The Company will berequired to include a volatility factor in determining the fair value ofoptions granted after completion of its initial public offering.

 

**4.             Selected Balance Sheet Information**

 

Thefollowing presents prepaid expenses and other current assets:

 
| ** **                                                | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------|------------|------------------|------------|-------------------|------------|
| ** **                                                | ** ** | **2004**         | ** ** | **2005**          | ** ** |
| ** **                                                | ** ** | ** **       | ** ** | ** **        | ** ** |
| Prepaid license fees                                      |       | $                | 205        |              | $          | 102 |   |
| Prepaid insurance                                         |       | 25               |       | 16                |       |
| Deferred convertible  note fees and public offering costs |       | —           |       | 790               |       |
| Prepaid rent                                              |       | —           |       | 114               |       |
|                                                      |       | $                | 230        |              | $          | 1,022 |   |

 

6

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The following presents property and equipment, net:

 
| ** **                         | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|------------------------------------|------------|------------------|------------|-------------------|------------|
| ** **                         | ** ** | **2004**         | ** ** | **2005**          | ** ** |
| ** **                         | ** ** | ** **       | ** ** | ** **        | ** ** |
| Computer equipment                 |       | $                | 896        |              | $          | 896 |   |
| Purchased software                 |       | 425              |       | 425               |       |
| Furniture and fixtures             |       | 165              |       | 165               |       |
|                               |       | $                | 1,486      |              | $          | 1,486 |   |
| Less: Accumulated  depreciation    |       | (1,377           | )          | (1,426            | )          |
| Total property and  equipment, net |       | $                | 109        |              | $          | 60 |   |

 

Depreciation expense was $33 and $14 for the threemonths ended September 30, 2004 and 2005, respectively, $137 and $49 for thenine months ended September 30, 2004 and 2005, respectively and $1,509cumulative for the period from inception (April 14, 1997) to September 30,2005.

 

The following presents accrued expenses:

 
| ** **             | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|------------------------|------------|------------------|------------|-------------------|------------|
| ** **             | ** ** | **2004**         | ** ** | **2005**          | ** ** |
| ** **             | ** ** | ** **       | ** ** | ** **        | ** ** |
| Accrued rent           |       | $                | 146        |              | $          | 158 |   |
| Accrued interest       |       | —           |       | —            |       |
| Accrued compensation   |       | 90               |       | 243               |       |
| Other                  |       | —           |       | 151               |       |
| Total accrued expenses |       | $                | 236        |              | $          | 552 |   |

 

**5.             Stockholders’Equity**

 

On November 1, 2005, the Company closed on its initialpublic offering of 4,000,000 shares of its common stock at $6.00 per share, resultingin net proceeds to the Company of approximately $22,100.  For the three and nine months ended September30, 2005, the Company granted options totaling 291,167 shares and 1,049,501shares, respectively.  Additionally, forthe three and nine months ended September 30, 2005, the Company grantedrestricted stock awards for 10,000 and 408,335 shares, respectively.

 

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**6.Subsequent Events**

 

InApril 2005, the Company issued convertible notes totaling $5,500.  The notes, which are due in November 2006,bear interest at 8% per year but are convertible into shares of the Company’scommon stock at a price per share of $4.80 (equal to 80% of the issuance priceof the Company’s stock in its initial public offering).  Following completion of the Company’s initialpublic offering, the note holders elected to convert $5,416 of the notes andaccrued interest into 1,128,401 shares of common stock, and the remaining $331of notes and accrued interest will be repaid in accordance with the terms ofthe notes.  The remaining unamortizeddiscount on these notes of $2,566 at September 30, 2005 will be charged tointerest expense during the quarter ending December 31, 2005.

 

During October 2005, theCompany borrowed $340 from a bank.  Theseborrowings, which bear interest at 4.8%, were collateralized by a certificateof deposit supplied by the Company’s President and Chief Executive Officer, whois also a shareholder.  These borrowingswere repaid in November 2005 following the closing of the Company’s initial publicoffering.

 

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**Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

*Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations, as well as information contained in the Risk Factorssection described below and elsewhere in this report, contains forward-lookingstatements, which are provided under the “safe harbor” protection of thePrivate Securities Litigation Reform Act of 1995.  Forward-looking statements are generallywritten in the future tense and/or are preceded by words such as “will,” “may,”“should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,”or other similar words.  Forward-lookingstatements include statements regarding the commercial success of our newproducts; the growth prospects of the semiconductor industry and programmablelogic market, including the field programmable object array (“FPOA”) and fieldprogrammable gate array (“FPGA”) product sub-segments; and trends inour future sales, including our opportunities for growth by displacing FPGAs,application-specific integrated circuits (“ASICs”) and other semiconductoralternatives.*

 

*Forward-lookingstatements are not guarantees of future performance and involve risks anduncertainties.  The forward-lookingstatements contained in this report are based on information that is currentlyavailable to us and expectations and assumptions that we deem reasonable at thetime the statements were made.  We do notundertake any obligation to update any forward-looking statements in thisreport or in any of our other communications, except as required by law.  All such forward-looking statements should beread as of the time the statements were made and with the recognition thatthese forward-looking statements may not be complete or accurate at a laterdate.*

 

*Manyfactors may cause actual results to differ materially from those expressed orimplied by the forward-looking statements contained in this report.  These factors include, but are not limitedto, those risks described in our final prospectus dated October 26, 2005.*

** **

**Business Overview**

 

We are a developmentstage fabless semiconductor company engaged in the development, marketing andselling of our high-performance, programmable platform chips and design toolsrequired to program our chips.  We havedemonstrated working versions of our first chip and provided an early releaseof our design tools to a limited number of customers.  To date, we have recognized only nominalrevenue from research services provided under grants from governmentalagencies, engineering services and sales of prototype chips and our fieldprogrammable object array, or FPOA, development kits.

 

We were incorporated inApril 1997.  In August 2001, weacquired Digital MediaCom, Inc. and began a new and separate operatingsegment, the physical media dependent, or PMD, segment.  The primary business objective of the PMDsegment was to develop in-process technology in high-speed serial interfacechips for the 10-gigabit Ethernet market. In August 2002, we decided to cease operations of the PMD segmentbecause of a severe downturn in the market for 10-gigabit Ethernetproducts.  On November 15, 2002, wesold or disposed of the assets of our PMD operating segment, including all ofthe valuable technology, property and equipment, licensed software andemployees, for $1,752,000 in cash and the buyer’s assumption of $187,000 ofliabilities.  The results of operationsof the PMD segment are reported as discontinued operations in the cumulativeperiod from inception (April 14, 1997) through September 30, 2005.

 

In January 2002, wedecided to cease the development of the fixed-function chips that had been thegoal of our research and development efforts until then and to switch to thedevelopment of a family of programmable platform chips.  In November 2003, we initiated thefabrication of the first version of our FPOA chip with Taiwan SemiconductorManufacturing Company, or TSMC, our chip fabrication contractor.  In March 2004, TSMC delivered to us thefirst working silicon of that chip. Since that time, we have been principally engaged in furtherdevelopments of our FPOA products and in marketing and selling our first FPOAto a small number of early customers. Although there can be no assurance, we expect to produce FPOA chips thatwill be ready for a broader market release, and we believe we will beginselling to customers in the first quarter of 2006.

 

**Financial Operations Overview**

 

From inception throughSeptember 30, 2005, we had gross revenues of $801,000, a loss fromcontinuing operations of $44,368,000, and a loss from our discontinued PMDoperations of $31,874,000.

 

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At December 31,2004, we had federal and state income tax net operating loss carryforwards ofapproximately $48,617,000.  The operatingloss carryforwards will expire in the calendar years from 2014 to 2024.  At December 31, 2004, we had federal andstate research credit carryforwards of approximately $2,503,000.  The research credit carryforwards will expirein the calendar years from 2015 to 2024. Under the Internal Revenue Code of 1986, the utilization of these netoperating loss carryforwards may be limited as a result of significant changesin our ownership.

 

***Researchand Development***

 

Research and developmentexpenses represent costs incurred for designing and engineering our FPOA chipand developing design tools and applications to enable customers to more easilyprogram our chip.  Research and developmentexpenses consist primarily of salaries and related costs of our engineeringorganization, fees paid to third party consultants and an allocation offacilities and depreciation expenses.  Weexpense all research and development costs related to the development of ourFPOA.  Development of certain designtools and applications include the development of software.  Such research and development expenses arerequired to be expensed until the technological feasibility of the software isestablished.  We determine technologicalfeasibility based upon completion of a working model of the software.  To date, the period between technologicalfeasibility and general release of the software has been short, so virtuallyall of our software development costs relate to software development during theperiod before technological feasibility. Accordingly, all such costs have been charged to operations asincurred.  We expect to incur significantadditional research and development costs as we develop more chips using ourFPOA technology.

 

***Selling,General and Administrative Expenses***

 

Selling, general andadministrative expenses consist primarily of salaries and related costs of oursales and marketing and administrative staff, general corporate activities andan allocation of facilities and depreciation expenses.  We anticipate that selling, general andadministrative costs will increase as a result of increasing our sales andmarketing and administrative staff to support sales of FPOA chips in worldwidemarkets and to support our growth and operation as a public company.

 

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**Results of Operations**

 

***Three Months Ended September 30, 2004 and2005***

 

*Revenueand Cost of Goods Sold. *For thethree months ended September 30, 2005, we generated revenue of $15,000 comparedto $100,000 for the same period last year. Revenues for the three months ended September 30, 2005 were from thesale of FPOA development kits and non-recurring engineering fees.  Revenues for the three months ended September30, 2004 were from the sale of FPOA development kits.  These product development kits includedsoftware that we licensed from a third party for the development of designtools for our FPOA chips. Costs of goods sold for the three months endedSeptember 30, 2004 are the cost of the third party software licenses. Thecost of producing our development kits are expensed as research and developmentcosts as incurred because we do not anticipate substantial sales of the currentversion of the chip we have produced and because the aggregate cost of thedevelopment kits we expect to sell are immaterial.  There were no cost of goods sold for thethree months ended September 30, 2005.

 

*Researchand Development.* For the three months ended September 30, 2005, research and developmentexpenses increased $464,000 or 33% to $1,806,000 from $1,342,000 for the threemonths ended September 30, 2004.  Theincrease is the result of increased outside engineering and design consultants($551,000), increased payroll costs ($310,000) and increased travel costs ($62,000)partially offset by less costs for outside product development ($400,000).  The increase in the use of outside engineeringand design consultants and payroll costs is the result of increased staffing andefforts to complete the FPOA chip design and to continue development of ourlibrary of development algorithms for use by our customers. In March 2005,we completed the development of another version of our FPOA chip that correcteddesign flaws in the previous versions. We continue to use outside engineeringconsultants, but we anticipate that our use of such consultants will begin todecline as we build our internal staffing. We expect to always use a mix ofinternal staff engineers and outside engineering consultants, and we expectthis mix will change with changing business needs. However, over time, as ourresearch and development needs change, we anticipate the mix will become moreheavily weighted toward the use of internal staff. The use of internal staffprovides better control over the engineering functions and is more costeffective. We anticipate that we will have the appropriate, initial mix ofresearch and development staff by the end of the first quarter of 2006.  Travel costs increased as a result ofincreased travel between our facilities in Portland, Oregon and Minneapolis,Minnesota.

 

*Selling,General and Administrative  *For thethree months ended September 30, 2005, selling, general and administrativeexpenses increased $546,000 or 56% to $1,519,000 compared to $973,000 for thethree months ended September 30, 2004. The increase was primarily the result of increased salaries ($278,000),as we hired a chief operating officer, chief financial officer and vicepresidents of marketing and engineering and other marketing and sales staff in2005, whose salaries were reflected in our financial results during the threemonths ended September 30, 2005.  Salesconsulting costs increased $120,000 as a result of using an outside consultantto help with our sales and marketing efforts. Travel costs increased $87,000 as the result of increased travel relatedto our increased sales and marketing efforts and additional travel between ourfacilities in Portland, Oregon and Minneapolis, Minnesota.  Outside consulting costs increased $83,000 asa result of timing of expenses.

 

*OtherIncome (Expense).  *For the three months endedSeptember 30, 2005, we had net other expenses of $893,000 compared withother income of $14,000 for the three months ended September 30,2004.  In April 2005, we issued$5,500,000 of our 8% convertible promissory notes.  The note holders also received warrants topurchase 366,715 shares of our common stock at a per share exercise price of$4.80 (equal to 80% of the price at which shares of common stock were sold inour initial public offering).  The notesprovide the note holders the option to convert the principal amount plusaccrued interest into common stock at a beneficial conversion price equal of$4.80 (equal to 80% of the price at which shares of common stock were sold inour initial public offering).  The notesare payable on December 1, 2005 if they are not converted into commonstock on or before November 21, 2005. The carrying value of the notes is reported net of a $1,126,000 discountresulting from the allocated fair value of the warrants and net of a $2,502,000beneficial conversion charge related to the beneficial conversion terms. The remainingdiscount at September 30, 2005 of $2,566,000 will be charged to interestexpense during the quarter ending December 31, 2005.  For the three months ended September 30,2005, we recognized interest expense of $900,000****related to these notes. For the three months ended September 30, 2005, we had $7,000 ofinterest income earned on cash and cash equivalents compared to $14,000 for thesame period last year.

 

***Nine Months Ended September 30, 2004 and2005***

*** ***

*Revenueand Cost of Goods Sold. *For the ninemonths ended September 30, 2005, we generated revenue of $55,000 compared to$100,000 for the same period last year. Revenues for the nine months ended September 30, 2005 were from the saleof FPOA development kits and non-recurring engineering fees.  Revenues for the nine months ended September30, 2004 were from the sale of FPOA development kits.  These product development kits includedsoftware that we licensed from a third party for the development of designtools for our FPOA chips. Costs of goods sold for the three months endedSeptember 30, 2004 and 2005 are the cost of the third party softwarelicenses. The cost of producing our development kits are expensed as research anddevelopment costs as incurred because we do not anticipate substantial sales ofthe current version of the chip we have produced and because the aggregate costof the development kits we expect to sell are immaterial.

 

*Researchand Development.* For the nine months ended September 30, 2005, research and developmentexpenses increased $2,882,000 or 82% to $6,384,000 from $3,502,000 for the ninemonths ended September 30, 2004.  Theincrease is the result of increased outside engineering and design consultants($1,509,000), increased payroll costs ($642,000), increased outside materialand other costs ($603,000) and increased travel costs ($86,000).  The increase in the use of outsideconsultants and payroll costs is the result of increased staffing and efforts tocomplete the FPOA chip design and to continue development of our library ofdevelopment algorithms for use by our customers. In March 2005, wecompleted the development of another version of our FPOA chip that correcteddesign flaws in the previous versions. We continue to use outside engineeringconsultants, but we anticipate that our use of such consultants will begin todecline as we build our internal staffing. We expect to always use a mix ofinternal staff engineers and outside engineering consultants, and we expectthis mix will change with changing business needs. However, over time, as ourresearch and development needs change, we anticipate the mix will become moreheavily weighted toward the use of internal staff. The use of internal staffprovides better control over the engineering functions and is more costeffective. We anticipate that we will have the appropriate, initial mix ofresearch and development staff by the end of the first quarter of 2006.  Outside material and other costs increased asthe result of the fabrication and other material costs incurred to produce thecurrent version of our FPOA.  Travel costsincreased as a result of increased travel between our facilities in Portland,Oregon and Minneapolis, Minnesota.

 

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*Selling,General and Administrative.* For the nine months ended September 30, 2005, selling, general andadministrative expenses increased $1,181,000 or 42% to $3,997,000 compared to$2,796,000 for the nine months ended September 30, 2004.  The increase was primarily the result ofincreased salaries ($697,000), as we hired a chief operating officer, chieffinancial officer and vice presidents of marketing and engineering and othermarketing and sales staff during the nine months ended September 30, 2005.  Sales consulting costs increased $195,000 asa result of using an outside consultant to help with the sales and marketingefforts.  Travel increased $178,000 asthe result of increased travel related to our increased sales and marketingefforts and additional travel between our facilities in Portland, Oregon andMinneapolis, Minnesota.

 

*OtherIncome (Expense). *For the ninemonths ended September 30, 2005, we had net other expenses of $1,362,000****compared with other income of **$**47,000 for the nine months endedSeptember 30, 2004.  InApril 2005, we issued $5,500,000 of our 8% convertible promissorynotes.  The note holders also receivedwarrants to purchase 366,715 shares of our common stock at a per share exerciseprice of $4.80 (equal to 80% of the price at which shares of common stock weresold in our initial public offering). The notes provide the note holders the option to convert the principalamount plus accrued interest into common stock at a beneficial conversion priceequal of $4.80 (equal to 80% of the price at which shares of common stock weresold in our initial public offering). The notes are payable on December 1, 2005 if they are not convertedinto common stock on or before November 21, 2005.  The carrying value of the notes is reportednet of a $1,126,000 discount resulting from the allocated fair value of thewarrants and net of a $2,502,000 beneficial conversion charge related to thebeneficial conversion terms. The remaining discount at September 30, 2005 of$2,566,000 will be charged to interest expense during the quarter endingDecember 31, 2005.  For the nine monthsended September 30, 2005, we recognized interest expense of $1,395,000****related to these notes.  For the nine months ended September 30,2005, we had $7,000 of interest income earned on cash and cash equivalentscompared to $47,000 for the same period last year.

 

**Liquidity and CapitalResources**

Since inception onApril 14, 1997, we have funded our cash flow needs principally throughsales of our common stock, rights to purchase our common stock and 8%convertible promissory notes.  During theperiod from April 14, 1997 to September 30, 2005, we raised netproceeds of $70,718,000 from sales of common stock and common stock warrantsand $5,500,000 from sales of 8% convertible promissory notes and common stockwarrants.  During the nine month periodended September 30, 2005, we raised $5,500,000 from the issuance of our 8%convertible promissory notes and $223,000 from the exercise of certain warrantsheld by investors.  During the nine monthperiod ended September 30, 2004, we raised $7,533,000 from the issuance ofcommon stock and $536,000 from the issuance of warrants to purchase commonstock.

 

DuringOctober 2005, we borrowed $340,000 from a bank.  These borrowings, which bear interest at 4.8%,are collateralized by a certificate of deposit supplied by our President and ChiefExecutive Officer, who is also a shareholder. We repaid these borrowings in November 2005 following the closingof our initial public offering of 4,000,000 shares of our common stock for$6.00 per share.  We raised net proceedsfrom this offering of approximately $22,100,000.

 

Our sales and marketinginfrastructure as well as the administrative support to commercialize our FPOAtechnology will be substantially in place by the end of 2005.  We anticipate that we will commence theproduction and sale of the new version of our FPOA chip in the first half of2006, although such production and sale cannot be assured.  Going forward, our results of operations willdepend upon how long it takes and how successful we are in achieving marketacceptance of our FPOA technology. Depending upon our success in commercializing the product and the extentand timing of market acceptance of our FPOA technology, we may need to raiseadditional capital.  However, there canbe no assurance that debt or equity financing will be available on termsacceptable to us, or at all, and there can be no assurance that we willsuccessfully market our products.  If weare unable to obtain additional financing or successfully market our productson a timely basis, we would have to slow our product development and marketingefforts and may be unable to continue our operations.

 

 

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Our future capitalrequirements will depend on many factors, including our sales growth, marketacceptance of our existing and new FPOA chips, the amount and timing of ourresearch and development expenditures, the timing of our introduction of newchips, the expansion of our sales and marketing efforts and working capitalneeds.  We believe our cash on hand,combined with our capital resources, will be sufficient to meet our capital andoperating needs at least through December 2006. However, our long-term financing requirements will depend significantlyon our ability to penetrate the market with our FPOA chip technology.  If existing cash and cash equivalents areinsufficient to satisfy our liquidity requirements, we may seek to sell additionalequity or debt securities.  If additionalfunds are raised through the issuance of debt or equity securities, thesesecurities may have rights senior to those associated with our common stock,and they could contain covenants that would restrict our operations.

 

***NetCash Used in Operating Activities***

*** ***

Net cash used inoperating activities was $6,485,000 and $9,557,000 for the nine months endedSeptember 30, 2004 and 2005.  Netcash used for operating activities for the nine months ended September 30,2004 and 2005 was to fund our on-going research and development activities andour selling, general and administrative costs and to fund costs associated withour initial public offering.

 

***NetCash Provided (Used) by Investing Activities***

*** ***

We had no investingactivities for the nine months ended September 30, 2004 and 2005.

 

***NetCash Provided by Financing Activities***

*** ***

Net cash providedby financing activities was $8,069,000 and $5,723,000 for the nine months endedSeptember 30, 2004, and 2005.  Forthe nine months ended September 30, 2004, financing cash flows consisted of theproceeds from the issuance of common stock and warrants for the purchase ofcommon stock.  For the nine months endedSeptember 30, 2005, financing cash flows consisted of the proceeds fromthe issuance of $5,500,000 of our 8% convertible promissory notes and relatedcommon stock warrants and proceeds from the exercise of warrants, as discussedabove.

 

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**Off-Balance Sheet Arrangements**

 

We do not currently have,nor have we ever had, any relationships with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance or special purpose entities, which would have been established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes.  In addition,we do not engage in trading activities involving non-exchange tradedcontracts.  As such, we are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in these relationships.

 

**Risk Factors**

 

The semiconductorindustry is characterized by rapid technological change, intense competitionand cyclical market patterns which contribute to create factors that may affectour future operating result.  The riskfactors are described in the section entitled “Risk Factors” beginning onpage 8 of our prospectus dated October 26, 2005 on file with theSecurities and Exchange Commission at www.sec.gov.  Other information included in this QuarterlyReport on Form 10-Q also should be carefully considered.  The risks and uncertainties described in ourprospectus are not the only risks the Company faces.  Additional risks and uncertainties notpresently known to the Company or that the Company’s management currently deemsimmaterial also may impair its business operations.  If any of the risks described were to occur,our business, financial condition, operating results and cash flows could bematerially adversely affected.

 

**Item 3.    Quantitative and Qualitative Disclosures about Market Risk**

 

Our exposure to marketrisk is confined to our cash equivalents. We have invested in high-quality financial instruments, primarily moneymarket funds, federal agency notes and asset-backed securities, which webelieve are subject to limited credit risks. The effective duration of the portfolio is less than three months, andno individual investment has an effective duration in excess of one year.  We currently do not hedge interest rateexposure.  Due to the short-term natureof our investments, we do not believe we have any material exposure to interestrate risk arising from our investments.

 

**Item 4.    Controls and Procedures**

 

*Evaluation of Disclosure Controlsand Procedures*

 

We maintain a system of disclosure controls andprocedures designed to ensure that information required to be disclosed in ourreports filed or submitted under the Securities Exchange Act of 1934, asamended (“Exchange Act”), is recorded, processed, summarized and reportedwithin the time periods specified in the SEC rules and forms.  These controls and procedures are alsodesigned to ensure that such information is accumulated and communicated to theCompany’s management, including the Chief Executive Officer (CEO) and ChiefFinancial Officer (CFO), as appropriate to allow timely decisions regardingrequired disclosure.  Internal controlsare procedures designed to provide reasonable assurance that transactions areproperly authorized; assets are safeguarded against unauthorized or improperuse; and transactions are properly recorded and reported, to permit thepreparation of our financial statements in conformity with generally acceptedaccounting principles.

 

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A control system, no matter how well designed andoperated, can provide only reasonable, not absolute, assurance that the controlsystem’s objectives will be met. Further, the design of a control system must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs.  Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerrors or mistakes.  Controls can also becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the controls.  The design of any system of controls is basedin part upon certain assumptions about the likelihood of future events, andthere can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions. Over time, controls may become inadequate because of changes inconditions or a deterioration in the degree of compliance with its policies orprocedures.  Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.  Wecontinuously evaluate our internal controls and make changes to improve them asnecessary.  Our intent is to maintain ourdisclosure controls as dynamic systems that change as conditions warrant.

 

As of the end of the period covered by this report,the Company carried out an evaluation, under the supervision and with theparticipation of Company management, including its CEO and the CFO, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct.  Based upon, and as of the date ofthis evaluation, the CEO and the CFO concluded that the Company’s disclosurecontrols and procedures were not effective because of the material weaknessdescribed below.

 

*Changes in Internal Control OverFinancial Reporting*

 

As described in the Company’s prospectus dated October26, 2005, in connection with its audit of our financial statements for the yearended December 31, 2004, our independent registered public accounting firmreported two conditions, which together constitute a material weakness in theinternal controls over our ability to produce financial statements free frommaterial misstatements.  A materialweakness is a control deficiency, or combination of control deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected.  Our independent registered public accountingfirm reported to our board of directors that we do not have a sufficient numberof financial personnel with adequate training and experience in accounting orfinancial reporting, and our controls do not ensure that operating expenses andstock compensation transactions are identified and recorded accurately and inthe appropriate accounting period.  Thesetwo conditions, in combination, constitute a material weakness in our internalcontrols.

 

As described in our prospectus dated October 26, 2005,our board of directors agrees that the conditions identified by our independentregistered public accounting firm constitute a material weakness.  The Company has developed a plan to addressthis material weakness that includes the addition of our new chief financialofficer and controller, as well as the performance of an assessment of ourcurrent accounting and reporting policies and procedures, assessment of our financialaccounting and reporting staff requirements, implementation of supervisoryreviews by our chief financial officer and controller, implementation of newaccounting policies and procedures, and the hiring and training of additionalfinancial accounting and reporting staff. We hired a new chief financial officer in June 2005 and a new controllerin July 2005.  In addition to this plan,our new chief financial officer and controller are assessing our system ofinternal controls over financial reporting and intend to implement and areimplementing controls designed to assure that, among other things, operatingexpenses and stock compensation transactions are identified and accuratelyrecorded.  The Company will be reviewingand testing the steps

 

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described abovethroughout fiscal 2006.  The Companybelieves that these steps will correct the material weakness described above.

 

The changes in our internal control over financialreporting during our third fiscal quarter ended September 30, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting, are described above.

 

**Part II    OtherInformation**

 

**Item 1.    LegalProceedings**

 

We are currently not aparty to any legal proceedings.

 

**Item 2.    Unregisterd Sales of Equity Securities and Use of Proceeds**

 

*Unregistered Sales of EquitySecurities*

 

During the three monthsended September 30, 2005, we issued the following equity securities in thefollowing transactions which were not registered under the Securities Act of1933:

 

1.               In July 2005, we granted options topurchase 145,000 shares of common stock at an exercise price of $6.30 per shareto various employees under our 2004 Amended and Restated Long-TermIncentive Plan.(1)

 

2.               In July 2005, we issued 3,334 sharesof common stock to two investors, which represented in writing that theinvestors were accredited investors, at a price of $2.25 per share upon theexercise of warrants, resulting in gross proceeds of $7,501.50.(2)

 

3.               In July 2005, we issued 4,356 sharesof common stock to an agent of an investment banking firm, which acted as aselling agent in a private placement, at a price of $8.25 per share uponexercise of warrants, resulting in gross proceeds of $35,937.(3)

 

4.               In August 2005, we granted optionsto purchase 103,667 shares of common stock at an exercise price of $6.30 pershare to various employees under our 2004 Amended and Restated Long-TermIncentive Plan.(1)

 

5.               In August 2005, we issued warrantsto purchase 80,000 shares of our common stock to 17 individuals who werenon-employees of MathStar but who were employees of Valley Technologies, Inc.for services rendered and to be rendered at an exercise price of $6.30 pershare.(3)

 

6.               In September 2005, we issued 1,667 sharesof common stock to an investor, which represented in writing that the investorwas an accredited investor, at a price of $2.25 per share upon the exercise ofwarrants, resulting in gross proceeds of $3,750.75.(2)

 

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(1)          The issuance of stock options andwarrants to our employees, our director and individual consultants and advisorsand the issuance of shares of common stock to employees or former employeesupon their exercise of stock options described in these paragraphs were made inreliance upon the exemption provided by Rule 701 under the Securities Act.

 

(2)          The sales of securities described inthese paragraphs were made to accredited investors in reliance on the exemptionprovided by Rule 506 of Regulation D under the Securities Act.

 

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(3)          The sales of securities described inthese paragraphs were made in reliance upon the exemption provided bySection 4(2) of the Securities Act.

 

The purchasers ofsecurities described above represented to us in written subscription agreementsor other written agreements that, among other things, they acquired thesecurities for their own account and not with a view to any distributionthereof to the public.  The certificatesevidencing the securities described above bear legends providing that theshares are not to be offered, sold or transferred other than pursuant to aneffective registration statement under the Securities Act or an exemption fromsuch registration requirements.

 

*Initial Public Offering and Useof Proceeds*

 

On November 1, 2005, wesold 4,000,000 shares of our common stock at $6.00 per share in our initialpublic offering (IPO).  Feltl andCompany, which is the underwriter of our IPO, has an option until December 9,2005 to purchase up to 600,000 additional shares to cover over-allotments.  Our net proceeds in the IPO totaledapproximately $22.1 million.  Inconnection with the IPO, we granted warrants to the underwriter to purchase400,000 shares of our common stock at an exercise price of $7.20 pershare.  The warrants become exercisableon October 27, 2006 and expire on October 26, 2010.

 

We intend to use the netproceeds of the IPO as follows:

•                  to fund the research and development ofour FPOA chip;

•                  to fund the expansion of our sales forceand marketing efforts;

•                  to repay our 8% convertible promissorynotes (to the extent they are not converted into shares of our common stock atthe option of the holders);

•                  to repay our revolving line of creditfrom a commercial bank; and

•                  for general working capital purposes.

 

Pending the usesdescribed above, we have invested the net proceeds of the IPO in short- tomedium-term, investment-grade, interest-bearing securities.

 

**Item 3.    Defaults Upon Senior Securities**

 

None.

 

**Item 4.    Submission of Matters to a Vote of Security HoldersNone.**

 

None.

 

**Item 5.    OtherInformation**

 

None.

 

**Item 6.    Exhibits**

 

The exhibits aredescribed on the Exhibit Index to this Quarterly Report on Form 10-Q.

 

17

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** **

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                         | Mathstar, Inc. |
|------------------------------|----------------|
|                         | (Registrant)   |
|                         |           |   |
|                         |           |   |
| Date: November 22, 2005 | By:            | /s/ James W. Cruckshank |   |
|                         |           | James W. Cruckshank |
|                         |           | Vice President of Administration and |
|                         |           | Chief Financial Officer |
|                         |           | (Principal Financial Officer and Principal |
|                         |           | Accounting Officer) |

 

18

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                | ** ** | **Page** |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| 3.1                  |       | Certificate of  Incorporation of MathStar, Inc. (incorporated by reference to  Exhibit 3.1 to the Registration Statement on Form S-1 filed  by MathStar, Inc. with the Securities and Exchange Commission (“SEC”) on  August 3, 2005 (File No. 333-127164) (the “Registration  Statement”)). |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 3.2                  |       | By-laws of  MathStar, Inc. (incorporated by reference to Exhibit 3.2 to the  Registration Statement).                                                                                                                                                                                                                           |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 4.1                  |       | Form of common stock  certificate of MathStar, Inc. (incorporated by reference to  Exhibit 4.1 to the Registration Statement).                                                                                                                                                                                                  |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 10.1                 |       | First Amendment to the  Standard Commercial Lease dated as of July 22, 2005 by and between  Parkway Point Joint Venture and MathStar, Inc. (incorporated by reference  to Exhibit 10.11 to the Registration Statement).                                                                                                    |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 10.2                 |       | Schedule of Executive  Officer Compensation and Director Compensation for 2005 (incorporated by  reference to Exhibit 10.15 to Amendment No. 2 to the Registration  Statement on Form S-1 filed by MathStar, Inc. with the SEC on  September 29, 2005 (File No. 333-127164)).*                                   |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 10.3                 |       | Form of Non-Statutory  Stock Option Agreement evidencing options granted and to be granted to the  non-employee directors of MathStar, Inc. as described in Exhibit 10.2 (filed  herewith electronically).*                                                                                                                               |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 10.4                 |       | Amendment No.1 to  Strategic Partnership Agreement dated August 11, 2005 by and between  MathStar, Inc. and Valley Technologies, Inc. (incorporated by reference to  Exhibit 10.20 to Amendment No. 1 to the Registration Statement on  Form S-1 filed by MathStar, Inc. with the SEC on September 9,  2005).         |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 31.1                 |       | Certification of Chief  Executive Officer pursuant to Rules 13a-14(a)/15d-14(a) under the Securities  Exchange Act of 1934 (filed herewith electronically).                                                                                                                                                                               |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 31.2                 |       | Certification of Chief  Financial Officer pursuant to Rules 13a-14(a)/15d-14(a) under the Securities  Exchange Act of 1934 (filed herewith electronically).                                                                                                                                                                               |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 32.1                 |       | Section 1350  Certification of Chief Executive Officer (filed herewith electronically).                                                                                                                                                                                                                                                   |       |     |
|                 |       |                                                                                                                                                                                                                                                                                                                                      |       |     |
| 32.2                 |       | Section 1350  Certification of Chief Financial Officer (filed herewith electronically).                                                                                                                                                                                                                                                   |       |     |

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*              Indicates a management contract or compensatory plan orarrangement.

 

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