**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20549**

**FORM 10-K**

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**x        ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

For the Fiscal YearEnded: December 31, 2006

OR

**o        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

Commission File Number:**000-51072**

**CASCADE MICROTECH, INC.**

(Exact name of registrant as specified in its charter)

| **Oregon**                                                                   |   | **93-0856709**                             |
|------------------------------------------------------------------------------|--------|--------------------------------------------|
| (State or other  jurisdiction of incorporation or organization)              |   | (I.R.S. Employer  Identification No.)      |
|                                                                         |   |                                       |
| **2430  N.W. 206th Avenue**                                                  |   | ** **                                 |
| **Beaverton,  Oregon**                                                       |   | **97006**                                  |
| (Address of  principal executive offices)                                    |   | (Zip Code)                                 |
|                                                                         |   |                                       |
| Registrant’s  telephone number, including area code: **(503) 601-1000** |
|                                                                         |   |                                       |
| Securities Registered  pursuant to Section 12(b) of the Act:                 |   |                                       |
| Title of each  class                                                         |   | Name of each  exchange on which registered |
| **Common  Stock, $0.01 par value**                                           |   | **NASDAQ  Global Market**                  |

 

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

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Indicateby check mark if the Registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.

Yes  o  No  x

Indicateby check mark if the Registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act.

Yes  o  No  x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days:  Yes  x  No  o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-K,or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. Largeaccelerated filer  o  Acceleratedfiler  x  Non-accelerated filer  o

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

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant was$65,432,142, computed by reference to the last sales price ($11.46) as reportedby the Nasdaq National Market System, as of the last business day of theRegistrant’s most recently completed second fiscal quarter (June 30, 2006).

The number of shares outstanding of the registrant’scommon stock as of March 5, 2007 was 11,877,796 shares.

**Documents Incorporated by Reference**

Portions of the registrant’s definitive ProxyStatement for the 2007 Annual Shareholders’ Meeting are incorporated byreference into Part III.

 

 

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**CASCADEMICROTECH, INC.**

**2006 FORM10-K ANNUAL REPORT**

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

 

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**PART I**

**ITEM 1.       BUSINESS**

**Forward-LookingStatements**

This Annual Reporton Form 10-K and the documents incorporated herein by reference containforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Allstatements other than statements of historical fact made in this Annual Reporton Form 10-K are forward-looking. These statements relate to future events orour future financial performance. In some cases, you can identifyforward-looking statements by terminology, including “intend,” “could,” “may,” “will,”“should,” “expect,” “plan,” “anticipate,” “believe,” “estimate” “predict,” “potential,”“future” or “continue,” the negative of these terms or other comparableterminology. These statements are not guarantees of future performance andinvolve risks and uncertainties that are difficult to predict. Therefore,actual outcomes or results may differ materially from those expressed orimplied in such forward-looking statements. In evaluating these statements, youshould specifically consider various factors, including the risks identified inItem 1A below and from time to time in our other filings with the Securitiesand Exchange Commission. We do not intend to update any of the forward-lookingstatements after the date of this document to conform them to actual results orto changes in our expectations.

**Overview**

We design, develop and manufacture advanced waferprobing solutions for the electrical measurement of high performance chips. Wedesign, manufacture and assemble our products in Beaverton, Oregon, with globalsales, service and support centers in North America, Europe, Japan, Taiwan,China and Singapore. We were incorporated and introduced our first commercialproducts in 1984.

Our products include engineering probe stations,analytical probes, production probe cards, application software and services.Engineering probe stations address the need for precise and accuratemeasurement of semiconductor electrical characteristics during chip design orwhen optimizing the chip fabrication process. Our engineering probe stationsare highly configurable and are typically sold with various accessories,including our analytical probes and application software, as well asaccessories from third parties. Also, we design and build custom engineeringprobe stations to address the specific requirements of our customers.Analytical probes are used as consumable components of our engineering probestations. Our production probe cards are designed and sold for production testapplications, ranging from very low current parametric testing tosophisticated, high speed radio frequency testing. We refer to analyticalprobes and production probe cards as consumables, as they are routinelyreplaced during the testing process. We also generate revenue through the saleof service contracts to our customers.

To date, we have derived the majority of our revenuefrom the sale of our engineering probe stations, and we expect to continue todo so for the next few years. Our production probe card revenue, however, hasincreased as a percentage of total revenues in 2006 as compared to 2005 and weexpect that trend to continue in 2007.

# **Where You Can Find More Information**

Wefile annual, quarterly and current reports, proxy statements and other informationwith the Securities and Exchange Commission (“SEC”) under the SecuritiesExchange Act of 1934 as amended (the “Exchange Act”). You can inspect and copyour reports, proxy statements, and other information filed with the SEC at theSEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Pleasecall the SEC at 1-800-SEC-0330 for further information on the Public ReferenceRoom. The SEC maintains an Internet Web site at http://www.sec.gov where youcan obtain some of our SEC filings. In addition, you can inspect our reports,proxy materials and other information at the offices of the Nasdaq Stock Marketat 1735 K Street NW, Washington D.C. 20006. We also make available free ofcharge on our website at www.cascademicrotech.com our annual report on Form10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, andamendments to those reports 

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filedor furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon asreasonably practicable after they are filed electronically with theSEC. You can also obtain copies of these reports by contacting InvestorRelations at 503-601-1000.

**Industry Background**

During the last decade, growth in the computer,telecommunications, consumer and industrial electronics markets has increaseddemand for chips. The Semiconductor Industry Association estimates thatworldwide semiconductor sales totaled $248 billion in 2006 and areexpected to grow to $309 billion in 2008. To reduce the cost and increasethe performance of electronic products, chips have become smaller and fasterand incorporate greater levels of functionality at a lower price. Advancementsin manufacturing technologies, such as smaller chip elements, new materials andlarger wafer sizes have permitted manufacturers to meet these requirements.However, these advancements in chip manufacturing technologies have led toincreasing challenges in the design, manufacturing and testing of chips.

Chips are measured and tested multiple timesthroughout the design and manufacturing process to ensure the integrity of thechip design and the quality of the manufacturing process. Chip testing thatoccurs during design or in support of production is referred to as engineeringtest. Chip testing that occurs during manufacturing is referred to as productiontest. Engineering test involves performing a wide variety of highly precisemeasurements during chip research and development activities on a low volume ofchips. Production test, in contrast, involves performing a targeted set oftests at a rapid rate on a high volume of chips.

Our engineering products business and operatingresults depend in significant part on the level of capital expenditures relatedto semiconductor research and development, which, in turn, depends upon currentand anticipated market demand for chips. Historically, the semiconductorindustry has been highly cyclical with recurring periods of over-supply, whichhas often resulted in a reduction in demand for our products. While ourfinancial results are impacted by cycles within the semiconductor industry, webelieve our business cycles are typically less pronounced than those of othersemiconductor equipment companies. We believe this is due to our greaterreliance on our customers’ research and development capital spending and usageof test consumables rather than on our customers’ spending to increaseproduction capacity. Capital spending aimed at increasing production capacityis one of the first areas in which most semiconductor manufacturers reducespending in an industry downturn.

**Products**

We design, manufacture and sell multiple productlines, including engineering probe stations, analytical probes, productionprobe cards, application software and various services. An engineering probestation is used in conjunction with our application software and analyticalprobes to test chips in wafer form, together forming an engineering probingsystem. Analytical probes electrically connect test equipment to the chipsunder test and are sold as consumable components of, and are mounted into,engineering probe stations.

Engineering probing systems are required in thedevelopment of new generations of chip processes and designs, and we expectthat the demand for engineering probing systems will continue to growapproximately at the rate of worldwide semiconductor revenues. The processdevelopment complexities and costs have continually increased as eachgeneration of semiconductor process has required the integration of more layersof smaller chip elements incorporating a longer list of new materials.Engineering probing systems are a basic tool for characterizing and verifyingthe electrical performance, reliability and repeatability of the new chipelements.

*EngineeringProbe Stations.*  Weoffer engineering probe stations for 300mm, 200mm and 150mm or smaller wafersizes. Engineering probe stations are highly configurable depending upon thesize and type of wafer, the particular characteristics of the chip that thecustomer is testing, the required measurements, the temperatures at which thechip is tested and the test equipment that the customer is using. Ourengineering probe stations are available in either manual or semiautomatic 

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versions. We also offer many probe stationaccessories, including thermal control systems, special cables and connectors,microscopes, lasers, cameras and other items.

300mm wafer technology more than doubles the availablearea on a wafer, increasing the number of chips per wafer and reducing per unitmanufacturing costs compared to 200mm wafers. While many industry players continue to ramp up 300mm wafer volumes,high conversion costs combined with continued process developments on 200mmwafers continue to make sales of our non-300mm probing systems an importantcomponent of our revenue stream for the foreseeable future.

We also offer our Pureline option for our 200mm and300mm probe stations. Pureline extends the low-current and low-voltagemeasurement capabilities of these stations, thus extending our performance andtechnology lead compared to competitors’ stations.

We also offer our eVue microscope for our 300mm and200mm probe station families, which is a high-performance digital microscopewith advanced and unique navigation and probing-specific features. eVue enablesus to address and differentiate our offerings in new application segmentswithin engineering wafer probing. One of our stated growth strategies is towork with strategic partners to deliver new solutions, and the eVue microscopeis the result of one such relationship. During the fourth quarter of 2006, weacquired certain assets related to the eVue microscope technology from ourstrategic partner in a transaction which was accounted for as a businessacquisition.

In addition, we offer our L-Series platform, which isour first standard product line for life sciences applications. For severalyears biological researchers have been one of the niche groups using ourengineering probe stations. These customers require sophisticated microscopy,sample environment control, electrical probing and mechanical manipulators. TheL-Series adds to these capabilities microfluidic ports for delivery of precisequantities of liquids for microfluidics research.

*AnalyticalProbes.*  Weoffer over 50 different analytical probe models primarily for engineering test.The newer Infinity series probes are designed with unique probe tips derivedfrom our proprietary lithographic manufacturing technology, and offerexceptional electrical contact on aluminum and copper pads. While ouranalytical probes are used primarily for engineering test, several of ouranalytical probes are also used in production testing of some high-frequencydevices. We continue to add new models of analytical probes that address higherfrequency and higher complexity measurements.

*ApplicationSoftware.*  Ourproprietary WinCal2006 software is embedded in stations sold to customers andwas specifically designed to facilitate and improve the user’s productivityduring set-up, calibration and data-logging to perform sophisticated highfrequency measurements accurately and reliably.

*Services.*  In addition to routineinstallation services at the time of sale, we offer services to enable ourcustomers to maintain and more effectively utilize our equipment, probes andsoftware and to enhance our customer relationships.

*Production Probe Cards.* Thefastest growing segment of our business is our production probe cards, alsoknown as Pyramid probe cards. A probe card temporarily connects one or morechips on a wafer under test to a production tester. Probe cards are customizedfor each new chip type and physically wear out during usage in productiontesting. Depending upon the test environment, production probe cards may lastfor several hundred thousand to roughly 1 to 2 million contact cycles.Production card sales are driven by production unit volumes of the IC’s beingtested.

One of our stated growth strategies is to grow thesales of consumables. In 2006, our probe card revenues were up 68% over 2005,comprising approximately 20% of total 2006 revenue. We expect the growth inproduction cards to continue during 2007.

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As chip makers continue to decrease the cost offabricating chip elements, production test departments must similarly reducechip test costs. A common strategy today is to increase the number of chipstested simultaneously, or parallel test. At the production wafer probe stage,memory chips are typically tested 64 to 200 at a time. Comparatively, logic andmixed-signal chips are typically tested 2 to 8 at a time due to the highernumber of connections per chip, increased test complexities, and in many cases,lower unit volumes. We focus our production probe card applications exclusivelyon logic and mixed-signal chip testing.

The value propositions driving our Pyramid Probegrowth are several unique advantages that reduce the cost of productiontesting. First, Pyramid Probes provide a solid solution for decreased testcosts through increased parallelism in logic test, an application that hasbecome increasingly problematic for conventional cantilever probe cards onwirebonded chips. Second, for smaller and thinner chip pads Pyramid providesconsistent electrical contact with less pad damage, especially for chips withlow-k dielectrics or requiring higher reliability. Third, the cost of ownershipof Pyramid cards is often lower than for conventional cards. Fourth, for RF orwireless chip applications, Pyramid technology allows test speeds ranging towell above 20 GHz, which is many times the electrical performance of any otherproduction probe card. Other benefits include superior electrical contact, lessprobe card maintenance, and less tester downtime for probe cleaning or repair.

The chips tested by Pyramid Probe cards wereoriginally limited to mostly high-speed communications chips and wireless chips,where testing benefited from the unique electrical performance. Pyramid salesfor chips used in wireless and RF applications, such as cellular phones,wireless LAN or Bluetooth products, continue to increase due to the growth ofthose end applications as well as the trend to more thoroughly test these chipsat the wafer level before assembling them into more expensive modules. Theother major Pyramid application today is parallel test of wirebonded logicchips for a wide range of end applications. Such chips include variousmicrocontrollers, digital signal processors, data converters, power managementchips, application-specific standard products (“ASSPs”) and others.

**Customers and Geographic Revenue**

Our products are used by semiconductor manufacturers,test subcontractors, research organizations and designers. Fablesssemiconductor suppliers do not manufacture their own semiconductors but theypurchase our analytical probes and engineering probe stations for research anddevelopment and purchase, or direct their foundries to purchase, our PyramidProbe cards to test chips manufactured for them. We have built strongrelationships with our customers through frequent interactions over the past20 years. To foster stronger customer relationships, we conduct analysesfor the needs of our customers’ new labs or products, seminars on topics suchas measurement techniques and proactive service calls. This close interactionhas helped us build a consistently loyal customer base. More than 800 customerspurchased our products in 2006. Our top 20 end-user customers during 2006 were:Advanced Micro Devices, Avago, Broadcom, Chartered Semiconductor, Fujitsu,Hitachi, IBM, Infineon, Intel, Micron Technology, Nanya Technology, Philips, RFMicro Devices, Samsung, Spansion, ST Microelectronics, Taiwan SemiconductorManufacturing Company, Texas Instruments, Toshiba and United Microelectronics.

We believe our customers consider timely customerservice and support to be an important aspect of our relationship. Ourengineering probe stations are installed at customer sites either by us, ourmanufacturers’ representatives or our distributors, depending on the complexityof the installation and the customer’s geographic location. We assist ourcustomers in the selection, integration and use of our products by providingengineering application support. We also provide worldwide on-site training,seminars and telephone support. Our manufacturers’ representatives anddistributors provide additional service and support.

In 2006, 2005 and 2004, no single customer accountedfor 10% or more of our total revenues. Our top 10 customers accounted forapproximately 35%, 33% and 34% of our total revenue in each of 2006, 2005 and2004, respectively.

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International sales accounted for more than 50% of ourtotal revenue in each of 2006, 2005 and 2004. One foreign country, Japan, had revenues that totaled 10% or more of ourtotal revenues in 2006 and two foreign countries, Japan and Taiwan, hadrevenues that totaled 10% or more of our total revenues in 2005 and 2004.  Geographic revenue was as follows (inthousands):
|               | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                          | 32,220     |   | $ | 23,877 |   | $ | 24,762 |   |
| Japan         |       | 14,239                                     |       | 15,085 |   | 14,909 |   |
| Taiwan        |       | 6,856                                      |       | 7,612 |   | 6,853 |   |
| Other         |       | 31,537                                     |       | 27,063 |   | 17,891 |   |
|          |       | $                                          | 84,852     |   | $ | 73,637 |   | $ | 64,415 |   |

 

**Segments**

The segment data below is presented in the same mannerthat management organizes the segments for assessing certain performancetrends. Our Chief Operating Decision Maker monitors the revenue streams of theengineering products division (“EPD”) and the pyramid products division (“PPD”).

The following table summarizes revenue for each of ourbusiness segments. We do not track our assets on a segment level, and,accordingly, that information is not provided (in thousands):
| Year Ended December 31, | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| External revenue  from EPD             |       | $        | 67,969     |     | $          | 63,566   |       | $ | 58,467 |   |
| External revenue  from PPD             |       | 16,883   |       | 10,071   |       | 5,948    |       |
|                                   |       | $        | 84,852     |     | $          | 73,637   |       | $ | 64,415 |   |

 

We are not able to provide revenue by product line orgroup of similar products within a division as it would be impracticable to doso.

**Technology**

We are a leading innovator in developing electricalmeasurement, or metrology, and production test tools. One of our stated growthstrategies is to continue to develop next-generation technologies. We havefocused our research and development efforts on enabling our customers to takemore precise electrical measurements in less time, on smaller and more densedevices, and with more robustness. Our core technologies include:

·                  *Broadband/High-Frequency/HighSpeed Interconnects and Probing.*  In 1983, our founders created the firstmicrowave analytical probes that enabled the first on-wafer 18 GHz measurementsand accelerated the commercialization of gallium arsenide chips. We use andmaintain a wide variety of design, verification, fabrication and calibrationtechnologies for high-frequency probes and interconnections. For example, wehave developed a complete library of high-frequency circuit elements for ourPyramid probe layouts, similar to passive element libraries for chip foundries.We believe that these technologies provide a competitive advantage by allowingus to more effectively design and commercialize production probe cards andanalytical probes.

·                  *Precise Low-LevelMeasurements.*  In1993, we were first to commercialize a shielded probe station utilizing ourpatented MicroChamber technology that increased thermal measurementproductivity by 10 times and current measurement resolutions by 1,000 times.Many of our engineering probe stations feature MicroChambers, which ensure adark, electrically noise-free measurement environment to enable low-currentmeasurements over a wide thermal range. Our engineering probe stations alsoincorporate our proprietary low-noise thermal chuck technologies that increasemeasurement integrity and reduce the time required to take precisemeasurements. These features, in turn, increase the number of chips that can betested or measured in a given amount of time. During 2005 we introduced ourPureline option, which implements our latest probe station technologies forimproved low-current and low-voltage measurements.

·                  *Microfabrication.*  Since 1990, we have shippedproducts that utilize our proprietary lithographic manufacturing processes fordepositing, lithographic patterning, etching and 

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plating probe structures on flexible substrates thatare similar to the processes used in making chips. Our proprietary Pyramidtechnology has been under development since 1992 and continues to evolve andimprove. At the center of a Pyramid probe card, tester connections converge onthe chips under test through our unique, lithographically defined microscopicprobe tips and electrical interconnection wiring. We print the patented probetips and interconnects on a flexible substrate in much the same manner as chipsor circuit boards are printed, but with our unique materials and probe designs.Our processing continues to mature and evolve, enabling faster delivery times,larger probe areas, smaller tip dimensions and interconnects, and wider testtemperature ranges. As chip elements continue to shrink, we expect to be ableto scale and evolve our lithographic processes to continue to meet ourcustomers’ requirements.

**Sales and Marketing**

We sell our engineering probe stations, analyticalprobes and production probe cards through a combination of manufacturers’representatives, distributors and direct sales people. Manufacturers’representatives are independent third parties that agree to sell our productsat our prices and on terms set by us, in return for a commission based onsales. We typically use manufacturers’ representatives in areas that we believerequire greater levels of customer support than we can deliver from our salesoffices.  Distributors purchase ourproducts and resell them at prices and upon terms set by the particulardistributor. We typically use distributors where local regulations or businesscustoms require local stocking of service parts, more immediate service supportor other local services. Finally, our direct sales force is made up of oursalaried employees.

In North America and Asia, excluding Japan, Singaporeand Malaysia, we sell our products through manufacturers’ representatives and adirect sales force. In Japan, we sell through Cascade Microtech Japan, K.K.,our direct sales and service subsidiary. In Singapore and Malaysia, we sellthrough our branch office, Cascade Microtech Singapore. During 2006, weestablished direct sales offices in China and Taiwan. In Europe, we primarilysell through distributors and manufacturers’ representatives managed by CascadeMicrotech Europe, Ltd., our direct sales and service subsidiary in theUnited Kingdom. We also sell certain products directly in Germany, Austria,Switzerland, France, the Benelux countries, Italy and Spain. In othercountries, we typically sell through manufacturers representatives ordistributors. Our sales managers oversee and manage these worldwide salesactivities.

We work closely with our customers to select the mostappropriate product or to configure a custom solution to best fit theirapplications. Sales of our engineering test solutions require significantinteraction with our customers’ engineering labs and knowledge of their productdevelopment schedules and systems, as well as on-site demonstration capability.We also may assist our customers in the design requirements for their productsto enhance testability. Sales of our production test solutions require significantinteraction with customer production test managers, knowledge of their specificproduct details and hands-on application support, particularly for newcustomers. Our production customers generally undertake an extensive evaluationof new probe technology before adoption. Our sales managers are experiencedsales professionals with in-depth technical training, customer knowledge andindustry expertise. The technical sophistication of our products requiressubstantial training for our manufacturers’ representatives, distributors andsales staff. We devote considerable effort and resources to developing a highlytrained sales force that is responsive to our customers’ changing needs.

We focus our marketing efforts on building awarenessof our products among designers and manufacturers of complex semiconductors. Wemarket our products and capabilities by participating in trade shows, providingproduct and technical information in print and on our website, hostingtechnical and product seminars, advertising in trade publications and usingdirect mailings. In addition, our marketing staff performs market research andproduct planning. We also participate in joint sales and marketing activitieswith complementary equipment and software vendors to offer our customerscomplete test solutions. These relationships benefit us because they can leadto broader awareness and increased sales of our products.

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**Research and Development**

Our industry is subject to rapid technological changeand new product introductions and improvements. Our continued investment inresearch and development and timely introduction of new products and servicesis critical to maintaining and improving our competitive position. Our growthdepends upon our ability to rapidly develop new products that enable customersto improve their electrical, optical and mechanical measurements and increasetheir productivity. As a result, we expect to continue to devote substantialresources to research and development. Our research and development expenseswere $8.9 million in 2006, $7.0 million in 2005 and $5.7 million in 2004.We received reimbursements of $94,000 in 2004 for work on a joint project. Wedid not expend material amounts on customer-sponsored research and developmentin 2006, 2005 or 2004. In addition, we do not currently have any agreementswith third parties for joint research and development projects. We arecurrently devoting substantial resources to projects such as releasing newPyramid Probe products, developing new Pyramid Probe manufacturing processes,developing faster, higher- accuracy analytical probes and enhancing thefunctionality of our engineering probe stations. At December 31, 2006, weemployed 56 research and development engineers. We conduct research anddevelopment for all of our product lines at our Beaverton, Oregon facilities.

**Manufacturing and Assembly**

Our manufacturing and assembly operations consist ofthe production of highly complex and sophisticated components and assemblies,some of which are customized to meet customers’ needs and specifications. Weperform nearly all of our manufacturing and assembly in Beaverton, Oregon atour manufacturing facility within our headquarters building, at our PyramidProbe microfabrication and assembly facility and at our machine shop. Ourmicrofabrication facility includes a 10,000 square foot clean room, which weare in the process of expanding to approximately 16,000 square feet to increaseour manufacturing capacity for probe cards. Our manufacturing strategy is topurchase components from vendors to the extent possible. However, wemanufacture key components that we deem to be proprietary or that provide uswith a competitive advantage. We depend on limited source suppliers for somematerials, components and subassemblies used in our products.

Our product design and manufacturing processactivities emphasize accurate electrical measurements, precise and reliablemechanical components and assemblies, and compliance with industry andgovernmental safety requirements. We prototype and test our new standardproduct designs and components to ensure high electrical signal integrity,mechanical accuracy and safety. In our manufacturing operations, we performelectrical, mechanical and chemical tests and use statistical process controlmethods, internally developed manufacturing information systems and inspectionsof purchased components and products to monitor our product quality throughoutthe various stages of our manufacturing process.

We have the ability toexpand the capacity of our probe card microfabrication facility throughadditional equipment and headcount to about $40 million annually based on ourcurrent product mix and facility. We are currently using approximately 50% of thefacility’s potential capacity. Once the expansion of our clean room iscomplete and all necessary equipment is installed, which we anticipate to beduring 2008, our capacity will be approximately $60 million with our currentprobe card mix. Our probe card growth rate also relies on our ability torecruit and train enough top-quality people for product fulfillment and fieldsupport. In 2006, we stepped up our recruiting efforts and expect to continueto recruit during 2007.

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**Competition**

The markets for engineering probe stations, analyticalprobes and production probe cards are highly competitive. We anticipate thatthe markets for our products will continually evolve and be subject to rapidtechnological change.

*EngineeringProbe Stations.*  Ourprimary competitor in the engineering probe station market is Suss MicroTec AG(Karl Suss), but we also compete with Vector Semiconductor Co. Ltd.,Lucas/Signatone Corporation, The Micromanipulator Company Inc. and WentworthLaboratories Inc., among others. We believe that the primary competitivefactors in the engineering probe station market are measurement accuracy andversatility, measurement speed, automation features, completeness of themeasurement solutions, applications support, delivery time and price. Wecompete favorably with respect to these factors, except in small niche marketswhere customers seek solutions that provide highly specialized testingenvironments.

*AnalyticalProbes.*  Ourprimary competitor in the analytical probe market is GGB Industries Inc. Webelieve that the primary competitive factors in this market are breadth ofprobe types, probe frequency and electrical signal integrity, contact integrityand the related cleaning required, calibration support, applications support,delivery time and price. We compete favorably with respect to these factors,except in small niche markets where customers seek solutions that providehighly specialized testing environments.

*ProductionProbe Cards.*  Competitionin the production probe card market is fragmented and characterized by manysuppliers offering products based on differing technologies. Our Pyramid Probecards compete with product offerings of other probe card vendors includingFeinmetall GmbH, FormFactor Inc., GGB Industries Inc., Japan ElectronicMaterials Corporation, Mesatronics S.A., Micronics Japan Company, Ltd.,MicroProbe Inc., Micro Square Technology Inc., PHICOM Corporation,SV Probe Inc., Technoprobe S.r.l., Tokyo Cathode Laboratory Company Ltd.,Wentworth Laboratories Inc. and others. At least five probe card vendors,FormFactor Inc., Japan Electronic Materials Corporation, Mesatronics S.A.,Micronics Japan Company, Ltd. and PHICOM Corporation, are also offering probecards built using types of lithographic patterning. The high capital investmentand other costs associated with the development of lithographically definedprobe cards and the time and high cost of customer evaluation, represent asignificant barrier to entry for this type of technology. We believe that theprimary competitive factors in the production probe market depend upon the typeof chip being tested, but include customer service, delivery time, price, probecard lifetime, chip damage, application support, probe tip touch-down accuracy,speed and frequency of the probe card, number of chips contacted in parallel,number of probe tips and their layout, signal integrity, and frequency andeffectiveness of cleaning required. We believe that we generally competefavorably in probe cards for high frequencies and high-speed signals, and inprobe cards for parallel testing of chips with densely-packed bond pads. Wegenerally do not compete in applications that require very large probe areas,such as memory test, or that require delivery times of less than two weeks, orthat require very high currents, such as some microprocessors.

**Intellectual Property**

Our success in large part depends on our proprietarytechnology. We do not depend on any one individual patent, instead relying onintellectual property, including patents and trade secrets, covering electricalmeasurement reliability and integrity, electrical shielding and the PyramidProbe contact structure and production process. As of December 31, 2006, we had104 issued patents and 56 pending patent applications in the U.S. and 63 issuedforeign patents and 72 pending foreign patent applications. In addition, weregard certain of our processes, information and know-how that we havedeveloped and used to design and manufacture our products as proprietary tradesecrets.

One important group of our patents claims technologyrelating to electrical shielding and other inventions required to measureextremely small signals on wafers. Most of these U.S. patents will expirebetween 2012 and 2015. Another important group of our patents claims designsand construction methods for probe tips on Pyramid probes. These patents willexpire beginning in 2016.

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Our policy is to seek patents where appropriate oninventions involving new products and improvements to existing products as partof our ongoing engineering and research and development activities. We cannotassure you that any of our pending patent applications will be approved, thatwe will develop additional proprietary technology that is patentable, that anypatents owned by or issued to us will provide us with competitive advantages orthat these patents will not be challenged by third parties. Furthermore, therecan be no assurance that third parties will not design around our patents.

We also use certain patented technology of thirdparties in the manufacture of our products pursuant to license agreements.Pursuant to an agreement with Micronics Japan Company Ltd. andHewlett-Packard Japan Ltd. (now Agilent Technologies), our subsidiary,Cascade Microtech Japan, Inc. and its affiliates, have been granted anon-exclusive worldwide license to make, have made, use, lease, sell, orotherwise transfer certain products that make use of patented technologyrelating to electric circuit measurement apparatuses. In exchange for therights granted under the license, we pay royalties to Micronics Japan Company Ltd.and Agilent Technologies based on the number of products sold or leased. Theseroyalties totaled $7,500 in 2006. Our license will expire upon the expirationof the patent covering the licensed technology, which will occur in June 2013.

**Seasonality**

In the past, our business has experienced seasonality.Typically, our revenue has been lower in our fiscal first quarter than in ourfiscal fourth quarter preceding it. However, revenue in the first quarter of2006 was greater than the revenue in the fourth quarter of 2005 due to delaysin closing certain orders in the fourth quarter of 2005. In addition, as istypical in our industry, we recognize a large percentage of our quarterlyrevenue in the last month of the quarter.

**Employees**

As of December 31, 2006, we had a total of 366employees: 56 in engineering and research and development; 206 inmanufacturing; and 104 in selling, general and administrative functions. Ofthese employees, 309 were located in the U.S., 18 were in Japan, 15 were inTaiwan and 24 were in other countries. Many of our employees are highly skilledand our future performance depends largely on our ability to continue toattract, train and retain qualified technical, sales, service, marketing andmanagerial personnel. None of our employees is subject to a collectivebargaining agreement. We have not experienced any work stoppages and considerour relations with our employees to be good.

**Environmental Matters**

As part of our manufacturing operations, we havehandled and continue to handle materials that are considered hazardous or toxicunder federal, state and local laws and regulations, and we are subject toenvironmental laws and regulations related to the use, storage, discharge,disposal and human exposure to such materials. We believe we are in materialcompliance with the environmental laws and regulations applicable to theconduct of our business and operations. However, there can be no assurance thatviolations of environmental laws or regulations will not occur in the future asa result of human error, equipment failure or other causes. The risk of arelease of hazardous or toxic materials cannot be completely eliminated, and ifsuch a release occurs, we could be held financially responsible for the cleanupor other consequences of the release. We are not aware of any releases at anyof our facilities that could reasonably be expected to result in any materialliabilities to us.

In addition, the European Parliament has finalized theRestriction on Use of Hazardous Substances Directive, or RoHS Directive, whichrestricts the sale of new electrical and electronic equipment containingcertain hazardous substances, including lead. Although a majority of ourproducts are exempt from this directive, we have modified our manufacturing processes,eliminating lead from products we put on the market as required by the RoHSDirective.

In addition, China has implemented a RoHS Directivethat is expected to become effective in 2007. This Directive is similar to theEuropean RoHS Directive, except for the fact that our products will not beexempt. Based on current information available, we believe we will be able tocomply with the China RoHS Directive. However, if we do not comply with thisDirective, we may suffer a loss of revenue, be unable to sell in certainmarkets or countries and suffer competitive disadvantage.

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TheEuropean Parliament has also recently finalized the Waste Electrical andElectronic Equipment Directive, or WEEE Directive, which makes producers ofelectrical and electronic equipment financially responsible for specifiedcollection, recycling, treatment and disposal of past and future coveredproducts. As a producer of industrial electronic equipment, we may incurfinancial responsibility for the collection, recycling, treatment or disposalof products covered under the WEEE Directive. Our products have been labeled inaccordance with the WEEE Directive since before August 13, 2005, the WEEEimplementation date. We determined the products we presently produce are exemptbecause they either meet the definition of “Large Scale Industrial Equipment,”or are passive or non-electrical accessories that do not function on their own.We have not incurred any costs or fees or penalties associated withnon-compliance. Therefore, we have some confidence that we are interpreting therules correctly. However, because the EU member states have not fullyimplemented the WEEE Directive, the nature and extent of the costs to complyand fees or penalties associated with non-compliance are still unknown at thistime. Costs to comply with the WEEE Directive and similar future legislation,if applicable, may also include legal and regulatory costs and insurance costs.We may also be required to take reserves for costs associated with compliancewith these regulations.

We aresubject to potentially conflicting and changing regulatory agendas ofpolitical, business and environmental groups and governmental prioritiesconcerning environmental laws and regulations. We may be required to incursubstantial costs to comply with current or future environmental laws orregulations, and our operations, business or financial condition could beadversely affected by such requirements.

**Backlog**

Ourbacklog consists of purchase orders we have received for products and serviceswith scheduled delivery dates that we expect to ship and deliver or performwithin the next 12 months. At December 31, 2006, our backlog was$18.0 million compared with $10.7 million at December 31, 2005.We generally ship our products within two months of receipt of a customer’spurchase order. Accordingly, we expect to deliver nearly all of ourDecember 31, 2006 backlog in 2007. Customers may cancel or delay deliveryon previously placed orders, although our standard terms and conditions includepenalties for cancellations made close to the scheduled delivery date. As aresult, the timing of the receipt of orders or the shipment of products couldhave a significant impact on our backlog at any date. In addition, asignificant portion of our revenue is generated from orders received andproducts shipped within a quarter. For this and other reasons, the amount ofbacklog at any date is not necessarily indicative of revenue in future periods.

**ITEM1A.  RISK FACTORS**

**Our operating results have fluctuated in the past and arelikely to fluctuate in the future, which could cause us to miss analystexpectations about these results and cause the trading price of our commonstock to decline.**

Ouroperating results have fluctuated in the past and are likely to continue tofluctuate. As a result, we believe that you should not rely on period-to-periodcomparisons of our financial results as an indication of our futureperformance. Factors that are likely to cause our revenue and operating resultsto fluctuate include:

·                  our geographic sales mix, product sales mix andaverage selling prices;

·                  timing, cancellation or delay of customer orders;

·                  seasonality, which has caused our first quarterrevenue typically to decline compared to our fourth quarter revenue of theprevious year;

·                  customer demand, which is influenced, in part, byconditions in the electronics and semiconductor industry, demand for productsthat use semiconductors and market acceptance of our products and those of ourcustomers;

·                  fluctuations in foreign currency exchange rates;

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·                  competition, such as competitive pressures on theprice, performance and reliability of our products, the introduction orannouncement of new products by us or our competitors and our competitors’intellectual property rights, which could prevent us from introducing productsthat compete effectively with their products;

·                  our production capacity and availability and cost ofmaterials, components and subassemblies;

·                  our ability to deliver reliable products in a timelymanner, including as a result of fluctuations in yield on some of our productlines;

·                  our customers’ decisions regarding the level andtiming of research and development spending;

·                  our product development costs, including research anddevelopment and sales and marketing expenses associated with new products orproduct enhancements and the costs of transitioning to new or enhancedproducts; and

·                  economic conditions in the United States and theworldwide markets we serve.

Forexample, a large majority of our revenue in the last five years wasderived from the research and development equipment spending of companies inthe semiconductor industry or, to a much lesser extent, various researchorganizations, including universities, that conduct research that benefits thesemiconductor industry. Our customers’ spending on research and development isroughly proportional to the customers’ overall revenues. Historically,semiconductor industry revenues have been highly cyclical. According toindustry data, the semiconductor industry has experienced four significantcyclical downturns in the 22 years from 1983 through 2005. For example,our revenue increased approximately 37% from 1999 to 2000. In contrast ourrevenue decreased approximately 29% from 2001 to 2002 and increasedapproximately 27%, 14% and 15% from 2003 to 2004, 2004 to 2005 and 2005 to2006, respectively. Given this history, there is no reason to expect that ourcustomers’ business and, therefore, their demand for our products, will be lesscyclical in the future.

If ourrevenue or operating results fall below the expectations of analysts orinvestors, the market price of our common stock could decline substantially.

**The cyclicality of the semiconductor industry affects ourfinancial results, and, as a result, we may experience reduced sales oroperating losses in a semiconductor industry downturn.**

Thesemiconductor industry is highly cyclical with recurring periods of widefluctuations in product supply and demand. From time to time, this industry hasexperienced significant downturns, often in connection with, or in anticipationof, periods of oversupply, maturing product and technology cycles, excessinventories and declines in general economic conditions. Our customers’purchase behavior in response to these cycles has been generally unpredictable.In the past, our operating results have been adversely affected by the cyclicaldownturns in the semiconductor industry.

Ourbusiness is heavily dependent on the level of research and development spendingof our customers, the volume of semiconductor production by semiconductormanufacturers, the development of new semiconductors and semiconductor designsand the overall financial strength of our customers, which, in turn, dependupon the current and anticipated market demand for semiconductors and theproducts incorporating them. Semiconductor manufacturers in particular areknown to sharply curtail their capital expenditures when confronted with anindustry downturn, such as the downturns experienced from 1996 through 1998 andfrom 2001 through the first six months of 2003. We expect that the markets forfuture generations of semiconductors will also be subject to similarfluctuations. Furthermore, some segments of the semiconductor industry mayexperience greater fluctuations than others. We may not achieve or maintain ourcurrent or prior levels of revenue growth. Any factor adversely affecting thesemiconductor industry in general, or the particular segments, regions or majorcustomers of the industry that our products target, will adversely affect ourability to generate revenue and could cause us to experience operating losses.

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**As is the case with other companies in our industry, many ofour customers defer purchasing decisions until late each quarter. As a result,we are****significantly****dependent upon the saleof our products in the third month of each quarter, and, if we do not generateenough revenue in the third month of each quarter to meet the earningsexpectations of analysts or investors, the price of our common stock coulddecline.**

As isthe case with other companies in our industry, we have historically recognizeda substantial portion of our revenue in the last month of each quarter becausemany of our customers defer purchasing decisions until late each quarter.Historically, we have often recognized more than 50% of our quarterly revenuein the third month of the quarter. We expect this trend to continue for theforeseeable future. As a result, our ability to meet the earnings expectationsof analysts depends on our ability to not only generate customer orders in thethird month of each quarter but also satisfy each of the various accountingrequirements for recognizing the revenue generated by such sales prior to theend of the quarter. Moreover, our engineering probe stations typically range inprice from $30,000 to $350,000 for a single unit, so a delay in the shipment ofeven one engineering probe station and the corresponding delay in recognitionof revenue for the sale of probe stations, can have a very large impact on ourquarterly results. If we are unable to generate a sufficient amount of salesduring the last month of the quarter or if we are unable to recognize therevenue generated by sales made during this period, we could miss the earningsexpectations of analysts or investors, which could cause the price of our commonstock to decline.

**Because we generally do not have a sufficient backlog ofunfilled orders to meet our quarterly revenue targets, revenue in any quarteris substantially dependent upon customer orders received and fulfilled in thatquarter.**

Ourrevenue is difficult to forecast because we generally do not have a sufficientbacklog of unfilled orders for our engineering probe stations, analyticalprobes and production probe cards to meet our quarterly revenue targets at thebeginning of a quarter. Historically, a significant portion of our revenue inany quarter depends upon customer orders that we receive and fulfill in thatquarter. Furthermore, because our expense levels are based in part on ourexpectations as to future revenue and, to a large extent, are fixed in theshort term, we might be unable to adjust spending in time to compensate for anyunexpected shortfall in revenue. Accordingly, any significant shortfall inrevenue in relation to our expectations and the expectations of analysts orinvestors could hurt our operating results and result in a decline in the priceof our common stock.

**We continue to devote significant effort and resources to thegrowth and development of our Pyramid Probe products, which has had, and couldcontinue to have, an adverse effect on our operating margins.**

Ourfuture growth depends, in part, on continued market adoption of, and growingdemand for, our production probe cards. Large-scale market adoption of theseproducts will depend on our ability to demonstrate the superior reliability andcost effectiveness of these products to potential customers and on thecontinued growth of the market for high-speed or complex chips. Productioncustomers are generally very risk-averse when adopting new technologies thatcould affect their production output, especially a sole source supplier such aswe are in the case of Pyramid Probes. We have devoted significant resources tothe development and growth of these products in the past, and expect to devotesignificantly more investment in the form of people and equipment during 2007.We are currently expanding our clean room space and increasing ourmanufacturing capacity from approximately $40 million based on our currentproduction mix to approximately $60 million. We expect this to be completedduring 2008. We anticipate spending approximately $10 million for capitaladditions related to this expansion and upgrade. If our production probe cardsare not adopted in the market at a rate that is sufficient to offset the costsand resources that we devote to the development and promotion of theseproducts, the future growth of our overall business and our operating marginswould be adversely affected.

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**If we do not keep pace with technological developments in thesemiconductor industry, especially the trend toward faster, smaller and lowercost chips, our revenue and operating results could suffer as potentialcustomers decide to adopt our competitors’ products.**

We mustcontinue to invest in research and development and certain manufacturingcapabilities to improve our competitive position and to meet the testing needsof our customers. Our future growth depends, in significant part, on ourability to work effectively with and anticipate the testing needs of ourcustomers and on our ability to develop and support new products and productenhancements to meet these needs on a timely and cost-effective basis. Ourcustomers’ testing needs are becoming more challenging as the semiconductorindustry continues to experience rapid technological change driven by thedemand for complex chips that have smaller element sizes and at the same timeare increasing in speed and functionality and becoming less expensive toproduce. Our customers expect that they will be able to integrate our waferprobing products into their design and production processes as soon as they aredeployed. Therefore, to meet these expectations and remain competitive, we mustcontinually design, develop and introduce on a timely basis new products andproduct enhancements with improved features. Successful product development andintroduction on a timely basis require that we:

·                  design innovative and performance-enhancing featuresthat differentiate our products from those of our competitors;

·                  identify emerging technological trends in our targetmarkets, including new engineering and production test strategies;

·                  respond effectively to technological changes orproduct announcements by others; and

·                  adjust to changing market conditions quickly andcost-effectively.

If weare unable to timely predict industry changes, or if we are unable to modifyour products on a timely basis, we might lose customers or market share, andour operating results could suffer. We cannot assure you that we willsuccessfully develop and bring new products to market in a timely andcost-effective manner, that any product enhancement or new product developed byus will gain market acceptance or that products or technologies developed byothers will not render our products or technologies obsolete or uncompetitive.

**Intense competition in the semiconductor wafer probingbusiness may reduce demand for our products and reduce our sales.**

Themarkets for our products are highly competitive, and we expect competition tocontinue in the future. We believe that our principal competitors are the majorproviders of probe stations, production probe cards and analytical probes. Ourprimary competitor in the probe station market is Suss MicroTec AG (Karl Suss),but we also compete with Vector Semiconductor Co. Ltd., Lucas/SignatoneCorporation, The Micromanipulator Company Inc., and Wentworth LaboratoriesInc., among others. Our Pyramid Probe cards compete with product offerings ofother probe card vendors including Feinmetall GmbH, FormFactor Inc., GGBIndustries Inc., Japan Electronic Materials Corporation, Mesatronics S.A.,Micronics Japan Company, Ltd., MicroProbe, Inc., Micro Square Technology Inc.,PHICOM Corporation, SV Probe, Technoprobe S.r.l., Tokyo Cathode LaboratoryCompany, Ltd., Wentworth Laboratories Inc. and others. At least five probe cardvendors, FormFactor Inc., Japan Electronic Materials Corporation,Mesatronics S.A., Micronics Japan Company, Ltd., and PHICOM Corporation,are also offering probe cards built using types of lithographic patterning. Ourprimary competitor in the analytical probe market is GGB Industries. Thesecompetitors or other potential competitors may have developed or may bedeveloping technology of which we are unaware that may render our productsuncompetitive. Some of our competitors have significantly greater financial,technical and marketing resources than we do. As a result, these competitorsmay be able to respond more quickly to new or emerging technologies and changesin customer requirements, to devote greater resources to the development,promotion and sale of their products or to deliver competitive products atlower prices. We cannot assure you that we will maintain our currentcompetitive position or that our production probe cards will achieve widespreadacceptance in the market. Finally, increased competition could result inpricing pressures, reduced sales, reduced margins or failure to 

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achieveor maintain widespread market acceptance for our products, any of which couldprevent us from growing our business.

**We obtain some of the materials, components and subassembliesused in our products from a single source or a limited group of suppliers. Ifthese suppliers are unable to provide us with these materials, components orsubassemblies in adequate quantities and on a timely basis, we may be unable tomanufacture our products or meet our customers’ needs.**

Weobtain some of the materials, components and subassemblies used in our productsfrom a single source or a limited group of suppliers. Certain of our productpurchases for 2006 were from sole source suppliers. Although we were not forcedto delay shipment of any product due to delays in 2006 related to suchsuppliers, from time to time, we may experience difficulties in obtaining thesematerials, components and subassemblies from some suppliers, especially duringperiods of high demand for semiconductor capital equipment. The manufacture ofsome of the materials, components and subassemblies that we use in ourproducts, such as thermal chucks and microscopes, is a complex process, and inthe event that we cannot obtain an adequate supply of these components, itwould be difficult and time-consuming to identify and qualify new suppliers. Ifsome of the materials used in our lithographic probe manufacturing processbecome unavailable, it would be costly and time consuming to identify andqualify new suppliers. Moreover, many of these suppliers are small companiesthat may be more susceptible to downturns in general economic conditions,thereby increasing the risks of product and shipment delays, increased costs orloss of suppliers. Finally, we do not have written agreements with any of thesesuppliers to guarantee the supply of these products.

Thedelay in shipments from, or complete loss of, any one of these suppliers couldprevent us from producing and shipping our products, resulting in delayed orlost orders for our products and damage to our customer relationships, whichwould harm our results of operations. Furthermore, a significant increase inthe price of one or more of these materials, components or subassemblies couldmaterially adversely affect our results of operations.

**We depend upon the sale of our engineering probe stations fora significant portion of our revenue, and a decline in demand for ourengineering probe stations would have a more significant impact on our revenuethan a downturn in demand for our analytical probes or production probe cards.**

Historically,we have derived a large majority of our revenue from the sale of ourengineering probe stations. We anticipate that sales of our engineering probestations will continue to represent a large majority of our revenue for thenext few years. Our business depends in large part upon continued demand incurrent markets for, and adoption in new markets of, current and futuregenerations of our engineering probe stations. In addition, while ouranalytical probes are sometimes sold to serve as components of test equipmentmanufactured by third parties, they are most often sold for use with ourengineering probe stations. Continued market adoption depends upon our abilityto increase customer awareness of the benefits of our engineering probestations and to prove their reliability and cost effectiveness.

We maybe unable to sell our engineering probe stations to existing and potentialcustomers if those customers change their chip test strategies, change theircapital equipment buying strategies or chose not to change or upgrade theirexisting test equipment. We might not be able to sustain or increase ourrevenue from sales of our engineering probe stations, particularly ifconditions in the semiconductor market deteriorate or if the market enters intoanother downturn.

Inaddition, sales of our engineering probe stations depend in part upon the levelof research and development spending in the semiconductor industry.Historically, the level of research and development spending in thesemiconductor industry has followed the overall cycles of the semiconductorindustry but at a reduced rate of growth or decline, as the case may be. If ourcustomers reduce their research and development spending or if the overalllevel of research and development spending in the semiconductor industry doesnot continue to follow the growth rate of the 

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overallsemiconductor industry, consistent with historical patterns, our revenue woulddecline, which could result in a decline in the price of our common stock.

Webelieve that we currently have a significant market share in the engineeringprobe station market. As a result, it may be difficult for us to both maintainour current level of market share and capture opportunities for growing ourmarket share, especially if the market for engineering probe stations does notcontinue to grow as we expect. If the market for engineering probe stationsdoes not continue to grow, our business may not expand, even if we aresuccessful in increasing our market share.

**We may make future acquisitions, which may be costly,difficult to integrate with our operations, divert management resources anddilute shareholder value.**

As partof our business strategy, we may make acquisitions of, or investments in,companies, products or technologies that complement our current productofferings, enhance our technical capabilities, expand our operations into newmarkets or offer other growth opportunities. If we fail to successfullyintegrate any acquired businesses, products or technologies, we would notachieve anticipated revenue and cost benefits. We may acquire companies,products or technologies in the future, which could pose risks to ouroperations including:

·                  difficulties assimilating the acquired operations,personnel, technologies or products into our company;

·                  diversion of management’s attention from our existingbusiness; and

·                  adverse effects on relationships with our existingsuppliers, customers or partners.

**We face economic, political and other risks associated withour international sales and operations, which could materially harm ouroperating results.**

Since1997, we have derived more than 50% of our annual revenue from sales outsideNorth America, primarily in Japan, other Asian countries and Europe. Oneforeign country, Japan, had revenues that totaled 10% or more of our totalrevenues in 2006 and two foreign countries, Japan and Taiwan, had revenues thattotaled 10% or more of our total revenues in 2005 and 2004. Geographic revenuewas as follows (in thousands):
|               | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                          | 32,220     |   | $ | 23,877 |   | $ | 24,762 |   |
| Japan         |       | 14,239                                     |       | 15,085 |   | 14,909 |   |
| Taiwan        |       | 6,856                                      |       | 7,612 |   | 6,853 |   |
| Other         |       | 31,537                                     |       | 27,063 |   | 17,891 |   |
|          |       | $                                          | 84,852     |   | $ | 73,637 |   | $ | 64,415 |   |

 

Weexpect international sales to continue to represent a substantial portion ofour revenue for the foreseeable future. In the past, the economic climate insome foreign markets, particularly in Asia, has quickly and dramaticallychanged, resulting in a negative effect on our operating results. For example,during the Asian economic crisis that began in 1998, we saw a 34% decline inrevenue in 1998 compared to 1997 from Asia not including Japan. We saw a 41%decrease in revenue from the same region in 2003 compared to 2001.

Currently,we maintain international offices in Europe and Asia, and we may establish newinternational offices in the future. If our gross margin from internationaloperations does not exceed the expense of establishing and maintaining ourinternational operations, our operating margins would be adversely affected.Additional risks we face in conducting business internationally include:

·                  difficulties and costs of staffing and managinginternational operations across different geographic areas;

·                  the possible lack of financial andpolitical stability in foreign countries, preventing overseas sales growth;

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·                  changes in domestic or foreign law or policy resultingin the need to comply with potentially burdensome government controls,regulations, tariffs, embargoes or export license requirements;

·                  longer payment cycles;

·                  differing and more burdensome labor regulations andpractices in Europe;

·                  the aftermath of the war in Iraq or other armedconflicts in the Middle East;

·                  the effects of sudden outbreaks of epidemics in Asia and other parts of the world; and

·                  the effects of terrorist attacks in the United Statesand any related conflicts or similar events worldwide.

Thedifferent cultures in countries where we do business often challenge us to meetor manage local expectations about how employees are hired, managed,compensated, or terminated. For example, most employees in Japan expect anorganization wherein a manager’s direct reports are younger than the manager.In Europe, governments force the severance costs of a reduction in force actionto be generally much higher than in the U.S.

Finally,there have been significant fluctuations in the exchange rates between thedollar and the currencies of countries in which we do business. While most ofour international sales have been denominated in U.S. dollars, ourinternational operating expenses have been denominated in foreign currencies.As a result, a decrease in the value of the U.S. dollar relative to the foreigncurrencies could increase the relative costs of our overseas operations, whichcould reduce our operating margins. Significant unfavorable fluctuations in theexchange rates between the U.S. dollar and foreign currencies could cause us tolower our prices and thus reduce our profitability. In addition, fluctuationsin exchange rates could cause customers to delay or cancel orders because ofthe increased cost of our products relative to those of our competitors whomanufacture in other countries. Other income (expense), net in 2006, 2005 and2004 included the following currency related gains and losses (in thousands):
|                                                        | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Gains related to  foreign currency hedges              |       | $                                          | 253,000    |   | $ | 151,000 |   | $ | 74,000 |   |
| Remeasurement related  foreign currency gains (losses) |       | 97,000                                     |       | (34,000 | ) | 132,000 |   |
|                                                        |            |                                            |            |  |  |  |  |  |  |  |

 

**We rely on independent manufacturers’ representatives anddistributors for a significant portion of our revenue, and a disruption in ourrelationship with our manufacturers’ representatives or distributors would havea material adverse effect on our revenue.**

Approximately72% of our revenue for 2006 was generated through independent manufacturers’representatives and distributors, whose activities are not within our directcontrol. In addition, in some locations, our manufacturers’ representatives anddistributors provide field service to our customers. A reduction in the salesefforts or financial viability of these manufacturers’ representatives ordistributors, or a termination of our relationship with these representativesor distributors, would have a material adverse effect on our sales, financialresults and ability to support our customers. Our manufacturers representativesand distributors are not obligated to continue selling our products, and theymay terminate their arrangements with us at any time with limited or no priornotice. If we make the business decision to terminate or modify ourrelationships with one or more of our independent manufacturers’representatives, or if a manufacturers’ representative decides to disengagefrom us, and we do not effectively and efficiently manage such a change, wecould lose sales to existing customers and fail to obtain new customers.Establishing alternative sales channels would consume substantial time andresources, decrease our revenue and increase our expenses.

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**If semiconductor manufacturers do not convert to 300mmwafers, or do not convert at the rate we anticipate, our growth andprofitability could be harmed.**

The2001 to 2003 downturn in the semiconductor industry caused various chipmanufacturers to readdress their respective strategies for converting existing200mm wafer fabrication facilities to 300mm wafer fabrication or for buildingnew 300mm wafer fabrication facilities. Some manufacturers, including some ofour customers such as Texas Instruments, Motorola and ST Microelectronicsdelayed, cancelled or postponed previously announced plans to convert to 300mmwafer fabrication. While we have since then seen an increase in theseconversion efforts, these delays have impacted demand for our 300mm probestations. We believe that the decision to convert to a 300mm wafer fabrication facilityis made by each manufacturer based upon both internal and external factors,such as:

·                  current and projected prices for semiconductors;

·                  projected price erosion for the manufacturer’sparticular semiconductors;

·                  supply and demand levels for semiconductors;

·                  overall manufacturing capacity within the manufacturer’starget market(s);

·                  the availability of funds to the manufacturer;

·                  the technology roadmap of the manufacturer; and

·                  the price and availability of equipment needed withinthe 300mm fabrication facility.

One ormore of these internal and external factors, as well as other factors,including factors that a manufacturer may choose not to disclose publicly,could impact the decision to maintain a 300mm conversion schedule, to delay theconversion schedule for a period of time or to cancel the conversion. We haveinvested significant resources to develop technology that addresses the marketfor 300mm wafers. Beginning in 2003 and continuing into early 2005, we saw anacceleration in the transition from 200mm to 300mm technology but since thenthe rate of acceleration has declined. If manufacturers delay or discontinuethe transition to 300mm wafers, or make the transition more slowly than wecurrently expect, our growth and profitability could be affected.

**There is no assurance that products recently introduced formicro-fluidics research for the life sciences industry will generate revenuesand profits.**

We have recently introduced new products formicro-fluidics research for the life sciences industry. To date there has beenno significant revenue from these products and there can be no assurance thatsignificant revenues will be achieved by this product line in the future. Inaddition, we cannot assure you that we shall bring new products for thisindustry to market in a timely and cost-effective manner and that any newproduct will gain market acceptance.

**Failure to retain key managerial, technical, and sales andmarketing personnel or to attract new key personnel could harm our business.**

Our successdepends on the continued services of our executive officers and other keymanagement, technical, and sales and marketing personnel and on our ability tocontinue to attract, retain and motivate qualified personnel. Currently, ourkey personnel include Eric Strid, our Chairman, President and Chief ExecutiveOfficer, Bruce McFadden, our Vice President, Corporate Development, WillisDamkroger, our Vice President and General Manager, Pyramid Probe Division,Steven Sipowicz, our Chief Financial Officer, John Pence, our Vice Presidentand General Manager, Engineering Products Division and K. Reed Gleason,our Vice President of Advanced Technology. Our executive officers and other keyemployees are able to exercise stock options and sell the underlying stock,which may reduce their incentive to continue their employment with us. The lossof key personnel could limit our ability to develop new products and adaptexisting products to our customers’ evolving requirements and may result inlost sales and a diversion of management resources. Furthermore, much of ourcompetitive advantage and intellectual property is based on the expertise,experience and know-how of our key personnel. We do not have employmentagreements or non-competition agreements with any of our employees except foran employment agreement with our Chief Financial Officer. To support our futuregrowth, we will need to attract and retain additional qualified management,technical 

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andsales and marketing employees. Competition for such personnel in our industryis intense, and we cannot assure you that we will be successful in attractingand retaining such personnel.

**Our customers’ evaluation processes can lead to lengthy salescycles, during which we may incur significant costs that may not result insales.**

Ourcustomers typically expend significant efforts in evaluating and qualifying ourproducts prior to placing an order, particularly for orders of engineeringprobe stations and production probe cards. This evaluation and qualificationprocess frequently results in a lengthy sales cycle, typically ranging fromthree to 12 months and sometimes longer. During the period in which ourcustomers are evaluating our products, we incur substantial sales, marketing,research and development expenses and expend significant management efforts.After completing this evaluation process, a potential customer may elect not topurchase our products. In addition, product purchases are frequently subject tounplanned processing and other delays, particularly with respect to largercustomers for which our products represent a very small percentage of theiroverall purchase activity.

Additionalfactors, some of which are partially or completely outside our control, thataffect the length of time it takes us to complete a sale, include:

·                  the efforts of our sales force;

·                  the history of previous sales to the customer;

·                  the complexity of the customer’s engineering orproduction processes;

·                  the internal technical capabilities and sophisticationof the customer; and

·                  the capital expenditure budgets of the customer.

Thelengthy and unpredictable nature of our sales cycle could result influctuations in our operating results, which could fall below the expectationsof analysts and investors for any particular period of time, and result in adecline in the price of our common stock.

**If our products contain defects, our reputation would bedamaged, and we could lose customers and revenue and incur warranty expenses.**

Thecomplexity and ongoing development of our products, as well as the inclusion inour products of components purchased from third parties, could lead to design,manufacturing or performance problems. Our products may contain defects whichcould cause our sales to decline, our reputation to be significantly damagedand our customers to be reluctant to buy our products, any or all of whichcould result in a decline in revenue, an increase in product returns, higherfield service costs, the loss of existing customers or the failure to attractnew customers. Our warranty expense totaled $573,000, $624,000 and $639,000,for 2006, 2005 and 2004, respectively. Although we are not currently seekingreimbursement from any vendors related to our warranty expense, we have in thepast, and may again in the future, seek reimbursement from certain vendors. Tothe extent that we experience additional failures of purchased components thatincrease our warranty expenses that are not reimbursed by the vendor, ourresults of operations will be adversely affected.

**If we fail to protect our proprietary technology and rights,competitors may be able to use our technologies, which would weaken ourcompetitive position and could reduce our sales.**

Oursuccess and competitive position depend in significant part on the technicallyinnovative features of our products, and, if we fail to protect our proprietaryrights, our competitors might gain access to our technology. Although we relyin part on patent, trade secret and trademark laws to protect the proprietarytechnology used in our products, our patents may be challenged by third partiesand held invalid, and any of our pending patent applications may not beapproved. Additionally, we may not be able to develop additional proprietarytechnology that is patentable. Policing unauthorized use of our products isdifficult, and we may not be able to prevent the misappropriation andunauthorized use of our technologies. Furthermore, our existing and futurepatents may not be sufficiently broad to protect our proprietary technologies,may not provide us with competitive advantages and may be circumvented by thedesigns of third parties.

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Unauthorizedparties may attempt to copy aspects of our products or to obtain and useinformation that we regard as proprietary. Others may independently develop orotherwise acquire similar or competing technologies or methods or design aroundour patents. Additionally, some of our proprietary technology cannot beeffectively protected by patents. In these cases, we rely on trade secret lawsand confidentiality agreements to protect our confidential and proprietaryinformation, processes and technology. However, our confidential andproprietary information, processes and technology could be independentlydeveloped by, or otherwise become known to, third parties, which would weakenour competitive position and might reduce our sales.

Since1997, we have derived more than 50% of our annual revenue from products sold tocustomers outside of North America. The laws of some foreign countries do notprotect our proprietary rights to the same extent as the laws of the UnitedStates, and many companies have encountered substantial problems in protectingtheir proprietary rights against infringement in such countries. The manner inwhich we protect our proprietary rights may not be adequate in some foreigncountries. Our failure to adequately protect our intellectual property inforeign countries would make it easier for competitors to copy or circumventour product designs and sell competing products in those countries, which couldadversely affect our revenue and cause us to lose customers.

**Intellectual property infringement claims by or against usmay result in litigation, the cost of which could be substantial and couldprevent us from selling our products.**

Thesemiconductor industry is characterized by uncertain and conflictingintellectual property claims, frequent litigation regarding patent and otherintellectual property rights and vigorous protection and pursuit of theserights. Questions of infringement in the semiconductor industry involve highlytechnical and subjective analyses. Litigation may be necessary to determine thevalidity and scope of our proprietary rights or to defend against claims ofinfringement or invalidity by third parties, and we may not prevail in anylitigation. Any such litigation, whether or not determined in our favor orsettled, might be costly, could harm our reputation, could cause productshipment delays and could divert the efforts and attention of our managementand technical personnel from our normal business operations.

During the first quarter of 2006, we began legalproceedings against two separate parties to protect against the infringement ofour patents. These proceedings increased our legal expenses during 2006. InOctober 2006, we settled one of these cases in our favor for minimal monetarycompensation.

Anadverse outcome in any intellectual property litigation might result in theloss of our proprietary rights, subject us to significant liabilities, requireus to spend significant resources to develop non-infringing technology, requireus to seek licenses from third parties, prevent us from manufacturing andselling our products or require us to discontinue the use of certain technologyin our products, any of which could have an adverse effect on our business,financial condition and results of operations. License agreements, if required,might not be available on terms acceptable to us or at all.

**Our growth could strain our personnel and infrastructureresources, and, if we are unable to implement appropriate controls andprocedures to manage our growth, we may not be able to successfully implementour business plan.**

Our growth has placed, and will continue to place,significant demands on our management, operational, financial and technicalresources and on our internal control, management information and reportingsystems. Our success will depend, in part, upon the ability of our seniormanagement to manage this growth effectively. To manage the expected growth ofour operations and personnel, we will need to:

·                  continue to improve our operational, financial andmanagement controls and our reporting systems and procedures;

·                  manage the growth of different product lines withdifferent cost structures; and

·                  recruit, train, manage and motivate our employees tosupport our expanded operations.

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**Our success depends on our continued investment in researchand development, the level and effectiveness of which could reduce ourprofitability.**

We willcontinue to make investments in research and development to sustain and improveour competitive position and meet our customers’ needs. These investmentscurrently include refining Pyramid Probe fabrication processes, developinghigher performance Pyramid Probe cards and enhancing engineering probe stationsfor both 300mm and sub-300mm wafers. To maintain our competitive position, we mayneed to increase our research and development investment, which could reduceour profitability. In addition, we cannot assure you that we will achieve areturn on these investments, nor can we assure you that these investments willimprove our competitive position and meet our customers’ needs.

**We manufacture nearly all of our products at our Oregonfacilities, and any disruption in the operations of these facilities could harmour business.**

Wemanufacture almost all of our products in our facilities located in Beaverton,Oregon. Our manufacturing processes are complex and require sophisticated andcostly equipment and specially designed facilities. As a result, any prolongeddisruption in the operations of our facilities, whether due to technical or labordifficulties or destruction of or damage to the facilities as a result of anearthquake, fire or any other reason, could materially and adversely affect ourbusiness, financial condition and results of operations.

**We may fail to comply with environmental regulations, whichcould result in significant costs and harm our business.**

We aresubject to a variety of federal, state and local laws, rules and regulationsrelating to the storage, use, discharge, disposal and human exposure tohazardous and toxic materials used in our thin-film fabrication facility andother manufacturing operations. The risk of a release of hazardous or toxicmaterials cannot be completely eliminated, and if such a release occurs, wecould be held financially responsible for the cleanup or other consequences ofthe release. We are not aware of any releases at any of our facilities thatcould reasonably be expected to result in any material liabilities to us. Ourpast, present or future failure to comply with environmental laws and regulationscould result in enforcement actions, substantial liabilities and suspension ofproduction or cessation of operations in extreme situations. Compliance withcurrent or future environmental laws and regulations could restrict our abilityto expand our facilities or build new facilities or require us to acquireadditional expensive equipment, modify our manufacturing processes, or incurother substantial expenses which could harm our business, financial conditionand results of operation.

Forexample, the European Parliament has finalized the RoHS Directive whichrestricts the sale of new electrical and electronic equipment containingcertain hazardous substances, including lead. Although a majority of ourproducts are exempt from this directive, we have modified our manufacturingprocesses, eliminating lead from products we put on the market as required bythe RoHS Directive.

Inaddition, China has implemented a RoHS Directive that is expected to becomeeffective in 2007. This Directive is similar to the European RoHS Directive,except for the fact that our products will not be exempt. Based on currentinformation available, we believe we will be able to comply with the China RoHSDirective. However, if we do not comply with this Directive, we may suffer aloss of revenue, be unable to sell in certain markets or countries and suffercompetitive disadvantage.

TheEuropean Parliament has also recently finalized the WEEE Directive, which makesproducers of electrical and electronic equipment financially responsible forspecified collection, recycling, treatment and disposal of past and futurecovered products. As a producer of industrial electronic equipment, we mayincur financial responsibility for the collection, recycling, treatment ordisposal of products covered under the WEEE Directive. Our products have beenlabeled in accordance with the WEEE Directive since before August 13, 2005, theWEEE implementation date. We determined the products 

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wepresently produce are exempt because they either meet the definition of “LargeScale Industrial Equipment,” or are passive or non-electrical accessories thatdo not function on their own. We have not incurred any costs or fees orpenalties associated with non-compliance. Therefore, we have some confidencethat we are interpreting the rules correctly. However, because the EU memberstates have not fully implemented the WEEE Directive, the nature and extent ofthe costs to comply and fees or penalties associated with non-compliance arestill unknown at this time. Costs to comply with the WEEE Directive and similarfuture legislation, if applicable, may also include legal and regulatory costsand insurance costs. We may also be required to take reserves for costsassociated with compliance with these regulations.

Theseenvironmental laws and regulations could become more stringent over time,imposing even greater compliance costs and increasing risks and penaltiesassociated with violations, which could seriously harm our business, financialcondition and results of operation. There can be no assurance that violationsof environmental laws or regulations will not occur in the future as a resultof the inability to obtain permits, human error, equipment failure or othercauses.

**Product liability claims may be asserted against us,resulting in costly litigation for which we may not have sufficient liabilityinsurance.**

Ourcustomers may use our products in the testing of high reliabilitysemiconductors for critical applications such as telecommunicationsinfrastructure, military, medical and aerospace equipment. Defects or otherproblems with the performance of our products could result in financial orother damages to our customers. In addition, some of our engineering probestations that use high powered lasers or operate at high voltage or extremetemperatures may cause death or injury to persons utilizing such equipment dueto undetected design or manufacturing defects or due to improper use ormaintenance by our customers. Although our product invoices and sales contractsgenerally contain provisions designed to limit our exposure to productliability claims, existing or future laws or unfavorable judicial decisionscould negate these provisions. Product liability litigation against us, even ifit were unsuccessful, could be time consuming and costly to defend.Additionally, although we carry product liability insurance, in somecircumstances it may not cover certain claims or be adequate to cover allclaims.

**We rely on a small number of customers for a significantportion of our revenue, and the termination of any of these relationships wouldadversely affect our business.**

Our topfour customers accounted for a total of 21% and 16% of our revenue in 2006 and2005, respectively. Our customer base is less diversified in our PPD Divisionthan in our EPD Division. Our customers are not obligated by long-termcontracts to purchase our products and may discontinue purchasing our productsat any time. The semiconductor industry is highly concentrated and a smallnumber of semiconductor manufacturers generally account for a substantialportion of the purchases of semiconductor test equipment, including ourproducts. Consequently, our business and operating results would be materially,adversely affected by the loss of any of our significant customers.

Inaddition, our ability to increase our revenue will depend in part upon ourability to obtain orders from new customers, particularly customers of ourproduction probe cards. Obtaining orders from new customers is difficultbecause semiconductor manufacturers typically select one vendor’s products fortesting a particular new generation of chips. Once a manufacturer has selecteda vendor, that manufacturer is more likely to continue to purchase productsfrom that vendor for that generation of chips, as well as subsequentgenerations of chips. We therefore place great emphasis on relationships withour current customers because these customers are difficult to replace. Inaddition, we focus on leveraging our relationships with current customers tosell into additional engineering labs and production lines in the same companyand similar groups in other companies. If we are unable to maintain ourrelationships with our existing significant customers or to obtain newcustomers that adopt and implement our products and technology, we will not beable to meet our revenue and growth targets, which could result in a decline inthe price of our common stock.

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**Our employment costs in the short-term are, to a largeextent, fixed, and therefore, any shortfall in sales would harm our operatingresults.**

Ouroperating expense levels are based, in significant part, on our headcount. Fora variety of reasons, particularly the high cost and disruption of layoffs, thecosts of recruiting and training new personnel and product delivery and servicecommitments to our customers, our headcount in the short-term is, to a largeextent, fixed. Accordingly, we may be unable to reduce employment costs in atimely manner to compensate for any shortfall in our sales or gross margins,which could materially harm our operating results.

**The additional costs that we incur as a result of being apublic company will affect our operating results.**

Weincurred incremental costs as a public company for additional expenses such asincreased auditing and legal fees and director and officer liability insurance,which increased our operating expenses and make it more difficult for us tooffset any future revenue shortfalls by offsetting expense reductions in theshort-term. In addition, the Sarbanes-Oxley Act of 2002, as well as new rulesand regulations subsequently enacted by the Securities and Exchange Commission,or the SEC, and the Nasdaq National Market have imposed new corporategovernance requirements for listed companies. We expect these rules to increaseour legal and financial compliance costs and to make some activities moredifficult, time consuming and costly. We also expect these new rules andregulations to make it more difficult and more expensive for us to obtain directorand officer liability insurance, and we may be required to accept reducedcoverage or incur substantially higher costs to obtain coverage. These newrules and regulations could also make it more difficult for us to attract andretain qualified members of our board of directors and qualified executiveofficers.

##### **Unanticipatedchanges in our tax rates or exposure to additional income tax liabilities couldaffect our profitability.**

##### We are subjectto income taxes in both the United States and various foreign jurisdictions,and our domestic and international tax liabilities are subject to theallocation of expenses in different jurisdictions. Our effective tax rate couldbe adversely affected by changes in the mix of earnings in countries withdifferent statutory tax rates, changes in the valuation of deferred tax assetsand liabilities, changes in tax laws, including pending tax law changes, suchas the benefit from export sales and the research and development credit bymaterial audit assessments. In particular, the carrying value of deferred taxassets, which are predominantly in the United States, is dependent on ourability to generate future taxable income in the United States.  In addition, the amount of income taxes wepay could be subject to ongoing audits in various jurisdictions and a materialassessment by a governing tax authority could affect our profitability.

**Our officers and directors and their affiliates will controlthe outcome of matters requiring shareholder approval.**

As ofMarch 5, 2007, our executive officers and directors and their affiliatesbeneficially own approximately 31% of our outstanding shares of common stock.Consequently, these shareholders will have substantial influence over theelection of our directors and the outcome of corporate actions requiringshareholder approval, such as a merger or a sale of our company or a sale ofall or substantially all of our assets. This concentration of voting power andcontrol could have a significant effect in delaying, deferring or preventing anaction that might otherwise be beneficial to our other shareholders and bedisadvantageous to our shareholders with interests different from those of ourofficers, directors and affiliates. These shareholders will also havesignificant control over our business, policies and affairs. Additionally, thissignificant concentration of share ownership may adversely affect the tradingprice for our common stock because investors often perceive disadvantages inowning stock in companies with controlling shareholders.

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**The anti-takeover provisions of our charter documents andOregon law may inhibit a takeover or change in our control that shareholdersmay consider beneficial.**

Provisions of our articles of incorporation and bylawsand provisions of Oregon law may have the effect of delaying or preventing amerger or acquisition of us, making a merger or acquisition of us lessdesirable to a potential acquirer or preventing a change in our management,even if the shareholders consider the merger or acquisition favorable or ifdoing so would benefit our shareholders. In addition, these provisions couldlimit the price that investors would be willing to pay in the future for sharesof our common stock. The following are examples of such provisions in ourarticles of incorporation or bylaws:

·                  We have a staggered board of directors, which will make it moredifficult for a group of shareholders to quickly change the composition of ourboard.

·                  Our board of directors is authorized, without prior shareholderapproval, to create and issue preferred stock with voting or other rights orpreferences that could impede the success of any attempt to acquire us orchange our control, commonly referred to as “blank check” preferred stock.

·                  Members of our board of directors can only be removed for cause.

·                  The board of directors may alter our bylaws without obtainingshareholder approval.

·                  Shareholders are required to provide advance notice for nominations forelection to the board of directors or for proposing matters to be acted upon ata shareholder meeting.

·                  Any action that is taken by writtenconsent of shareholders must be unanimous.

We arealso subject to the provisions of the Oregon Control Share Act and the OregonBusiness Combination Act, each of which may have certain anti-takeover effects.

**If our stock price is volatile, securities class actionlitigation may be brought against us, which could result in substantial costs.**

In thepast, securities class action litigation has often been brought against acompany following periods of volatility in the market price of its securities,and newly public companies tend to experience more volatility in their stockprice. We may be the target of such litigation in the future. Securitieslitigation may result in substantial costs and divert management’s attentionand resources, which may seriously harm our business.

##### **ITEM1B.   UNRESOLVED STAFF COMMENTS**

None.

##### **ITEM2.   PROPERTIES**

Wemaintain our corporate headquarters in Beaverton, Oregon. Our primary sitecontains corporate administration, sales and marketing, design, test, lightmanufacturing and assembly and various support functions in leased spacetotaling 102,438 square feet in three adjacent buildings. This lease expiresDecember 31, 2015 as to two of these buildings. The lease for the thirdbuilding, totaling 23,000 square feet, is available for sub-lease and expiresin June 2008. Our Pyramid Probe manufacturing is conducted in a 10,000square foot clean room within a 58,817 square foot facility that we lease at aseparate site in Beaverton, Oregon. Our lease of this facility expires December31, 2014. We lease small sales and service offices in Japan, England, China,Taiwan and Singapore.

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##### **ITEM3.   LEGAL PROCEEDINGS**

As ofthe date of filing this Form 10-K, we are not a party to any material legalproceedings. However, the semiconductor test industry is characterized byvigorous protection and pursuit of intellectual property rights and positions.To protect our intellectual property from infringement, we have from time totime initiated litigation against third parties and may be required to do so inthe future. We cannot assure you that we will be successful in futureintellectual property litigation and this litigation often is protracted andexpensive.

##### **ITEM4.   SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

No matters were submittedto a vote of security holders during the fourth quarter of 2006.

#### **PART II**

**ITEM 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY,RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES**

***Stock Prices and Dividends***

Our common stock begantrading on the Nasdaq National Market System under the symbol “CSCD” onDecember 15, 2004. The high and low closing sale price of our common stock byquarter for each of the eight quarters in the two-year period ended December31, 2006 was as follows:

| 2005      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------|------------|----------|------------|---------|------------|
| Quarter 1 |       | $        | 14.03      |    | $          | 9.55 |   |
| Quarter 2 |       | 14.60    |       | 8.40    |       |
| Quarter 3 |       | 16.00    |       | 12.42   |       |
| Quarter 4 |       | 14.72    |       | 11.35   |       |
|           |            |          |            |         |            |  |  |

 

| 2006      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------|------------|----------|------------|---------|------------|
| Quarter 1 |       | $        | 14.81      |    | $          | 11.17 |   |
| Quarter 2 |       | 13.30    |       | 10.89   |       |
| Quarter 3 |       | 12.52    |       | 10.80   |       |
| Quarter 4 |       | 13.65    |       | 12.25   |       |
|           |            |          |            |         |            |  |  |

 

As of March 5, 2007,there were 69 shareholders of record. Many shareholders hold their shares instreet name. We believe we currently have approximately 2,000 beneficialshareholders.

We have not declared orpaid any cash dividends on our common stock in the past two years. We currentlyexpect to retain any future earnings to fund the operation and expansion of ourbusiness, and therefore, we do not currently expect to pay cash dividends inthe foreseeable future.

***Use of Proceeds***

We filed a registrationstatement on Form S-1, File No. 333-113256 for an initial public offering ofcommon stock, which was declared effective by the Securities and ExchangeCommission on December 15, 2004. In that offering, we sold an aggregate of 3.3million shares of our common stock with net offering proceeds of $41.6 million.As of December 31, 2006, we had used approximately $5.5 million of thoseproceeds for the repayment of indebtedness. No payments were made to ourdirectors or officers or their associates, holders of 10% or more of any classof our equity securities or to any affiliates.

***Equity Compensation Plan Information***

See Item 12. for EquityCompensation Plan Information.

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***StockPerformance Graph***

TheSEC requires that registrants include in this report a line-graph presentationcomparing cumulative five-year shareholder returns on an indexed basis,assuming a $100 initial investment and reinvestment of dividends.  Our graph consists of (a) Cascade Microtech,Inc.; (b) the Nasdaq Stock Market Total Return Index — U.S. and (c) a peergroup index composed of Teradyne, Inc., FormFactor, Inc., Kulicke & SoffaIndustries, Inc., Credence Systems Corporation, Electro Scientific Industries,Inc. and Keithley Instruments, Inc. The peer group index utilizes the samemethods of presentation and assumptions for the total return calculation asdoes Cascade Microtech, Inc. and the NASDAQ Stock Market Total Return Index —U.S.  All companies in the peer groupindex are weighted in accordance with their market capitalizations. Our initialpublic offering was December 14, 2004 and, accordingly, our graph only includesthe time period of December 14, 2004 to December 31, 2006.

 

|                           | ** ** | **Base**     | ** ** | **Indexed Returns** | ** ** |
|---------------------------|------------|--------------|------------|--------------------------|------------|
| ** **                | ** ** | **Period**   | ** ** | **Period Ended**    | ** ** |
| **Company/Index**         | ** ** | **12/14/04** | ** ** | **12/31/04**             | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| Cascade  Microtech, Inc.  |       | $            | 100.00     |                     | $          | 95.93 |   | $ | 90.21 |   | $ | 93.57 |   |
| Semiconductor  Peer Group |       | 100.00       |       | 101.36                   |       | 89.37 |   | 93.25 |   |
| Nasdaq U.S.               |       | 100.00       |       | 100.73                   |       | 102.87 |   | 113.02 |   |
|                           |            |              |            |                          |            |  |  |  |  |  |  |  |  |

 

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##### **ITEM6.   SELECTED CONSOLIDATED FINANCIAL DATA**

The consolidatedstatement of operations and balance sheet data set forth below have beenderived from our consolidated financial statements. The selected consolidatedfinancial data set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andwith the consolidated financial statements and notes thereto included elsewherein this Form 10-K.

 
| ** **                                                             | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **IN THOUSANDS**                                                  | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(except per share amounts)**                          | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Statement of Operations Data**                                       | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                |       | $                                                            | 84,852     |   | $ | 73,637 |   | $ | 64,415 |   | $ | 50,556 |   | $ | 51,107 |   |
| Cost of sales                                                          |       | 47,367                                                       |       | 39,351 |   | 35,625 |   | 30,433 |   | 33,357 |   |
| Stock-based  compensation                                              |       | 443                                                          |       | 39 |   | 67 |   | 19 |   | 6 |   |
| Gross profit                                                           |       | 37,042                                                       |       | 34,247 |   | 28,723 |   | 20,104 |   | 17,744 |   |
| Operating  expenses:                                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
| Research and development                                               |       | 8,949                                                        |       | 6,986 |   | 5,681 |   | 5,422 |   | 6,274 |   |
| Selling, general and administrative                                    |       | 24,949                                                       |       | 19,778 |   | 16,831 |   | 15,436 |   | 16,157 |   |
| Total operating  expenses                                              |       | 33,898                                                       |       | 26,746 |   | 22,512 |   | 20,858 |   | 22,431 |   |
| Income (loss)  from operations                                         |       | 3,144                                                        |       | 7,501 |   | 6,211 |   | (754 | ) | (4,687 | ) |
| Other income  (expense), net                                           |       | 1,961                                                        |       | 1,991 |   | (117 | ) | 553 |   | 385 |   |
| Income (loss)  before income taxes                                     |       | 5,105                                                        |       | 9,492 |   | 6,094 |   | (201 | ) | (4,302 | ) |
| Provision  (benefit) for income taxes                                  |       | 1,495                                                        |       | 1,173 |   | 1,387 |   | 248 |   | (2,244 | ) |
| Net income  (loss)                                                     |       | 3,610                                                        |       | 8,319 |   | 4,707 |   | (449 | ) | (2,058 | ) |
| Accretion of  redeemable stock and loss on redemption                  |       | —                                                       |       | — |   | 113 |   | 583 |   | 362 |   |
| Net income  (loss) attributed to common shareholders                   |       | $                                                            | 3,610      |   | $ | 8,319 |   | $ | 4,594 |   | $ | (1,032 | ) | $ | (2,420 | ) |
| Basic net income  (loss) per share attributed to common shareholders   |       | $                                                            | 0.31       |   | $ | 0.75 |   | $ | 0.84 |   | $ | (0.20 | ) | $ | (0.48 | ) |
| Diluted net  income (loss) per share attributed to common shareholders |       | $                                                            | 0.30       |   | $ | 0.70 |   | $ | 0.56 |   | $ | (0.20 | ) | $ | (0.48 | ) |
| Shares used in  basic per share calculations                           |       | 11,482                                                       |       | 11,055 |   | 5,439 |   | 5,089 |   | 5,015 |   |
| Shares used in  diluted per share calculations                         |       | 11,959                                                       |       | 11,816 |   | 8,452 |   | 5,089 |   | 5,015 |   |

 
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **2006**         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance Sheet Data**                                              | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash  equivalents and short-term marketable securities        |       | $                | 43,794     |   | $ | 50,346 |   | $ | 43,747 |   | $ | 10,717 |   | $ | 8,632 |   |
| Working capital                                                     |       | 68,642           |       | 74,601 |   | 63,333 |   | 24,228 |   | 25,573 |   |
| Total assets                                                        |       | 103,786          |       | 90,120 |   | 79,016 |   | 37,766 |   | 40,815 |   |
| Current portion  of long-term debt and capital lease obligations    |       | —           |       | 8 |   | 21 |   | 2,043 |   | 21 |   |
| Long-term debt  and capital lease obligations, less current portion |       | —           |       | — |   | 14 |   | 5,038 |   | 25 |   |
| Other long-term  liabilities                                        |       | 1,370            |       | 1,100 |   | 1,449 |   | 1,398 |   | 1,622 |   |
| Redeemable stock                                                    |       | —           |       | — |   | — |   | 584 |   | 10,152 |   |
| Shareholders’ equity                                           |       | 90,193           |       | 81,505 |   | 70,188 |   | 22,960 |   | 23,848 |   |
|                                                                     |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM7.**                          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        *You should read the following discussion inconjunction with our consolidated financial statements and notes theretoappearing elsewhere in this Form 10-K. In addition to historical consolidatedfinancial information, the following discussion and analysis containsforward-looking statements that involve risks, uncertainties and assumptions.Our actual results could differ materially from those anticipated by theseforward-looking statements as a result of many factors, including thosediscussed under Item 1A, Part I, “Risk Factors,” and elsewhere in this Form10-K. We do not guarantee future results, levels of activity, performance orachievements. We do not intend to update any of the forward-looking statementsafter the date of this document to conform them to actual results or to changesin our expectations.*

**Overview**

Wedesign, develop and manufacture advanced wafer probing solutions for theelectrical measurement of high performance chips. We design, manufacture andassemble our products in Beaverton, Oregon, with global sales, service andsupport centers in North America, Europe, Japan, Taiwan, China and Singapore.We were incorporated and introduced our first commercial products in 1984.

Ourproducts include engineering probe stations, analytical probes, productionprobe cards, application software and services. Engineering probe stationsaddress the need for precise and accurate measurement of semiconductorelectrical characteristics during chip design or when optimizing the chipfabrication process. Our engineering probe stations are highly configurable andare typically sold with various accessories, including our analytical probes,as well as accessories from third parties. In addition, we design and buildcustom engineering probe stations to address the specific requirements of ourcustomers. Analytical probes are sold to serve as components of our engineeringprobe stations, or less often, to serve as components of test equipmentmanufactured by third parties. Our production probe cards are designed and soldfor production test applications, ranging from very low current parametrictesting to sophisticated, high speed radio frequency testing. We refer toanalytical probes and production probe cards as consumables, as they areroutinely replaced during the testing process. We also generate revenue throughthe sale of service contracts to our customers.

Ourengineering probe stations, analytical probes and probing accessories are soldthrough our Engineering Products Division (“EPD”). Our production probe cardsare sold through our Pyramid Probe Division (“PPD”). To date, we have derivedthe majority of our revenue from the sale of our engineering probe stations,and we expect to continue to do so for the next few years. Our production probecard revenue, however, increased as a percentage of total revenues in 2006 andwe expect that trend to continue in 2007 and beyond.

Ourengineering products business and operating results depend in significant parton the level of capital expenditures related to semiconductor research anddevelopment, which, in turn, depends upon current and anticipated market demandfor chips. Historically, the semiconductor industry has been highly cyclicalwith recurring periods of over-supply, which has often resulted in a reductionin demand for our products. While our financial results are impacted by cycleswithin the semiconductor industry, we believe our business cycles are typicallyless pronounced than those of other semiconductor equipment companies. Webelieve this is due to our greater reliance on our customers’ research anddevelopment capital spending and usage of test consumables rather than on ourcustomers’ spending to increase production capacity. Capital spending aimed atincreasing production capacity is one of the first areas in which mostsemiconductor manufacturers reduce spending in an industry downturn.

Whilethe conversion to 300mm technology continues, high conversion costs combinedwith continued process developments on 200mm wafers continue to make sales ofour sub-300mm probing systems an important component of our revenue stream forthe foreseeable future. 300mm technology more than doubles the available areaon a wafer, significantly increasing the number of chips per wafer and

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reducingper unit manufacturing costs. Revenue from our 300mm engineering probestations, including all probes, accessories and other items sold therewith,represented 37%, 33.0% and 32.2% of our total EPD revenue in 2006, 2005 and2004, respectively.

We sellour solutions to most segments of the semiconductor industry, includingmanufacturers of communications, wireless, microprocessors and other logic andmemory chips. A substantial portion of our revenue is generated from sales ofour engineering probe stations and analytical probes to research anddevelopment laboratories of semiconductor manufacturers as well as to fablesssemiconductor companies and academic institutions. As a result, we sell to ageographically diversified customer base, with more than 50% of our revenue in2006 and 2005 generated outside of North America, primarily in Japan, otherAsian countries and, to a lesser extent, Europe.

We sellour products both directly through our own sales force and indirectly through acombination of manufacturers’ representatives and distributors. In NorthAmerica and Asia, excluding Japan, Singapore and Malaysia, we sell most of ourproducts through manufacturers’ representatives. We sell certain products inthese regions directly. In Japan, Singapore and Malaysia, we sell throughCascade Microtech Japan, K.K. and Cascade Microtech Singapore, our direct salesand service subsidiary and branch office, respectively. In Europe, we sellprimarily through distributors and manufacturers’ representatives, except inthe U.K., where we sell through our direct sales subsidiary, Cascade MicrotechEurope, Ltd. We also sell certain products directly in Germany, Austriaand Switzerland. In the rest of the world, we typically sell throughmanufacturers’ representatives or distributors. During 2006, we establisheddirect sales offices in China and Taiwan. Our distributors normally placeorders with us once they have received an order from an end-user customer, and,therefore, the total amount of inventory held by our distributors at any givendate is not material.

During the fourth quarter of 2006, we acquiredcertain assets and liabilities related to the eVue product line from ourstrategic partner in a transaction which was accounted for as a businessacquisition. These assets included technology, design information for themanufacture of subassemblies and other intangibles. The purchase priceconsisted of $4.0 million in cash, paid to the seller, plus other direct costsincluding attorney and other fees of $35,000. In addition, if the sellercompletes certain milestones related to the eVue product line by December 31,2007, we will pay an additional $1.0 million contingent amount to the sellerwhich will be recorded as goodwill if and when it is paid.

**Results of Operations**

Thefollowing table sets forth our consolidated statement of operations data forthe periods indicated as a percentage of revenue.(1)
| ** **                                                       | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **IN THOUSANDS  (except per share amounts)** | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Statement  of Operations Data**                                |       |                                                         |       |   |   |   |   |
| Revenue                                                          |       | 100.0                                                        | %          | 100.0 | % | 100.0 | % |
| Cost of sales  and stock-based compensation                      |       | 56.3                                                         |       | 53.5 |   | 55.4 |   |
| Gross profit                                                     |       | 43.7                                                         |       | 46.5 |   | 44.6 |   |
| Operating  expenses:                                             |       |                                                         |       |   |   |   |   |
| Research and development                                         |       | 10.5                                                         |       | 9.5 |   | 8.8 |   |
| Selling, general and administrative                              |       | 29.4                                                         |       | 26.9 |   | 26.1 |   |
| Total operating  expenses                                        |       | 39.9                                                         |       | 36.3 |   | 34.9 |   |
| Income from  operations                                          |       | 3.7                                                          |       | 10.2 |   | 9.6 |   |
| Other income  (expense), net                                     |       | 2.3                                                          |       | 2.7 |   | (0.2 | ) |
| Income before  income taxes                                      |       | 6.0                                                          |       | 12.9 |   | 9.5 |   |
| Provision for  income taxes                                      |       | 1.8                                                          |       | 1.6 |   | 2.2 |   |
| Net income                                                       |       | 4.3                                                          |       | 11.3 |   | 7.3 |   |
| Accretion of  redeemable stock and loss on redemption            |       | —                                                       |       | — |   | 0.2 |   |
| Net income attributed  to common shareholders                    |       | 4.3                                                          | %          | 11.3 | % | 7.1 | % |

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##### (1)          Percentages may not add due to rounding.

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***Revenue***

Revenue increased $11.3million, or 15.2%, to $84.9 million in 2006 compared to $73.6 millionin 2005 and increased $9.2 million, or 14.3%, in 2005 compared to$64.4 million in 2004.

Revenue in EPD increased$4.4 million, or 6.9%, to $68.0 million in 2006 compared to$63.6 million in 2005 and increased $5.1 million, or 8.7%, in 2005compared to $58.5 million in 2004.

Certain financialinformation which contributed to the EPD revenue results was as follows:

 
| ** **                                             | ** ** | **2006 compared to  2005** | ** ** | **2005 compared to  2004** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| Percentage  increase in unit sales                     |       | 4.0                                  | %          | 31.6                                 | %          |
| Percentage increase  (decrease) in average order total |       | 1.4                                  | %          | (14.9                                | )%         |

Average order total includes the sales price of allanalytical probes, probe cards and other accessories purchased with anengineering probe station.

The increase in averageorder total in 2006 compared to 2005 was primarily attributable to increasedunit sales of our 300mm systems, which have a higher average sales price thanour non-300mm systems, which had declining unit sales in 2006 compared to 2005.Although the average order total increased overall, both the 300mm and thenon-300mm average order totals decreased in 2006 compared to 2005. Thesedecreases were primarily due to sales of our new line of lower-priced, entry-level150mm systems, more low-end options selected on our 300mm systems and morecompetitive pricing provided on multiple system orders in 2006 compared to2005. These decreases were partially offset by the purchase of our higher-endeVue microscopes with many of the 300mm systems.

The increase in unitsales in 2005 compared to 2004 primarily related to the sale of a higher numberof our lower cost 200mm systems in Asia. We also began direct sales intoSingapore during the latter half of 2004.

The decrease in theoverall average order total in 2005 compared to 2004 included decreases forboth 300mm and non-300mm stations. The 300mm station average order totaldecreased 1.9% in 2005 compared to 2004, while the non-300mm station averageorder total decreased 18.4% in the same time period. The decrease in averageorder total for our 300mm stations was primarily due to a high average ordertotal comparison from the second half of 2004 due to the sale of units withadditional accessories in that period. The decrease in the non-300mm stationaverage order total was due primarily to the sale of a new, lower cost versionof one of our preexisting 200mm stations.

Revenue in PPD increased$6.8 million, or 67.6%, to $16.9 million in 2006 compared to$10.1 million in 2005 and increased $4.2 million, or 69.3%, in 2005compared to $5.9 million in 2004.

The increases in PPDrevenue in 2006 compared to 2005 and in 2005 compared to 2004 were due toincreases in the number of production probe cards sold. The increase in 2006 comparedto 2005 was partially offset by a shift in mix to lower priced probe cards.

While our Pyramid probesstill represent a small portion of our customers’ total probe card purchases,many of our large customers are now ordering our Pyramid probes for numerous,mainstream, high-volume logic test applications, displacing their historicalpurchases of cantilever and vertical probe cards. We continue to have asignificant share of the market in probe cards for wireless devices. We alsoexpect to continue to increase our non-wireless production probe cardapplications for a variety of wirebonded chip types. We have been adding probecard capabilities in the form of headcount and equipment over the past severalquarters. We expect to continue to add headcount and equipment in the comingquarters.

We have the ability toexpand the capacity of our probe card microfabrication facility throughadditional equipment and headcount to about $40 million annually based on ourcurrent product mix and facility. We are currently using approximately 50% of thefacility’s potential capacity. Weare currently

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expanding our clean roomspace and increasing our manufacturing capacity from approximately $40 millionbased on our current production mix to approximately $60 million when newequipment installations are complete in 2008. Our growth rate also relies onour ability to recruit and train enough top-quality people for productfulfillment and field support.

***Cost of Sales and Gross Profit***

Cost ofsales includes purchased materials, fabrication, assembly, test andinstallation labor and overhead, customer-specific engineering costs, warrantycosts, royalties and provision for inventory valuation reserves.

Fluctuationsin gross profit as a percentage of revenue, or gross margin, primarily resultfrom changes in geographic mix, product mix, general pricing dynamics andyields in some of our production lines. Sales in Europe typically have a lowermargin than sales in North America and Japan due to our use of third-partydistributors in Europe. We typically achieve higher margins on our consumablesthan on our engineering probe stations.

Cost of sales increased$8.0 million, or 20.4%, to $47.4 million in 2006 compared to$39.4 million in 2005 and increased $3.8 million, or 10.5%, in 2005compared to $35.6 million in 2004.

The increase in 2006compared to 2005 was primarily due to the following:
| Increased direct  costs, such as raw materials, resulting from higher revenue and changes in  geographic and product mix |   | $         | 4,765,000 |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Increased  inventory costs related to scrapping, discrepancies, obsolescence, revisions  and returns                     |   | 463,000   |      |
| Increased  freight expenses due primarily to more overseas inventory purchases and  higher fuel costs                    |   | 562,000   |      |
| Increased  salaries and related costs in PPD resulting from increased headcount and  other labor                         |   | 1,146,000 |      |
| Other increases  related to increased sales                                                                              |   | 1,064,000 |      |
|                                                                                                                     |   | $         | 8,000,000 |   |

Gross profit as a percentage of revenue decreased to43.7% in 2006 compared to 46.5% in 2005. This decrease was primarily attributable to additionalcosts incurred to ramp our production run rate and reduce lead timeswithin PPD. We expect to continue to incur additional costs to build ourcapacity and ramp our production run rate within PPD. In addition, stock-based compensationincreased $0.4 million in 2006 compared to 2005, which resulted in anapproximately 0.5 percentage point decrease in gross margin in 2006 compared to2005.

The increase in cost ofsales in 2005 compared to 2004 was primarily due to the increase in revenuediscussed above, partially offset by an improvement in gross profit as apercentage of revenue to 46.5% in 2005 compared to 44.6% in 2004. The increasein our gross profit in 2005 compared to 2004 was primarily attributable to theincreased demand and production volumes of our products, as well as an improvedproduct mix for a higher gross profit as a percentage of revenue in 2005compared to 2004. In 2005, the product mix included more Pyramid proberevenue, and, since the fixed costs of the Pyramid microfabrication facilityare relatively high, this revenue increase resulted in margin leverage forthose products. This increase was partially offset by a shift in mix to morenon-300mm systems as compared to 300mm systems in 2005 compared to 2004. We achievelower gross profit as a percentage of revenue on our non-300mm systems than wedo on our 300mm systems.

***Research and Development***

Researchand development costs are expensed as incurred and include compensation andrelated expenses for personnel, materials, consultants and overhead. From timeto time, we enter into arrangements that provide for the reimbursement ofresearch and development expenses. Such reimbursements are netted against grossresearch and development expenses.

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Research and developmentexpenses increased $1.9 million, or 28.4%, to $8.9 million in 2006compared to $7.0 million in 2005 and increased $1.3 million, or 22.7%, in2005 compared to $5.7 million in 2004. We expect research and developmentexpenses to continue to increase as we add personnel to support our futuredevelopment plans. These plans involve the release of new PPD products, thedevelopment of new PPD manufacturing processes, the development of faster,higher-accuracy analytical probes and enhancing the functionality of ourengineering probe stations.

The increase in 2006compared to 2005 was primarily due to the following:
| Increase in  salaries and benefits primarily due to increases in headcount                               |   | $       | 1,221,000 |   |
|----------------------------------------------------------------------------------------------------------|--------|---------|-----------|--------|
| Increase in  stock-based compensation due to the adoption of SFAS No. 123R in the first  quarter of 2006 |   | 288,000 |      |
| Increases in  other costs, including supplies                                                            |   | 391,000 |      |
|                                                                                                     |   | $       | 1,900,000 |   |

 

The increase in 2005compared to 2004 was primarily due to the following:
| Increase in  employee wages and related costs due to headcount increases and salary  adjustments in the latter half of 2004 |   | $       | 587,000   |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|---------|-----------|--------|
| increase in  contractor fees for new product development efforts                                                            |   | 329,000 |      |
| Increase in  project supplies                                                                                               |   | 207,000 |      |
| Other                                                                                                                       |   | 177,000 |      |
|                                                                                                                        |   | $       | 1,300,000 |   |

***Selling,General and Administrative***

Selling,general and administrative, or SG&A, expense includes compensation andrelated expenses for personnel, travel, outside services, manufacturers’representative commissions, patent and trademark amortization and overheadincurred in our sales, marketing, customer support, management, legal and otherprofessional and administrative support functions, as well as costs to operateas a public company.

SG&A expenseincreased $5.2 million, or 26.1%, to $25.0 million in 2006 compared to$19.8 million in 2005 and increased $3.0 million, or 17.5%, in 2005compared to $16.8 million in 2004.

The increase in 2006compared to 2005 was primarily due to the following:
| Increase in  costs related to expansion and setting up direct sales offices in China,  Taiwan and Singapore, including costs for labor and recruiting, offset by a  decrease in representative commissions in these regions |   | $         | 755,000   |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Increase in  stock-based compensation due to the adoption of SFAS No. 123R in the first  quarter of 2006                                                                                                                    |   | 1,068,000 |      |
| Increase in  legal costs primarily related to initiating litigation against third parties  to protect against the infringement of our patents and corporate projects                                                        |   | 397,000   |      |
| Increase in IT  services, labor and software requirements for the network and expansion                                                                                                                                     |   | 476,000   |      |
| Increase in  representative commissions in regions other than China, Taiwan and Singapore  and other sales expenses, primarily related to increased revenue                                                                 |   | 336,000   |      |
| Amortization  costs related to our acquisition of eVue assets in the fourth quarter of 2006                                                                                                                                 |   | 130,000   |      |
| Increased  marketing and sales expenses, including communications                                                                                                                                                           |   | 1,131,000 |      |
| Increase in  human resources expenses                                                                                                                                                                                       |   | 249,000   |      |
| Increase in  accounting fees, offset by lower Sarbanes-Oxley costs                                                                                                                                                          |   | 242,000   |      |
| Other                                                                                                                                                                                                                       |   | 416,000   |      |
|                                                                                                                                                                                                                        |   | $         | 5,200,000 |   |

 

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During2006, we accelerated our timetable for establishing our direct sales offices inChina and Taiwan with the belief that there will be opportunity to increasebusiness and lower our selling costs as a percentage of sales in the future.These activities increased our operating expenses in 2006 and will increase ouroperating expenses going forward.

The increase in SG&Ain 2005 compared to 2004 was primarily due to the following:
| Increase in  representative commissions due to both the increase in revenue and an  increase in the commission rate in 2005 compared to 2004 |   | $         | 610,000   |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Increase in  employee wages and related costs due to headcount increases and salary  adjustments in the latter half of 2004 and 2005         |   | 650,000   |      |
| Increase in  media advertising                                                                                                               |   | 188,000   |      |
| Increase in  legal and patent costs                                                                                                          |   | 287,000   |      |
| Increase in  public company costs, including director and officer insurance, accounting  fees and Sarbanes-Oxley Act compliance consultants  |   | 1,296,000 |      |
| Other                                                                                                                                        |   | (31,000   | )         |
|                                                                                                                                         |   | $         | 3,000,000 |   |

This increase in 2005 was partially offset by $180,000of severance in 2004, which was not repeated in 2005.

***Other Income (Expense)***

Otherincome (expense) typically includes interest income, interest expense, gainsand losses on sales of investments and transaction and remeasurement relatedforeign currency gains and losses. Other income (expense) can also includeother miscellaneous non-operating gains and losses. Transaction related foreigncurrency gains and losses result from gains and losses recognized on foreign exchangeforward contracts and on certain of our accounts receivable that aredenominated in Japanese yen.

Interest incomerepresents interest earned on cash and cash equivalents and investments inmarketable securities and totaled $1.6 million, $1.1 million and $133,000,respectively, in 2006, 2005 and 2004. The increase in 2006 compared to 2005 wasprimarily due to higher average cash balances in 2006 compared to 2005, as wellas higher interest rates in 2006 compared to 2005. The increase in 2005 comparedto 2004 was primarily due to the increase in our invested balances as a resultof proceeds received from our initial public offering in December 2004.

Interest expense was$18,000 in 2005, of which $16,000 was related to interest on our $7.0 millionnote payable for the portion of the 30-day prepayment notice period thatoccurred in January 2005. We gave notice of prepayment and prepaid theremainder of our $7.0 million note payable and related interest in lateDecember 2004. Interest expense of $465,000 in 2004 represented interest on the$7.0 million note payable, which resulted from the conversion of ourSeries C preferred stock in the fourth quarter of 2003.

Other, net totaled$347,000 in 2006, $948,000 in 2005 and $215,000 in 2004. Other, net was comprisedof the following (in thousands):
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Foreign currency  remeasurement gain (loss) |       | $                                          | 97         |   | $ | (34 | ) | $ | 132 |   |
| Foreign currency  transaction gain          |       | 253                                        |       | 151 |   | 74 |   |
| Settlement  income from a service provider  |       | —                                     |       | 700 |   | — |   |
| Other                                       |       | (3                                         | )          | 131 |   | 9 |   |
|                                        |       | $                                          | 347        |   | $ | 948 |   | $ | 215 |   |

 

The settlement incomefrom a service provider was fully recognized in the second quarter of 2005 andwe do not anticipate any additional settlement income in future periods.

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***Income Taxes***

Our provision for incometaxes totaled $1.5 million, or 29.3% of income before income taxes, in 2006,$1.2 million, or 12.4%, of income before income taxes, in 2005 and $1.4million, or 22.8% of income before income taxes, in 2004.

The 2006 effective taxrate differed from federal statutory rates primarily due to the benefit ofnon-taxable interest income for federal tax purposes and the reinstatement ofthe research and development tax credit, offset by the non-deductible SFAS No.123R stock-based compensation expense.

Our 2005 effective taxrate differed from federal statutory tax rates primarily due to highernon-taxable income for both federal and state income tax purposes, utilizationof tax credits and the release of prior year valuation allowances sincemanagement believes the benefit of these credits is more likely than not to beutilized in future years.

Our 2004 tax provisionincluded the reversal of $726,000 of previously recorded valuation allowancebased on our 2004 performance. The reversal primarily related to U.S. researchand engineering credits and state net operating loss carryforwards, which wereutilized during 2004. In addition, in 2004, we increased the valuationallowance by $761,000 for excess foreign tax credits and State of Oregonresearch and engineering credits, which we believe are more likely than not tonot be utilized in the future.  The netresult was an increase in valuation allowance in 2004 of $35,000. Tax expense,net of associated tax credits for taxes paid in Japan, of $41,000 wasrecognized on the declaration of a $1.5 million dividend from our Japanesesubsidiary and is reflected in the tax provision for 2004.

Deferred tax assets arisefrom the tax benefit of amounts expensed for financial reporting purposesbut not yet realized for tax purposes and from unutilized tax credits and netoperating loss carry forwards. We evaluate our deferred tax assets on a regularbasis to determine if a valuation allowance is required. To the extent it isdetermined that it is more likely than not that we will not realize the benefitof our deferred tax assets, we record a valuation allowance against deferredtax assets.

At December 31, 2006, wehad a net deferred tax asset on our balance sheet totaling $2.5 million,primarily related to timing differences in the recognition of certain reservesand accruals.

***Accretion of Redeemable Stock***

Accretion of redeemablestock totaled $113,000 in 2004. Upon completion of our initial public offeringin December 2004, all outstanding redeemable stock converted to common stockand, therefore, we did not have any accretion of redeemable stock in 2005 or2006.

**Liquidity and Capital Resources**

Weanticipate meeting our cash requirements for the next 12 months and forthe foreseeable future from existing cash and short-term marketable securities,which totaled $43.8 million at December 31, 2006, as well as from cashexpected to be generated from operations.

Netcash provided by operating activities in 2006 was $7.1 million and consisted ofnet income of $3.6 million, depreciation, amortization and stock-basedcompensation of $3.9 million and net changes in our operating assets andliabilities as described below.

Accountsreceivable, net increased $1.4 million to $17.6 million at December 31,2006 compared to $16.2 million at December 31, 2005, due primarily tohigher revenue during the fourth quarter of 2006 compared to the fourth quarterof 2005, partially offset by improved shipment linearity in the fourth quarterof 2006 as compared to the fourth quarter of 2005. Our days sales outstandingwas approximately 71 days at December 31, 2006 compared to 84 days at December31, 2005.

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Inventoriesincreased $4.2 million to $15.1 million at December 31, 2006 compared to$10.9 million at December 31, 2005, primarily due to increased work-in-processand finished goods balances required to meet the projected demand for the firstquarter of 2007. We believe that our inventory levels at December 31, 2006 areadequate given our revenue projections for the first quarter of 2007.

Prepaidexpenses and other current assets decreased $0.7 million to $2.3 million atDecember 31, 2006 compared to $3.0 million at December 31, 2005 primarilydue to a $1.3 million decrease in income taxes receivable as a result ofreceiving payments.

Accountspayable increased $2.1 million to $6.0 million at December 31, 2006 compared to$3.9 million at December 31, 2005, primarily due to the increase in inventorydiscussed above and the timing of payments.

Accruedliabilities increased $1.9 million to $5.0 million at December 31, 2006compared to $3.1 million at December 31, 2005, primarily due to a $486,000increase in accrued compensation and benefits due to an increase in headcount,a $1.1 million increase in income taxes payable, a $316,000 increase in oursales return reserve due to normal business fluctuations, a $48,000 increase inour warranty reserve due to increased sales.

Netcash used in investing activities of $7.2 million in 2006 resulted from$4.0 million used for the purchase of fixed assets, $4.0 million used for theacquisition of eVue assets in the fourth quarter of 2006 and $0.8 million usedfor investment in patents and other assets. Purchases of fixed assets primarilywere for equipment related to our production probe division in 2006. These useswere partially offset by $1.6 million provided by the net sale of marketablesecurities. We anticipate spending approximately $12.0 million in 2007 forfixed assets, including approximately $10.0 million for our clean roomexpansion and related equipment, primarily for PPD capacity expansion.

Netcash provided by financing activities of $3.1 million in 2006 resultedprimarily from $2.2 million of proceeds from the exercise of employee stockoptions and the sale of stock pursuant to our employee stock purchase plan and$0.9 million of tax benefits related to stock option exercises.

**Seasonality**

Typically,our revenue is lower in our fiscal first quarter than in our fiscal fourthquarter preceding it. However, revenue in the first quarter of 2006 was greaterthan the revenue in the fourth quarter of 2005 due to delays in closing certainorders in the fourth quarter of 2005. In addition, as is typical in ourindustry, we recognize a large percentage of our quarterly revenue in the lastmonth of the quarter.

**ContractualCommitments**

Thefollowing is a summary of our contractual commitments and obligations as ofDecember 31, 2006 (in thousands):
| ** **                      | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation** | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008 and  2009** | ** ** | **2010 and  2011** | ** ** | **2012 and  beyond** | ** ** |
| Operating Leases                |       | $                                         | 18,304     |   | $ | 1,995 |   | $ | 4,217 |   | $ | 4,123 |   | $ | 7,969 |   |
| Purchase Order Commitments      |       | 5,911                                     |       | 5,911 |   | — |   | — |   | — |   |
|                            |       | $                                         | 24,215     |   | $ | 7,906 |   | $ | 4,217 |   | $ | 4,123 |   | $ | 7,969 |   |

Purchase order commitments primarily represent openorders for inventory.

 

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**Critical Accounting Policies and theUse of Estimates**

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates and assumptions. These estimates and assumptions affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amount ofrevenue and expenses during the reporting period. It is possible that theestimates we make may change in the future.

***Revenue Recognition***

Revenue from product sales to customers that do nothave acceptance criteria, including product sales to distributors, isrecognized when a written purchase order has been obtained, the product isshipped, title has transferred, no obligations remain and collectibility isreasonably assured. Generally, we ship our products FOB shipping point. For anyshipments with FOB destination terms, we defer revenue until delivery to thecustomer. Revenue from customers who have acceptance criteria beyond ourstandard terms and conditions is deferred until all acceptance criteria aresatisfied. Revenue for installation services, consisting of assembly andtesting, and for systems shipped to integrators is also deferred. Deferredrevenue related to service contracts is recognized over the life of thecontract, typically one to two years. Deferred revenue for systems shipped tointegrators is recognized upon shipment to the final customer.

Our transactions may involve the sale of systems andservices under multiple element arrangements. Revenue under multiple elementarrangements is allocated based on the fair value of each element. A typicalmultiple element arrangement may include some or all of the followingcomponents: products, accessories, installation services and extended warrantycontracts. The total sales price is allocated based on the relative fair valueof each component when sold separately.

***Allowance for Doubtful Accounts***

The allowance for doubtful accounts is estimated basedon past collection history and known trends with current customers. Ourestimates for allowance for doubtful accounts are reviewed and updated on aquarterly basis. Changes to the reserve occur based upon changes in revenuelevels, associated balances in accounts receivable and estimated changes incollectibility.

***Valuation of Excess and Obsolete Inventory***

We regularly analyze the value of our inventory basedon a combination of factors including, but not limited to, the following:forecasted sales or usage, historical usage rates, estimated service period,product end-of-life dates, estimated current and future market values, serviceinventory requirements and new product introductions. Inventories are stated atthe lower of standard cost, which approximates cost computed on a first-in,first-out basis, or market and include materials, labor and manufacturingoverhead. Inventory is reviewed for obsolescence and excess quantities on aquarterly basis, based on estimated future use of quantities on hand, which isdetermined based on past usage, planned changes to products and known trends inmarkets and technology. Because of the long-lived nature of many of ourproducts, we maintain a supply of parts for possible use in future repairs andcustomer field service. As these service parts become older, we apply a higherwrite-down against the recorded balance, recognizing that the older the part,the less likely it will be used. If circumstances related to our inventorieschange, our estimates of the value of inventory could materially change.Inventory write-downs are recorded quarterly as a component of cost of sales.

***Lives and Recoverability of Equipment and Other Long-LivedAssets***

We evaluate the remaining lives and recoverability ofequipment and other assets, including intangible assets, whenever events orchanges in circumstances indicate that the carrying amount of the asset may notbe recoverable in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” If there is an indication ofimpairment, we prepare an estimate of future, undiscounted cash flows expectedto result from the use of the asset and its eventual disposition. If these cashflows are less than the carrying value of the asset, we adjust the carryingamount of the

36

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asset to its estimated fair value. We have notrecorded any impairment charges for long-lived assets during the years ended2006, 2005 or 2004.

***Warranty Liabilities***

Warranty costs include labor to repair the system andreplacement parts for defective items, as well as other costs incidental towarranty repairs. Any cost recoveries from warranties offered to us by oursuppliers covering defective components are also netted against the warrantyexpense. We estimate a liability for costs to repair or replace products underwarranties ranging from 90 days to one-year and technical support costswhen the related product revenue is recognized. The products are sold without aright of return or price protection rights. The liability for productwarranties is calculated as a percentage of sales. The percentage is based onhistorical actual product repair costs. Our estimated warranty costs arereviewed and updated on a quarterly basis. We anticipate our future warrantyreserve accrual rate to be approximately 1% of revenue. Changes to the reserveoccur as volume, product mix and actual warranty costs fluctuate.

***Deferred Tax Asset Valuation Allowance***

We record deferredtax assets for the estimated future benefit of research and development taxcredits, foreign tax credits, net operating loss carryforwards and othertemporary differences to the extent management believes these assets will berealized. A valuation allowance is recorded when management can not reachthe conclusion that it is more likely than not that the deferred tax assetswill be realized. At December 31, 2006, we had a net deferred taxasset on our balance sheet totaling $2.5 million, primarily related to timingdifferences in the recognition of certain reserves and accruals. We believe itis more likely than not that the benefits of these assets will be realized. Wemay record additional valuation allowances in the future.

***Stock-Based Compensation***

On January 1,2006, we adopted SFAS No. 123R, “Share-Based Payment,” which requires themeasurement and recognition of compensation expense for all share based paymentawards granted to our employees and directors, including employee stockoptions, non-vested stock and stock purchases related to our employee stockpurchase plan based on the estimated fair value of the award on the grantdate. Upon the adoption of SFAS No. 123R, we maintained our method ofvaluation for stock option awards using the Black-Scholes valuation model,which has historically been used for the purpose of providing pro-formafinancial disclosures in accordance with SFAS No. 123.

The use of the Black-Scholesvaluation model to estimate the fair value of stock option awards requires usto make judgments on assumptions regarding the risk-free interest rate,expected dividend yield, expected term and expected volatility over theexpected term of the award. The assumptions used in calculating the fairvalue of share-based payment awards represent management’s best estimates, butthese estimates involve inherent uncertainties and the application of expensecould be materially different in the future.

Compensationexpense is only recognized on awards that ultimately vest. Therefore, wehave reduced the compensation expense to be recognized over the vesting periodfor anticipated future forfeitures. Forfeiture estimates are based onhistorical forfeiture patterns. We update our forfeiture estimatesquarterly and recognize any changes to accumulated compensation expense in theperiod of change. If actual forfeitures differ significantly from ourestimates, our results of operations could be materially impacted.

**New Accounting Pronouncements**

See Note 2 of Notes toConsolidated Financial Statements included in Item 8 of this Form 10-K for adiscussion of new accounting pronouncements.

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**Off-Balance Sheet Arrangements**

We do not have any off-balance sheet arrangements thathave or are reasonably likely to have a material current or future effect onour financial condition, changes in financial condition, revenue or expenses,results of operations, liquidity, capital expenditures or capital resources.

##### **ITEM7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

***Foreign Currency Exchange Risk***

We sometimes attempt to mitigate our currencyexposures for recorded transactions by using forward exchange contracts. Thepurpose of these activities is to reduce the risk that future cash flows of theunderlying assets and liabilities will be adversely affected by changes inexchange rates. In some cases, we enter into forward sale or purchase contractsfor foreign currencies, primarily the Japanese yen, to hedge specificreceivables and bookings positions. As of December 31, 2006, we had contractsoutstanding for the purchase of Japanese yen totaling approximately$4.5 million, which mature through April 2007.

Historically, we have not attempted to mitigate theimpact of foreign currency fluctuations on the remeasurement of oursubsidiaries’ net assets and results of operations, nor do we enter intoderivative financial instruments for speculative purposes.

Our forward exchange contracts do not qualify forhedge accounting treatment in accordance with SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities — anamendment of SFAS No. 133,” and, accordingly, gains and losses on ourforward exchange contracts are recognized currently as a component of otherincome (expense).

***Interest Rate Risk***

Our exposure to market risk from changes in interestrates relates primarily to our investments. The primary objective of ourinvestment activities is to preserve principal while maximizing yields withoutsignificantly increasing risk. This is accomplished by investing in diversifiedinvestments, consisting only of investment grade securities.

As of December 31, 2006, we held cash, cashequivalents and short-term marketable securities of $43.8 million.Declines of interest rates over time would reduce our interest income from ourhighly liquid short-term investments. A decrease in interest rates of onepercent would cause a corresponding decrease in our annual interest incomerelated to our cash, cash equivalents and marketable securities ofapproximately $438,000, assuming our December 31, 2006 balances remainedconstant. Due to the nature of our highly liquid cash equivalents, a change ininterest rates would not materially affect the fair market value of our cashand cash equivalents.

As of December 31, 2006, we held long-term fixed rateinvestments of $9.7 million that consisted primarily of municipal obligations.An increase or decrease in interest rates would not have a material impact onour results of operations, financial position or cash flows, as we haveclassified our securities as available-for-sale and, therefore, may choose tosell or hold them as changes in the market occur. Declines in interest ratesover time would reduce our interest income from our long-term investments, asfunds are re-invested at current market interest rates.

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##### **ITEM8.  CONSOLIDATED FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

The financial statementsand notes thereto required by this item begin on page F-1 of this document, aslisted in Item 15 of Part IV. Unaudited quarterly financial data**for each of the eight quarters in the two-year period endedDecember 31, 2006 is as follows:
| **In thousands, except per share data** | ** ** | **1**st Quarter | ** ** | **2**nd Quarter | ** ** | **3**rd Quarter | ** ** | **4**th Quarter | ** ** |
|------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **2005**                                                         | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** |
| Revenue                                                          |       | $                    | 18,661     |                 | $          | 18,311               |       | $                    | 18,987     |   | $ | 17,678 |   |
| Gross profit                                                     |       | 9,159                |       | 8,650                |       | 8,866                |       | 7,572                |       |
| Net income                                                       |       | 2,495                |       | 2,231                |       | 2,148                |       | 1,445                |       |
| Basic net income  per share                                      |       | 0.23                 |       | 0.20                 |       | 0.19                 |       | 0.13                 |       |
| Diluted net  income per share                                    |       | 0.21                 |       | 0.19                 |       | 0.18                 |       | 0.12                 |       |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| **2006**                                                         | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** |
| Revenue                                                          |       | $                    | 19,699     |                 | $          | 19,598               |       | $                    | 22,950     |   | $ | 22,605 |   |
| Gross profit                                                     |       | 8,567                |       | 8,746                |       | 9,914                |       | 9,815                |       |
| Net income                                                       |       | 656                  |       | 796                  |       | 1,232                |       | 926                  |       |
| Basic net income  per share                                      |       | 0.06                 |       | 0.07                 |       | 0.11                 |       | 0.08                 |       |
| Diluted net income per  share                                    |       | 0.06                 |       | 0.07                 |       | 0.10                 |       | 0.08                 |       |

 

##### **ITEM9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

##### **ITEM9A.  CONTROLS AND PROCEDURES**

# **Management’sReport on Internal Control Over Financial Reporting**

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules 13a —15(f).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting based on the framework in *InternalControl — Integrated Framework**issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO).* Based onour evaluation under the framework in *InternalControl — Integrated Framework**issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO)*, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Ourindependent registered public accounting firm, KPMG LLP, has issued an auditreport on management’s assessment of our internal control over financialreporting as of December 31, 2006. Their report appears below.

**Changes in Internal Controls**

There has been nochange in our internal control over financial reporting that occurred duringour last fiscal quarter that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

**DisclosureControls and Procedures**

Our management hasevaluated, under the supervision and with the participation of our ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934(the “Exchange Act”). Based on that evaluation, our Chief Executive Officer andChief Financial Officer have concluded that, as of the end of the periodcovered by this report, our disclosure controls and procedures are effective inensuring that information required to be disclosed in our Exchange Act reportsis (1) recorded, processed, summarized and reported in a timely manner, and (2)accumulated and communicated to our management, including our Chief

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Executive Officerand Chief Financial Officer, as appropriate to allow timely decisions regardingrequired disclosure.

**Limitationon Effectiveness of Controls**

Our management,including our Chief Executive Officer and Chief Financial Officer, do notexpect that our disclosure controls and procedures or our internal control overfinancial reporting will prevent or detect all errors and all occurrences offraud. A control system, no matter how well designed and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystems are met. Further, the design of a control system must reflect the factthat there are resource constraints, and the benefits of all controls must beconsidered relative to their costs. Control systems can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the control. In addition, over time, controls may becomeinadequate because of changes in conditions, or the degree of compliance withthe policies or procedures may deteriorate. Because of the inherent limitationsin all control systems, no evaluation of controls can provide absoluteassurance that the control systems will detect all control issues, includinginstances of fraud, if any.

**Reportof Independent Registered Public Accounting Firm**

The Board of Directorsand ShareholdersCascade Microtech, Inc.:

We have auditedmanagement’s assessment, included in the accompanying Management’s Report onInternal Control Over Financial Reporting appearing in Item 9A., that CascadeMicrotech, Inc. maintained effective internal control over financial reportingas of December 31, 2006 based on criteria established in *Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO)*. CascadeMicrotech Inc.’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted ouraudit in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal controlover financial reporting, evaluating management’s assessment, testing andevaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control overfinancial reporting includes those policies and procedures that(1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

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In our opinion,management’s assessment that Cascade Microtech, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2006 isfairly stated, in all material respects, based on criteria established in *Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO)*. Also, inour opinion, Cascade Microtech, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO)*.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Cascade Microtech, Inc. andsubsidiaries as of December 31, 2006 and 2005 and the related consolidatedstatements of operations, redeemable stock, shareholders’ equity andcomprehensive income and cash flows for each of the years in the three-yearperiod ended December 31, 2006, and our report dated March 16, 2007expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Portland, Oregon

March 16, 2007

##### **ITEM9B.  OTHER INFORMATION**

None.

**PART III**

We haveincorporated by reference into Part III the information that will appear in ourdefinitive proxy statement for our 2007 Annual Meeting of Shareholders (the “ProxyStatement”), which will be filed within 120 days after the end of our yearended December 31, 2006 pursuant to Regulation 14A.

**ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE**

Information withrespect to directors and executive officers is included under “Election ofDirectors,” “Meetings and Committees of the Board of Directors,” “ExecutiveOfficers,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “AuditCommittee Financial Expert” and “Code of Ethics” in our definitive proxystatement for our 2007 Annual Meeting of Shareholders and is incorporatedherein by reference.

##### **ITEM11.  EXECUTIVE COMPENSATION**

Information withrespect to executive compensation is included under “Director Compensation,” “ExecutiveCompensation,” “Compensation Committee Report,” “Compensation Discussion andAnalysis,” “Potential Payments Upon Termination or Change-in-Control” and “CompensationCommittee Interlocks and Insider Participation” in our definitive proxystatement for our 2007 Annual Meeting of Shareholders and is incorporatedherein by reference.

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##### **ITEM12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

**EquityCompensation Plan Information**

Thefollowing table summarizes equity securities authorized for issuance pursuantto compensation plans as of December 31, 2006.
| ** **                                                 | ** ** | **A**                                                                                                                                               | ** ** | **B**                                                                                                            | ** ** | **C**                                                                                                                                                                                                         | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan Category**                                     | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights**(1) | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for future  issuance under equity  compensation plans  (excluding securities  reflected in column A** | ** ** |
| Equity compensation plans approved by  shareholders(3)     |       | 1,728,116                                                                                                                                           | (1)        | $                                                                                                                | 9.95       |                                                                                                                                                                                                          | 937,196    | (2) |
|                                                       |       |                                                                                                                                                |       |                                                                                                             |       |                                                                                                                                                                                                          |       |
| Equity compensation plans not approved by  shareholders(4) |       | —                                                                                                                                              |       | —                                                                                                           |       | —                                                                                                                                                                                                        |       |
| Total                                                      |       | 1,728,116                                                                                                                                           |       | $                                                                                                                | 9.95       |                                                                                                                                                                                                          | 937,196    |   |

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(1)    Excludespurchase rights accruing under our 2004 Employee Stock Purchase Plan (the “PurchasePlan”) which has a shareholder approved reserve of 400,000 shares. Under thePurchase Plan, each eligible employee may purchase shares of our common stockat semi-annual intervals at a purchase price per share equal to 85% of thelower of (i) the fair market value of the common stock on the enrollment datefor the offering period in which that semi-annual purchase date occurs or (ii)the fair market value on the semi-annual purchase date.

(2)    Represents659,296 shares of common stock available for issuance under our 1993 StockIncentive Plan and our 2000 Stock Incentive Plan combined and 277,900 shares ofcommon stock available for purchase under our 2004 Employee Stock PurchasePlan.

(3)    Consistsof our 1993 Stock Incentive Plan, 2000 Stock Incentive Plan and 2004 EmployeeStock Purchase Plan.

(4)    Wedo not have any equity compensation plans or arrangements that have not beenapproved by shareholders.

Additionalinformation required by this item is included under “Security Ownership ofCertain Beneficial Owners and Management” in our definitive proxy statement forour 2007 Annual Meeting of Shareholders and is incorporated herein byreference.

##### **ITEM13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS, AND DIRECTOR INDEPENDENCE**

The informationrequired by this item is included under “Certain Relationships and RelatedTransactions” and “Director Independence and Lead Independent Director” in ourdefinitive proxy statement for our 2007 Annual Meeting of Shareholders and isincorporated herein by reference.

##### **ITEM14.  PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

The informationrequired by this item is included under “Ratification of Appointment ofIndependent Registered Public Accounting Firm” in our Proxy Statement for our2007 Annual Meeting of Shareholders and is incorporated herein by reference.

 

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##### **PART IV**

##### **ITEM15.  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

**Financial Statements andSchedules**

TheConsolidated Financial Statements, together with the report thereon of KPMGLLP, are included on the pages indicated below:
|                                                                                                                                                          | **Page**    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                 | F-1         |
|                                                                                                                                                     |        |
| Consolidated Balance Sheets as of December 31, 2006  and 2005                                                                                            | F-2         |
|                                                                                                                                                     |        |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                                                              | F-3         |
|                                                                                                                                                     |        |
| Consolidated Statements of Redeemable Stock,  Shareholders’ Equity and Comprehensive Income for 

the years ended  December 31, 2006, 2005 and 2004 |  

F-4 |
|                                                                                                                                                     |        |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                                                              | F-5         |
|                                                                                                                                                     |        |
| Notes to Consolidated Financial Statements                                                                                                               | F-6         |
|                                                                                                                                                     |        |
| Schedule II — Valuation and Qualifying Accounts                                                                                                     | F-24        |

 

**Exhibits**

The followingexhibits are filed herewith and this list is intended to constitute the exhibitindex.  Exhibit numbers marked with anasterisk (*) represent management or compensatory arrangements.
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                   |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Third Amended and Restated Articles of Incorporation  of Cascade Microtech, Inc. Incorporated 

by reference to Exhibit 3.1 to our Form 8-K  filed December 23, 2004.                                                                                        |
| 3.2         |       | Second Amended and Restated Bylaws of Cascade  Microtech, Inc., as amended March 31, 

2006. Incorporated by reference to Form 10-Q for the  quarterly period ended March 31, 2006 

and filed with the Securities and Exchange  Commission on May 10, 2006. |
| 4.1         |       | Reference is made to Exhibit 3.1                                                                                                                                                                                                                             |
| 10.1*       |       | Form of Indemnity Agreement between Cascade  Microtech, Inc. and each of its Officers and 

Directors. Incorporated by reference to  Exhibit 10.1 to our Registration Statement on Form S-1, 

File No. 333-47100.                                 |

 

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| Exhibit  No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2*        |       | Cascade Microtech, Inc. 1993 Stock Incentive  Plan, as amended. Incorporated by reference to 

Exhibit 10.2 to our Registration Statement on  Form S-1, File No. 333-47100.                                                                                                                                                                                                                   |
| 10.3*        |       | Cascade Microtech, Inc. 2000 Stock Incentive Plan,  as amended. Incorporated by reference to 

Form 8-K as filed with the Securities and Exchange  Commission on May 24, 2006.                                                                                                                                                                                                                                    |
| 10.4*        |       | Cascade Microtech, Inc. 2004 Employee Stock  Purchase Plan. Incorporated by reference to 

Exhibit 10.4 to our Registration Statement on  Form S-1, File No. 333-113256.                                                                                                                                                                                                                      |
| 10.5*        |       | Employment Agreement of Steven Sipowicz.  Incorporated by reference to Exhibit 10.12 to our 

Registration Statement on Form S-1, File  No. 333-113256.                                                                                                                                                                                                                                            |
| 10.6*        |       | First Amendment to Executive Employment Agreement of  Steven Sipowicz dated October 27, 

2005. Incorporated by reference to Exhibit 10.2 to  our Form 10-Q for the quarterly period ended 

September 30, 2005 and filed November 14, 2005.                                                                                                                                                                      |
| 10.7         |       | Lease Agreements I and II between Amberjack, Ltd.  And Cascade Microtech, Inc. dated 

August 20, 1997, and Amendment No. 2 to  Lease Agreement I dated July 23, 1998, and 

Amendment No. 2 to Lease Agreement II  dated April 12, 1999. Incorporated by reference to 

Exhibit 10.9 to our Registration Statement on  Form S-1, File No. 333-47100. |
| 10.8         |       | Third Amendment dated August 11, 2006 to Lease  Agreement I dated August 20, 1997 between 

Amberjack, LTD. And Cascade Microtech, Inc.  Incorporated by reference to Exhibit 10.2 to our 

Form 10-Q for the quarterly period ended September  30, 2006 and filed November 9, 2006.                                                                                                                              |
| 10.9         |       | Third Amendment dated August 11, 2006 to Lease  Agreement II dated August 20, 1997 

between Amberjack, LTD. And Cascade Microtech, Inc.  Incorporated by reference to Exhibit 

10.3 to our Form 10-Q for the quarterly period ended  September 30, 2006 and filed November 

9, 2006.                                                                                                                           |
| 10.10        |       | Lease Agreement between Bermuda Trust (Singapore)  Limited and Cascade Microtech, Inc. 

commencing December 12, 2003. Incorporated by  reference to Exhibit 10.6 to our Registration 

Statement on Form S-1, File  No. 333-113256.                                                                                                                                                     |
| 10.11        |       | Patent License Agreement between Micronics Japan  Co., Ltd, Hewlett Packard Japan, Ltd., and 

Cascade Microtech Japan, Inc. dated  July 28, 1997. Incorporated by reference to Exhibit 10.14 

to our Registration Statement on Form S-1, File  No. 333-47100.                                                                                                                     |
| 10.12        |       | Purchase Agreement between Intel Corporation and  Cascade Microtech, Inc., dated April 12, 

2003. Incorporated by reference to  Exhibit 10.11 to our Registration Statement on Form S-1, 

File No. 333-113256.                                                                                                                                                                         |
| 10.13*       |       | Cascade Microtech, Inc. 2006 Executive Compensation  Plan for the Six-Month Period Ending 

December 31, 2006. Incorporated by reference to  Exhibit 10.1 to our Form 10-Q for the 

quarterly period ended September 30, 2006 and filed  November 9, 2006.                                                                                                                                                       |
| 10.14        |       | Summary of Non-Employee Director Compensation.  Incorporated by reference to Exhibit 10.1 to 

Form 8-K filed December 13, 2005.                                                                                                                                                                                                                                                                                  |
| 14           |       | Code of Ethics. Incorporated by reference to  Exhibit 14 to our Form 10-K for the year ended 

December 31, 2004 and filed March 29, 2005.                                                                                                                                                                                                                                                                   |
| 21           |       | List of Subsidiaries.                                                                                                                                                                                                                                                                                                                                                                                             |
| 23           |       | Consent of KPMG LLP                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.1         |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the 

Securities Exchange Act of 1934.                                                                                                                                                                                                                                                                                  |
| 31.2         |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the 

Securities Exchange Act of 1934.                                                                                                                                                                                                                                                                                  |
| 32.1         |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the 

Securities Exchange Act of 1934 and 18 U.S.C.  Section 1350.                                                                                                                                                                                                                                                      |
| 32.2         |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(b) or Rule 15d-14(b) of the 

Securities Exchange Act of 1934 and 18 U.S.C.  Section 1350.                                                                                                                                                                                                                                                      |

 

 

44

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,Cascade Microtech, Inc. has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized on March 16, 2007:
|  

 

  | CASCADE MICROTECH, INC.

(Registrant)

  |
|------------------------|-----------------------------------------------|
|                   |                                          |
|                   | By:                                           | /s/ ERIC W.  STRID |
|                   | Eric W. Strid                                 |
|                   | Chairman of the  Board, President             |
|                   | and Chief  Executive Officer                  |
|                   | (Principal  Executive Officer)                |

Pursuant to the request of the Securities Exchange Act of 1934, this report hasbeen signed below on behalf of the Registrant and in the capacities indicatedon March 16, 2007.
| SIGNATURE                  | ** ** | **TITLE**                                    |
|----------------------------|------------|----------------------------------------------|
|                       |       |                                         |
| /s/ ERIC W. STRID          |       | Chairman of the Board, President             |
| Eric W. Strid              |       | and Chief Executive Officer                  |
|                       |       | (Principal Executive Officer)                |
|                       |       |                                         |
| /s/ STEVEN SIPOWICZ        |       | Chief Financial Officer and Treasurer        |
| Steven Sipowicz            |       | (Principal Financial and Accounting Officer) |
|                       |       |                                         |
| /s/ KEITH BARNES           |       | Director                                     |
| Keith Barnes               |       |                                         |
|                       |       |                                         |
| /s/ F. PAUL CARLSON        |       | Director                                     |
| F. Paul Carlson            |       |                                         |
|                       |       |                                         |
| /s/ GEORGE P. O’LEARY |       | Director                                     |
| George P. O’Leary     |       |                                         |
|                       |       |                                         |
| /s/ WILLIAM R. SPIVEY      |       | Director                                     |
| William R. Spivey          |       |                                         |
|                       |       |                                         |
| /s/ RAYMOND A. LINK        |       | Director                                     |
| Raymond A. Link            |       |                                         |

 

45

----

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and ShareholdersCascade Microtech, Inc.:

We have audited the accompanying consolidated balancesheets of Cascade Microtech Inc., and subsidiaries as of December 31, 2006and 2005, and the related consolidated statements of operations, redeemablestock, shareholders’ equity and comprehensive income, and cash flows for eachof the years in the three-year period ended December 31, 2006. Inconnection with our audits of the consolidated financial statements, we alsohave audited the accompanying financial statement schedule. These consolidatedfinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on theseconsolidated financial statements and financial statement schedule based on ouraudits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Cascade Microtech, Inc. and subsidiaries as of December 31,2006 and 2005 and the results of their operations and their**cashflows for each of the years in the three-year period endedDecember 31, 2006, in conformity with U.S. generally accepted accountingprinciples. Also, in our opinion, the related financial statement schedule,when considered in relation to the basic consolidated financial statementstaken as a whole, presents fairly, in all material respects, the informationset forth therein.

As discussed in Note 1 to the consolidated financialstatements, effective January 1, 2006, Cascade Microtech, Inc. adopted the provisionsof Statement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Cascade Microtech Inc.’s internal control over financialreporting as of December 31, 2006 based on criteria established in *Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO)*, and ourreport dated March 16, 2007 expressed an unqualified opinion on management’sassessment of, and the effective operation of, internal control over financialreporting.

KPMG LLP

Portland, OregonMarch 16, 2007

 

F-1

----

**CascadeMicrotech, Inc.Consolidated Balance Sheets(In thousands, except share par value)**
| ** **                                                                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                                                                                  | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Assets**                                                                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Assets:                                                                                       |       |                  |       |   |   |
| Cash and cash  equivalents                                                                            |       | $                     | 5,260      |   | $ | 2,224 |   |
| Short-term  marketable securities                                                                     |       | 38,534                |       | 48,122 |   |
| Accounts  receivable, net of allowances of $153 and $97                                               |       | 17,642                |       | 16,182 |   |
| Inventories, net                                                                                      |       | 15,094                |       | 10,889 |   |
| Prepaid expenses  and other                                                                           |       | 2,293                 |       | 3,000 |   |
| Deferred income  taxes                                                                                |       | 2,042                 |       | 1,699 |   |
| Total Current  Assets                                                                                 |       | 80,865                |       | 82,116 |   |
|                                                                                                  |       |                  |       |   |   |
| Long-term marketable  securities                                                                      |       | 9,662                 |       | 1,549 |   |
| Fixed assets, net of  accumulated depreciation of $13,385 and $12,093                                 |       | 6,818                 |       | 4,422 |   |
| Deferred income taxes                                                                                 |       | 444                   |       | 336 |   |
| Goodwill                                                                                              |       | 1,295                 |       | — |   |
| Other assets, net                                                                                     |       | 4,702                 |       | 1,697 |   |
| Total Assets                                                                                          |       | $                     | 103,786    |   | $ | 90,120 |   |
|                                                                                                  |       |                  |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Liabilities:                                                                                  |       |                  |       |   |   |
| Current portion  of capital leases                                                                    |       | $                     | —     |   | $ | 8 |   |
| Accounts payable                                                                                      |       | 6,013                 |       | 3,904 |   |
| Deferred revenue                                                                                      |       | 1,184                 |       | 516 |   |
| Accrued  liabilities                                                                                  |       | 5,026                 |       | 3,087 |   |
| Total Current  Liabilities                                                                            |       | 12,223                |       | 7,515 |   |
|                                                                                                  |       |                  |       |   |   |
| Deferred revenue                                                                                      |       | 199                   |       | 255 |   |
| Other long-term  liabilities                                                                          |       | 1,171                 |       | 845 |   |
| Total  Liabilities                                                                                    |       | 13,593                |       | 8,615 |   |
|                                                                                                  |       |                  |       |   |   |
| Shareholders’ Equity:                                                                            |       |                  |       |   |   |
| Common stock,  $0.01 par value. Authorized 100,000 shares; issued and outstanding: 11,717  and 11,328 |       | 117                   |       | 113 |   |
| Additional  paid-in capital                                                                           |       | 63,144                |       | 58,287 |   |
| Deferred  stock-based compensation                                                                    |       | —                |       | (142 | ) |
| Accumulated  other comprehensive loss - unrealized holding losses on investments                      |       | (1                    | )          | (76 | ) |
| Retained  earnings                                                                                    |       | 26,933                |       | 23,323 |   |
| Total  Shareholders’ Equity                                                                      |       | 90,193                |       | 81,505 |   |
| Total  Liabilities and Shareholders’ Equity                                                      |       | $                     | 103,786    |   | $ | 90,120 |   |
|                                                                                                  |       |                  |       |   |   |

 

See accompanying Notes to Consolidated FinancialStatements.

F-2

----

**CascadeMicrotech, Inc.Consolidated Statements of Operations(In thousands, except per share par value)**

 
| ** **                                                                                                             | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Revenue                                                                                                                |       | $                                                            | 84,852     |   | $ | 73,637 |   | $ | 64,415 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Cost of sales                                                                                                          |       | 47,367                                                       |       | 39,351 |   | 35,625 |   |
| Stock-based  compensation                                                                                              |       | 443                                                          |       | 39 |   | 67 |   |
| Gross profit                                                                                                           |       | 37,042                                                       |       | 34,247 |   | 28,723 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Operating  expenses:                                                                                                   |       |                                                         |       |   |   |   |   |
| Research and development (includes $305, $17  and $30, respectively, of stock-based  compensation)                |       | 8,949                                                        |       | 6,968 |   | 5,681 |   |
| Selling, general and administrative (includes  $1,134,  $66 and $229, respectively, of  stock-based compensation) |       | 24,949                                                       |       | 19,778 |   | 16,831 |   |
|                                                                                                                   |       | 33,898                                                       |       | 26,746 |   | 22,512 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Income from  operations                                                                                                |       | 3,144                                                        |       | 7,501 |   | 6,211 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Other income  (expense):                                                                                               |       |                                                         |       |   |   |   |   |
| Interest income                                                                                                        |       | 1,615                                                        |       | 1,061 |   | 133 |   |
| Interest expense                                                                                                       |       | (1                                                           | )          | (18 | ) | (465 | ) |
| Other, net                                                                                                             |       | 347                                                          |       | 948 |   | 215 |   |
|                                                                                                                   |       | 1,961                                                        |       | 1,991 |   | (117 | ) |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Income before  income taxes                                                                                            |       | 5,105                                                        |       | 9,492 |   | 6,094 |   |
| Provision for  income taxes                                                                                            |       | 1,495                                                        |       | 1,173 |   | 1,387 |   |
| Net income                                                                                                             |       | 3,610                                                        |       | 8,319 |   | 4,707 |   |
| Accretion of  redeemable stock                                                                                         |       | —                                                       |       | — |   | 113 |   |
| Net income  attributed to common shareholders                                                                          |       | $                                                            | 3,610      |   | $ | 8,319 |   | $ | 4,594 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Basic net income  per share                                                                                            |       | $                                                            | 0.31       |   | $ | 0.75 |   | $ | 0.84 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Diluted net  income per                                                                                                |       | $                                                            | 0.30       |   | $ | 0.70 |   | $ | 0.56 |   |
|                                                                                                                   |       |                                                         |       |   |   |   |   |
| Shares used in  per share calculations:                                                                                |       |                                                         |       |   |   |   |   |
| Basic                                                                                                                  |       | 11,482                                                       |       | 11,055 |   | 5,439 |   |
| Diluted                                                                                                                |       | 11,959                                                       |       | 11,816 |   | 8,452 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

F-3

----

**Cascade Microtech, Inc.**

**Consolidated Statements ofRedeemable Stock, Shareholders’ Equity and Comprehensive Income**

**For The Years Ended December 31,2006, 2005, and 2004**

**(inthousands)**
| ** **                                                                                 | ** ** | ** **            | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | ** **   | ** ** | **Deferred**           | ** ** | **Accumulated**  | ** ** | ** **   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------------|------------|--------------|------------|------------|------------|
| ** **                                                                                 | ** ** | **Redeemable**        | ** ** | **Convertible**          | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | **Stock**         | ** ** | **Other**    | ** ** | ** **             | ** ** | **Total**        | ** ** |
| ** **                                                                                 | ** ** | **Common Stock** | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Based**      | ** ** | **Comprehensive** | ** ** | **Retained** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                 | ** ** | **Shares**            | ** ** | **Amount**               | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Shares**     | ** ** | **Amount**        | ** ** | **Capital**  | ** ** | **Comp.**              | ** ** | **Income(Loss)** | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2003**                                                           |       | 442                   |       | $                        | 584        |                  | 2,346      |        | $          | 23             |       | 4,653             |       | $            | 47         |                   | $          | 13,335           |       | $            | (902       | )          | $          | 6 |   | $ | 10,451 |   | $ | 22,960 |   |
|                                                                                       |       |                  |       |                     |       |                  |       |        |       |           |       |              |       |         |       |                   |       |             |       |         |       |       |       |
| Common stock issued                                                                        |       | —                |       | —                   |       | —                |       | —      |       | 146            |       | 2                 |       | 166          |       | —                 |       | —           |       | —       |       | 168        |       |
| Common stock issued in  IPO, net of IPO costs  of $4,572                              |       | —                |       | —                   |       | —                |       | —      |       | 3,300          |       | 33                |       | 41,628       |       | —                 |       | —           |       | —       |       | 41,661     |       |
| Common stock repurchased                                                                   |       | (16                   | )          | (150                     | )          | —                |       | —      |       | (7             | )          | —            |       | (7           | )          | —                 |       | —           |       | (41          | )          | (48        | )          |
| Accretion of common  stock redemption                                                      |       | —                |       | 113                      |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | —           |       | (113         | )          | (113       | )          |
| Amortization of deferred  stock-based compensation, net                                    |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | (265         | )          | 592                    |       | —           |       | —       |       | 327        |       |
| Termination of the  redemption feature of the redeemable common stock                      |       | (426                  | )          | (547                     | )          | —                |       | —      |       | 426            |       | 4                 |       | 543          |       | —                 |       | —           |       | —       |       | 547        |       |
| Conversion of all  outstanding shares of our convertible preferred stock into common stock |       | —                |       | —                   |       | (2,346                | )          | (23         | )          | 2,346          |       | 23                |       | —       |       | —                 |       | —           |       | —       |       | —     |       |
| Tax benefit of stock  option exercises                                                     |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | 2            |       | —                 |       | —           |       | —       |       | 2          |       |
| Unrealized holding loss  on investments                                                    |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | (23              | )          | —       |       | (23        | )          |
| Net income                                                                                 |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | —           |       | 4,707        |       | 4,707      |       |
| **Balance at December 31, 2004**                                                           |       | —                |       | —                   |       | —                |       | —      |       | 10,864         |       | 109               |       | 55,402       |       | (310                   | )          | (17              | )          | 15,004       |       | 70,188     |       |
| ** **                                                                                 | ** ** | ** **            | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | ** **   | ** ** | ** **             | ** ** | ** **       | ** ** | ** **   | ** ** | ** ** | ** ** |
| Common stock issued                                                                        |       | —                |       | —                   |       | —                |       | —      |       | 464            |       | 4                 |       | 2,175        |       | —                 |       | —           |       | —       |       | 2,179      |       |
| Additional IPO costs                                                                       |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | (99          | )          | —                 |       | —           |       | —       |       | (99        | )          |
| Amortization of deferred  stock-based compensation, net                                    |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | (46          | )          | 168                    |       | —           |       | —       |       | 122        |       |
| Tax benefit of stock  option exercises                                                     |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | 855          |       | —                 |       | —           |       | —       |       | 855        |       |
| Unrealized holding loss  on investments                                                    |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | (59              | )          | —       |       | (59        | )          |
| Net income                                                                                 |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | —           |       | 8,319        |       | 8,319      |       |
| **Balance at December 31, 2005**                                                           |       | —                |       | —                   |       | —                |       | —      |       | 11,328         |       | 113               |       | 58,287       |       | (142                   | )          | (76              | )          | 23,323       |       | 81,505     |       |
|                                                                                       |       |                  |       |                     |       |                  |       |        |       |           |       |              |       |         |       |                   |       |             |       |         |       |       |       |
| Common stock issued                                                                        |       | —                |       | —                   |       | —                |       | —      |       | 389            |       | 4                 |       | 2,172        |       | —                 |       | —           |       | —       |       | 2,176      |       |
| Reversal of deferred  stock-based compensation upon adoption of SFAS No. 123R              |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | (142         | )          | 142                    |       | —           |       | —       |       | —     |       |
| Stock-based compensation                                                                   |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | 1,882        |       | —                 |       | —           |       | —       |       | 1,882      |       |
| Tax benefit of stock  option exercises                                                     |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | 945          |       | —                 |       | —           |       | —       |       | 945        |       |
| Unrealized holding gain  on investments                                                    |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | 75               |       | —       |       | 75         |       |
| Net income                                                                                 |       | —                |       | —                   |       | —                |       | —      |       | —         |       | —            |       | —       |       | —                 |       | —           |       | 3,610        |       | 3,610      |       |
| **Balance at December 31, 2006**                                                           |       | —                |       | $                        | —     |                  | $          | —      |       | $              | —     |              | $          | 11,717       |       | $                      | 117        |             | $          | 63,144       |       | $          | —     |   | $ | (1 | ) | $ | 26,933 |   | $ | 90,193 |   |
|                                                                                            |            |                       |            |                          |            |                       |            |             |            |                |            |                   |            |              |            |                        |            |                  |            |              |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanyingNotes to Consolidated Financial Statements

F-4

----

**CascadeMicrotech, Inc.Consolidated Statements of Cash Flows(In thousands)**

 
| ** **                                                                               | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Cash flows from operating  activities:**                                               |       |                                                         |       |   |   |   |   |
| Net income                                                                               |       | $                                                            | 3,610      |   | $ | 8,319 |   | $ | 4,707 |   |
| Adjustments to  reconcile net income to net cash flows provided by operating activities: |       |                                                         |       |   |   |   |   |
| Depreciation and  amortization                                                           |       | 2,065                                                        |       | 1,859 |   | 2,031 |   |
| Stock-based  compensation, net                                                           |       | 1,882                                                        |       | 122 |   | 326 |   |
| Loss on disposal  of fixed assets                                                        |       | 3                                                            |       | 27 |   | 9 |   |
| Deferred income  taxes                                                                   |       | (451                                                         | )          | (418 | ) | (160 | ) |
| Excess tax  benefits related to stock options exercises                                  |       | (945                                                         | )          | 855 |   | 2 |   |
| (Increase)  decrease in:                                                                 |       |                                                         |       |   |   |   |   |
| Accounts  receivable, net                                                                |       | (1,460                                                       | )          | (2,542 | ) | (3,037 | ) |
| Inventories                                                                              |       | (4,086                                                       | )          | (709 | ) | (2,115 | ) |
| Prepaid expenses  and other                                                              |       | 707                                                          |       | (1,421 | ) | (814 | ) |
| Increase  (decrease) in:                                                                 |       |                                                         |       |   |   |   |   |
| Accounts payable                                                                         |       | 1,990                                                        |       | (47 | ) | 1,129 |   |
| Deferred revenue                                                                         |       | 612                                                          |       | (90 | ) | 174 |   |
| Accrued and  other long-term liabilities                                                 |       | 3,210                                                        |       | (49 | ) | 349 |   |
| Net cash  provided by operating activities                                               |       | 7,137                                                        |       | 5,906 |   | 2,601 |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Cash flows from investing  activities:**                                               |       |                                                         |       |   |   |   |   |
| Purchase of  marketable securities                                                       |       | (52,152                                                      | )          | (46,814 | ) | (46,583 | ) |
| Proceeds from  sale of marketable securities                                             |       | 53,702                                                       |       | 41,577 |   | 9,379 |   |
| Purchase of  fixed assets                                                                |       | (3,970                                                       | )          | (2,018 | ) | (926 | ) |
| Proceeds from  disposal of fixed assets                                                  |       | 9                                                            |       | 29 |   | — |   |
| Investment in  patents and other assets                                                  |       | (768                                                         | )          | (542 | ) | (484 | ) |
| Business  acquisition of eVue product line                                               |       | (4,035                                                       | )          | — |   | — |   |
| Net cash used in  investing activities                                                   |       | (7,214                                                       | )          | (7,768 | ) | (38,614 | ) |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Cash flows from financing  activities:**                                               |       |                                                         |       |   |   |   |   |
| Principal  payments on capital lease obligations                                         |       | (8                                                           | )          | (27 | ) | (46 | ) |
| Principal  payments on long-term debt                                                    |       | —                                                       |       | — |   | (7,000 | ) |
| Excess tax  benefits related to stock options exercises                                  |       | 945                                                          |       | — |   | — |   |
| Proceeds from  issuance of common stock, net of offering costs of $4,572                 |       | —                                                       |       | — |   | 41,661 |   |
| Additional  offering costs                                                               |       | —                                                       |       | (99 | ) | — |   |
| Proceeds from  other issuances of common stock, net                                      |       | 2,176                                                        |       | 2,179 |   | 168 |   |
| Payments to  repurchase common stock                                                     |       | —                                                       |       | — |   | (198 | ) |
| Net cash  provided by financing activities                                               |       | 3,113                                                        |       | 2,053 |   | 34,585 |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
| Increase (decrease) in  cash and cash equivalents                                        |       | 3,036                                                        |       | 191 |   | (1,428 | ) |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Cash and cash equivalents:**                                                           |       |                                                         |       |   |   |   |   |
| Beginning of  year                                                                       |       | 2,224                                                        |       | 2,033 |   | 3,461 |   |
| End of year                                                                              |       | $                                                            | 5,260      |   | $ | 2,224 |   | $ | 2,033 |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Supplemental disclosure of cash  flow information:**                                   |       |                                                         |       |   |   |   |   |
| Cash paid for  interest                                                                  |       | $                                                            | 1          |   | $ | 2 |   | $ | 480 |   |
| Cash paid  (refunds received) for income taxes, net                                      |       | (1,193                                                       | )          | 2,127 |   | 2,893 |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Non-cash operating activities:**                                                       |       |                                                         |       |   |   |   |   |
| Inventory and  payables related to business acquisition                                  |       | $                                                            | 119        |   | $ | — |   | $ | — |   |
|                                                                                     |       |                                                         |       |   |   |   |   |
| **Non-cash financing activities:**                                                       |       |                                                         |       |   |   |   |   |
| Reversal of  deferred stock-based compensation                                           |       | $                                                            | 142        |   | $ | 46 |   | $ | 265 |   |
| Termination of  redemption feature on redeemable common stock                            |       | —                                                       |       | — |   | 547 |   |
| Conversion of  convertible preferred stock to common stock                               |       | —                                                       |       | — |   | 23 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

F-5

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**Cascade Microtech, Inc.**

**Notesto Consolidated Financial Statements**

**NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

***Nature of Business***

We are involved in the development, manufacturing andselling of wafer probing solutions for the electrical measurement and test ofintegrated circuits, or ICs. We design, manufacture and assemble products inBeaverton, Oregon, with global sales, service and support centers in NorthAmerica, Europe, Japan, Singapore, Taiwan and China.

***Principles ofConsolidation***

The consolidated financial statements include theaccounts of Cascade Microtech, Inc. and its wholly owned subsidiaries. Allsignificant intercompany accounts and transactions have been eliminated.

The functional currency of our foreign subsidiaries isthe U.S. dollar. Nonmonetary balance sheet items are remeasured at historicalrates and monetary balance sheet items are remeasured at current rates.Exchange gains and losses from remeasurement of monetary assets and liabilitiesare recognized currently in our consolidated statements of operations.

***Use of Estimatesin Financial Reporting***

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, as well as revenues and expenses reported for theperiods presented. On an on-going basis, we evaluate our estimates, including thoserelated to revenue recognition, allowance for doubtful accounts, valuation ofexcess and obsolete inventory, lives and recoverability of equipment and otherlong-lived assets, warranty liabilities, deferred tax asset valuationallowance, stock-based compensation, contingencies and litigation. We base our estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

***Cash and CashEquivalents***

Included in cash and cash equivalents were cash equivalentsof $342,000 and $213,000 at December 31, 2006 and 2005, respectively,which consisted of money market funds, and are stated at cost, whichapproximates market value. We consider all highly liquid investments with anoriginal maturity of three months or less to be cash equivalents.

***MarketableSecurities***

We account for our marketable securities in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accountingfor Certain Investments in Debt and Equity Securities.” We classify ourmarketable securities as available-for-sale and, accordingly, record them atcurrent market value. Unrealized holding gains and losses are excluded fromearnings and are reported as a separate component of shareholders’ equity untilrealized. Dividend and interest income is recognized when earned. Realizedgains and losses are included in earnings and are derived using the specificidentification method for determining the cost of securities sold.

We periodically evaluate whether declines in fair valuesof our investments below their cost are “other-than-temporary.” This evaluationconsists of qualitative and quantitative factors regarding the severity andduration of the unrealized loss, as well as our ability and intent to hold theinvestment until a forecasted recovery occurs.

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***Trade AccountsReceivable***

Trade accounts receivable are recorded at theirinvoiced amount and do not bear interest. The allowance for doubtful accountsis our best estimate of the amount of probable credit losses in our existingaccounts receivable. We determine our allowance for doubtful accounts utilizinghistorical collection percentages considering the aging of the accounts andknown trends with current customers, including recent significant changes intheir financial position.

The provision for doubtful accounts totaled $114,000,$15,000 and $15,000, respectively, in 2006, 2005 and 2004. The allowance fordoubtful accounts totaled $153,000 and $97,000, respectively, at December 31,2006 and 2005. Historically, write-offs have been insignificant.

***Inventories***

Inventories are stated at the lower of standard cost,which approximates cost computed on a first-in, first-out basis, or market, andinclude materials, labor and manufacturing overhead. Demonstration goods, whichare included as a component of finished goods, represent inventory that is usedfor customer demonstration purposes. This inventory is typically sold after 12to 18 months. We analyze the carrying value of our inventory quarterly,considering a combination of factors including, but not limited to, thefollowing: forecasted sales or usage, historical usage rates, estimated serviceperiod, product end-of-life dates, estimated current and future market values,service inventory requirements and new product introductions. We estimatemarket value based on factors including, but not limited to, replacement costand estimated resale value. Write-downs of inventory totaled $285,000, $125,000and $159,000, respectively, in 2006, 2005 and 2004.

***Fair Value ofFinancial Instruments***

The carrying value of cash and cash equivalents,accounts receivable, accounts payable and accrued liabilities approximate fairvalue due to their short maturities. The fair value of our capital leaseobligations approximate carrying value as such instruments’ stated interestrates do not differ significantly from current market rates.

***Fixed Assets***

Equipment and leasehold improvements are stated atcost. Equipment under capital lease is recorded at the net present value of thefuture minimum lease payments at the inception of the lease. Maintenance andrepairs are expensed as incurred. We donot accrue for the future cost of periodic major overhauls and plannedmaintenance of plant and equipment in annual or interim periods.Depreciation of owned equipment is provided using the straight-line method overthe estimated useful lives of the assets, ranging from two to seven years.Amortization of equipment under capital leases and leasehold improvements isprovided using the straight-line method over the life of the lease or theuseful life of the asset, whichever is shorter.

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***Goodwill***

***Goodwill represents the excess of the aggregate purchaseprice over the fair value of the net assets acquired in a purchase businesscombination. Goodwill is not amortized but rather is reviewed for impairment atleast annually in accordance with the provisions of SFAS No. 142, “Goodwill andOther Intangible Assets.” The goodwill impairment test is a two-step test.Under the first step, the fair value of the reporting unit is compared with itscarrying value, and if an indication of goodwill impairment exists for thereporting unit, the enterprise must perform step two of the impairment test(measurement). Under step two, an impairment loss is recognized for any excessof the carrying amount of the reporting unit’s goodwill as determined byallocating the fair value of the reporting unit in a manner similar to apurchase price allocation in accordance with SFAS No. 141, “BusinessCombinations.” The residual fair value after this allocation is the impliedfair value of the reporting unit goodwill. Fair value of the reporting unit isdetermined using a discounted cash flow analysis. If the fair value of thereporting unit exceeds its carrying value, step two does not need to be performed.***

***During 2006, we performed our annual impairment review ofgoodwill and concluded that there was no impairment.***

***Other Assets***

Other assets at December 31, 2006 and 2005 includedvarious patents, acquired intangible assets and other long-term assets withdefinite useful lives. These assets are amortized using the straight-linemethod over estimated useful lives of one to eight years.

Intangible assets with determinable lives arereviewed for impairment as discussed below under “Accounting for the Impairmentof Long-Lived Assets.”

***Accounting for theImpairment of Long-Lived Assets***

Long-lived assets held and used by us, includingpatents and intangible assets with determinable lives are reviewed forimpairment whenever events or circumstances indicate that the carrying amountof assets may not be recoverable in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.” We evaluaterecoverability of assets to be held and used by comparing the carrying amountof an asset to future net undiscounted cash flows to be generated by the asset.If such assets are considered to be impaired, the impairment to be recognizedis measured as the amount by which the carrying amount of the assets exceedsthe fair value of the assets. Such reviews assess the fair value of the assetsbased upon estimates of discounted future cash flows that the assets areexpected to generate. We did not record any impairment charges against ourlong-lived assets during 2006, 2005 or 2004.

***Revenue Recognition***

We sell or deliver our products to the end-userthrough distributors, manufacturers’ representatives and integrators:

·                  distributorspurchase our products directly from us and pay us directly according to ourstandard terms and conditions. They then resell the products to end users atprices and terms set by them;

·                  manufacturers’representatives are independent companies that agree to sell our products atour prices and on our terms and they are paid a commission based on apercentage of their sales of our products; and

·                  integratorsdesign and assemble application specific measurement solutions consisting ofproducts from two or more companies. They typically do not purchase ourproducts directly from us. The end user is billed directly and is liable to usfor the purchase of the products. The integrator is paid a fee by the end user.

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Revenue from product sales to customers that do nothave special acceptance criteria, including product sales to distributors andmanufacturers’ representatives, is recognized when a written purchase order hasbeen obtained, the price is fixed and determinable, the product is shipped,title has transferred and collectibility is reasonably assured. Generally, weship our products FOB shipping point. For any shipments with FOB destinationterms, we defer revenue until delivery to the customer. Revenue from customerswho have special acceptance criteria is not recognized until all acceptancecriteria are satisfied. Revenue for installation services, consisting ofassembly and testing, is recognized when the services are performed.

Our transactions may involve the sale of systems andservices under multiple element arrangements. A typical multiple elementarrangement may include some or all of the following: products, accessories,installation services or extended warranty contracts. For any arrangements withmultiple elements, we recognize revenue only after we have determined thatelements with stand alone value have been delivered to customers and anyundelivered elements have objective and reliable evidence of fair value.

We record deferred revenue for service contracts andfor custom engineering probe stations and other systems requiring specialacceptance criteria from the customer. Deferred revenue related to servicecontracts is recognized over the life of the contract, typically one to twoyears. For systems shipped to integrators, no revenue is recognized untilshipment to the end user. Deferred revenue related to shipped systems requiringacceptance by the customer is recognized upon receipt of such acceptance.

***Sales Returns***

Customers may return standard products for any reasonwithin 30 days after delivery, provided that the return is received in itsoriginal condition, including all packing materials, for a refund, less astocking charge. Custom products are non-refundable unless agreed to in writingby us. For certain products, we also provide for a credit against the purchaseof future products. Our reserve for sales returns, which is included as acomponent of other current liabilities, was $473,000 and $154,000,respectively, at December 31, 2006 and 2005.

***Significant Customers***

No customer in 2006, 2005 or 2004 accounted for 10% ormore of our total revenues and no customers accounted for 5% or more of ourgross accounts receivable balance at December 31, 2006 or 2005.

***Product Warranty***

We estimate a liability for costs to repair or replaceproducts under warranties for a period of approximately twelve months andtechnical support costs when the related product revenue is recognized. Theproducts are sold without a right of return or price protection rights. Theliability for product warranties is calculated as a percentage of sales. Thepercentage is based on historical actual product repair costs. The liabilityfor product warranties is included in accrued liabilities on our consolidatedbalance sheet. Product warranty activity was as follows (in thousands):

 
| **Warranty accrual, December 31, 2003**  |   | $    | 178    |   |
|------------------------------------------|--------|------|--------|--------|
| Reductions for  warranty charges         |   | (452 | )      |
| Additions to  warranty reserve           |   | 639  |   |
| **Warranty  accrual, December 31, 2004** |   | 365  |   |
| Reductions for  warranty charges         |   | (501 | )      |
| Additions to  warranty reserve           |   | 624  |   |
| **Warranty  accrual, December 31, 2005** |   | 488  |   |
| Reductions for  warranty charges         |   | (525 | )      |
| Additions to warranty  reserve           |   | 573  |   |
| **Warranty accrual, December 31,  2006** |   | $    | 536    |   |

*** ***

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***Advertising***

Advertising costs are expensed as incurred and totaled$393,000, $196,000 and $7,000 in 2006, 2005 and 2004, respectively.

***Research and Development***

Research and development costs are expensed asincurred. See Note 10.

***Forward Exchange Contracts***

We account for forward exchange contracts inaccordance with SFAS No. 138, “Accounting for Certain DerivativeInstruments and Certain Hedging Activities - an amendment of FASB Statement No. 133”and SFAS No. 137, “Accounting for Derivative Instruments and HedgingActivities.” SFAS No. 137 is an amendment to SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities.” SFAS Nos. 133, 137 and 138establish accounting and reporting standards requiring that every derivativeinstrument (including certain derivative instruments embedded in othercontracts) be recorded on the balance sheet as either an asset or liabilitymeasured at its fair value. SFAS Nos. 137 and 138 require that changes in thederivative’s fair value be recognized currently in earnings unless specifichedge accounting criteria are met. Special accounting for qualifying hedgesallows a derivative’s gains and losses to offset related results on the hedgeditem in the income statement, and requires that a company must formallydocument, designate and assess the effectiveness of transactions that receivehedge accounting.

At times, we enter into forward foreign currencyexchange contracts, which typically expire within six months, to manage ourexposure against foreign currency fluctuations on sales denominated in Japaneseyen. These foreign exchange contracts are not considered hedges under SFASNo. 138, and as such are recorded at fair value on the balance sheet withany changes in fair value included as other income (expense), net on ourstatements of operations. At December 31, 2006 and 2005, we had $4.5million and $2.2 million, respectively, of forward exchange contractsoutstanding. The estimated fair value of the contracts outstanding atDecember 31, 2006 and 2005 was $4.4 million and $2.1 million,respectively.

***Income Taxes***

We account for income taxes in accordance with SFASNo. 109, “Accounting for Income Taxes.” Accordingly, deferred income taxesare established for the difference between the financial reporting and incometax basis of assets and liabilities as well as operating loss and tax creditcarryforwards. Deferred tax assets are reduced by a valuation allowance when,in the opinion of management, it is more likely than not that some portion ofthe deferred tax assets will not be realized. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled. The effect on deferred taxes of a change in tax rates isrecognized in income in the period that includes the enactment date.

***Net Income Per Share***

We compute net income per share in accordance withSFAS No. 128, “Earnings Per Share.” Under the provisions of SFASNo. 128, basic net income per share is computed by dividing the net incomeattributed to common shareholders for the period by the weighted average numberof shares of common stock outstanding during the period. Diluted net income pershare incorporates the incremental shares issuable upon the assumed exercise ofstock options and warrants using the treasury stock method and assumedconversions of preferred stock, if dilutive. In addition, upon assumedconversion of the preferred stock, the accretion of redeemable stock is addedback to net income. Accordingly, the net income used for calculating net incomeper share for 2004 was $4.7 million.

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The following table reconciles the shares used incalculating basic net income per share to the shares used in calculatingdiluted net income per share (in thousands):

 
| Year Ended December 31,                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used to  calculate basic net income per share                           |       | 11,482   |       | 11,055   |       | 5,439    |       |
|                                                                           |       |     |       |     |       |     |       |
| Dilutive effect  of:                                                           |       |     |       |     |       |     |       |
| Outstanding stock options                                                      |       | 477      |       | 761      |       | 776      |       |
| Redeemable and convertible preferred stock                                     |       | —   |       | —   |       | 2,237    |       |
| Shares used to  calculate diluted net income per share                         |       | 11,959   |       | 11,816   |       | 8,452    |       |
|                                                                           |       |     |       |     |       |     |       |
| Outstanding stock  options not considered as they would have been antidilutive |       | 727      |       | 296      |       | 273      |       |

*** ***

***Stock-Based Compensation***

Effective January 1, 2006, we adopted SFAS No. 123R, “Share-BasedPayment.” We elected to use the modified prospective transition method asprovided by SFAS No. 123R and, accordingly, financial statement amounts for theprior periods presented in this Form 10-Q have not been restated to reflect thefair value method of expensing stock-based compensation. Under this method, theprovisions of SFAS No. 123R apply to all awards granted or modified after thedate of adoption. Our deferred compensation balance of $142,000 as of December31, 2005, which was accounted for under Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees,” was reclassifiedinto additional paid in capital upon the adoption of SFAS No. 123R. Inaddition, the unrecognized expense of awards not yet vested at the date ofadoption is recognized in the net income in the periods after the date ofadoption using the Black-Scholes valuation method over the remainder of therequisite service period. The cumulative effect of the change in accountingprinciple from APB 25 to SFAS No. 123R was not material.

Prior to January 1, 2006,we accounted for stock options using the intrinsic value method as prescribedby APB 25. We provided disclosures of net income and earnings per share as ifthe method prescribed by SFAS No. 123, “Accounting for Stock-BasedCompensation,” had been appliedin measuring compensation expense as follows (in thousands, except per shareamounts):

 
| **Year Ended December 31,**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income  attributed to common shareholders, as reported                |       | $        | 8,319      |     | $          | 4,594 |   |
| Add stock-based  compensation included in reported net income, net of tax |       | 107      |       | 252      |       |
| Fair value of  stock-based employee compensation, net of tax              |       | (1,849   | )          | (1,585   | )          |
| Net income, pro  forma                                                    |       | $        | 6,577      |     | $          | 3,261 |   |
|                                                                      |       |     |       |     |       |
| Net income per  share — basic, as reported                           |       | $        | 0.75       |     | $          | 0.84 |   |
| Net income per  share — basic, pro forma                             |       | $        | 0.59       |     | $          | 0.60 |   |
|                                                                      |       |     |       |     |       |
| Net income per  share — diluted, as reported                         |       | $        | 0.70       |     | $          | 0.56 |   |
| Net income per share —  diluted, pro forma                           |       | $        | 0.56       |     | $          | 0.40 |   |

 

To determine stock-based compensation included inreported net income, net of tax, we used a tax rate approximating our effectivetax rate of 12.4% for 2005 and 22.8% for 2004.

***Comprehensive Income***

Pursuant to SFAS No. 130, “ReportingComprehensive Income,” comprehensive income is defined as changes inshareholders’ equity exclusive of transactions with owners, such as capitalcontributions and dividends. Unrealized holding gains and losses on ouravailable-for-sale marketable securities are included as a separate componentof shareholders’ equity until realized. The differences between net income(loss) and comprehensive income (loss) for the periods presented are notmaterial.

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***Reclassifications***

Certain reclassifications have been made to the priorperiod financial statements to conform with the current period presentation,and include the reclassification of stock-based compensation to research anddevelopment expense and selling, general and administrative expense.

***Certain Risks and Uncertainties***

Our future operating results and financial conditionare subject to influences driven by rapid technological changes, a highlycompetitive industry, a lengthy sales cycle, and the cyclical nature of generaleconomic conditions. Future operating results will depend on many factors,including demand for our products, the introduction and industry acceptance ofnew products and the level and timing of available shippable orders andbacklog.

In addition, we rely on several suppliers to providecertain key components used in our products. Some of these items are availablefrom only one supplier or a limited group of suppliers. Any disruption in theavailability and delivery of these items could materially adversely affect ourrevenues.

***Segment Reporting***

Based upon the requirements of SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” we have determined that we operate in two business segments:the Engineering Products Division (“EPD”) and the Pyramid Probe Division (“PPD”).Our engineering probe stations, analytical probes, probing accessories andapplication software are sold through EPD. Our production probe cards are soldthrough PPD.

***NOTE2.  NEW ACCOUNTING PRONOUNCEMENTS***

***SFAS No. 159***

In February 2007,******the FASB issued SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities,”which permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS No. 159 is effective as of thebeginning of an entity’s first fiscal year that begins after November 15, 2007.We are currently in the process of analyzing the impact of adopting SFAS No.159 on our financial position and results of operations.

***SFAS No. 157***

In September 2006, the FASBissued SFAS No. 157, “Fair Value Measurements,” which establishes a singleauthoritative definition of fair value, sets out a framework for measuring fairvalue and requires additional disclosures about fair-value measurements. SFASNo. 157 is effective for fiscal years beginning after November 15, 2007.  We are currently in the process of analyzingthe impact of applying SFAS No. 157 on our financial position and results ofoperations.

***Staff Accounting Bulletin No. 108***

In September 2006, theSecurities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No.108, “Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements,” which addresses how theeffects of prior-year uncorrected misstatements should be considered whenquantifying misstatements in current-year financial statements. SAB No. 108requires companies to quantify misstatements using both the balance sheet andincome statement approaches and to evaluate whether either approach results inquantifying an error that is material in light of relevant quantitative andqualitative factors. SAB No. 108 is effective for annual financial statementscovering the first fiscal year ending after November 15, 2006. Theimplementation of SAB No. 108 did not have a material effect on our financialposition or results of operations.

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***FASB Staff Position No. AUG AIR-1***

In September 2006, the FASBissued Staff Position No. AUG AIR-1, “Accounting for Planned Major MaintenanceActivities,” which prohibits accruing for the future cost of periodic majoroverhauls and planned maintenance of plant and equipment in annual and interimperiods. This Staff Position is effective for fiscal years beginning afterDecember 15, 2006 and must be retrospectively applied. We do not accrue forsuch costs in annual or interim periods and, accordingly, the adoption of thisStaff Position is not expected to have any effect on our financial position orresults of operations.

***FASB Interpretation No. 48***

In July 2006, the FASBissued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,”which defines the threshold for recognizing the benefits of tax returnpositions in the financial statements as “more-likely-than-not” to be sustainedby the taxing authority. Interpretation No. 48 applies to all tax positionsaccounted for under SFAS No. 109, “Accounting for Income Taxes.” InterpretationNo. 48 is effective as of the beginning of the first fiscal year beginning afterDecember 15, 2006. We are currently in the process of analyzing the impact ofadopting Interpretation No. 48, however, we believe that the adoption ofInterpretation No. 48 will not have a material effect on our financial positionor results of operations.

***EITF Issue No. 06-3***

Emerging Issues Task Force (“EITF”) Issue 06-3, “HowTaxes Collected from Customers and Remitted to Governmental Authorities ShouldBe Presented in the Income Statement (That Is, Gross versus Net Presentation),”requires us to disclose our accounting policy for any tax assessed by agovernmentalauthority that is directly imposed on a revenue-producing transaction (i.e.,sales, use, value added) on a gross (included in revenues and costs) or net(excluded from revenues) basis. EITF Issue 06-3 is effective for periodsbeginning after December 15, 2006, with earlier application permitted. Weaccount for such taxes on a net basis.

**NOTE 3*. *BUSINESS ACQUISITION**

During the fourth quarter of 2006, we acquired certain assets andliabilities related to the eVue product line from our strategic partner in atransaction which was accounted for as a business acquisition. These assetsincluded technology, design information for the manufacture of subassembliesand other intangibles. The results of this acquisition have been included inthe consolidated financial statements since the date of acquisition. Thepurchase price consisted of $4.0 million in cash, paid to the seller, plusother direct costs including attorney and other fees of $35,000. In addition,if the seller completes certain milestones related to the eVue product line byDecember 31, 2007, we will pay an additional $1.0 million contingent amount tothe seller which will be recorded as goodwill if and when it is paid. Thepurchase price was allocated as follows (in thousands):
|                                | ** ** | ** ** | ** ** | **Useful Life** | ** ** |
|--------------------------------|------------|------------|------------|----------------------|------------|
| Inventory                      |       | $          | 119        |                 | —     |   |
| Patent  technology             |       | 961        |       | 8 years              |       |
| Developed  software technology |       | 165        |       | 3 years              |       |
| Customer backlog               |       | 77         |       | 1 year               |       |
| Customer  relationships        |       | 1,537      |       | 7 years              |       |
| Goodwill                       |       | 1,295      |       | indefinite           |       |
|                           |       | 4,154      |       |                 |       |
| Current  liabilities           |       | (119       | )          |                 |       |
|                           |       | $          | 4,035      |                 |       |   |

To determine the value of the technology and otheridentifiable intangible assets acquired, we projected such items as revenues,gross margins, operating expenses, future research and development costs,income taxes and returns on requisite assets. The resulting operating incomeprojections were discounted to a net present value. Pro forma results ofoperations are not included as they are not materially different from actualresults of operations.

 

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**NOTE4.  MARKETABLE SECURITIES**

Certain information regarding our marketablesecurities was as follows (in thousands):
| December 31,                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Fair market  value:                               |       |     |       |     |       |
| Municipal obligations                             |       | $        | 47,196     |     | $          | 48,474 |   |
| Agency discount notes                             |       | 1,000    |       | —   |       |
| Government securities                             |       | —   |       | 1,197    |       |
|                                              |       | $        | 48,196     |     | $          | 49,671 |   |
| Cost:                                             |       |     |       |     |       |
| Municipal obligations                             |       | $        | 47,197     |     | $          | 48,542 |   |
| Agency discount notes                             |       | 1,000    |       | —   |       |
| Government securities                             |       | —   |       | 1,205    |       |
|                                              |       | $        | 48,197     |     | $          | 49,747 |   |
| Fair market  value by maturity:                   |       |     |       |     |       |
| Within one year                                   |       | $        | 38,534     |     | $          | 48,122 |   |
| One to two years                                  |       | 9,662    |       | 1,549    |       |
|                                              |       | $        | 48,196     |     | $          | 49,671 |   |
| Gross unrealized  holding losses:                 |       |     |       |     |       |
| Municipal obligations                             |       | $        | (1         | )        | $          | (68 | ) |
| Agency discount notes                             |       | —   |       | —   |       |
| Government securities                             |       | —   |       | (8       | )          |
|                                              |       | $        | (1         | )        | $          | (76 | ) |
|                                              |       |     |       |     |       |
| Fair value of  investments with unrealized losses |       | $        | 20,695     |     | $          | 36,352 |   |
| Fair value of  investments with unrealized gains  |       | $        | 10,491     |     | $          | — |   |

 

At December 31, 2006 and 2005, we determined that unrealized losses onour marketable securities were temporary based on the duration of theunrealized losses and on our ability to hold the marketable securities untilmaturity. No investments were in an unrealized loss position for more than oneyear.

**NOTE 5.  INVENTORIES**

Inventories consisted of the following (in thousands):
| December 31, | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Raw materials     |       | $        | 6,205      |     | $          | 4,747 |   |
| Work-in-process   |       | 2,947    |       | 1,138    |       |
| Finished goods    |       | 5,942    |       | 5,004    |       |
|              |       | $        | 15,094     |     | $          | 10,889 |   |

 

**NOTE 6. FIXED ASSETS**

Fixed assets consisted of the following (in thousands):
| December 31,              | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Equipment                      |       | $        | 14,751     |     | $          | 12,996 |   |
| Leasehold  improvements        |       | 3,027    |       | 2,743    |       |
| Construction in  progress      |       | 2,425    |       | 776      |       |
|                           |       | 20,203   |       | 16,515   |       |
| Less accumulated  depreciation |       | (13,385  | )          | (12,093  | )          |
|                           |       | $        | 6,818      |     | $          | 4,422 |   |

 

Depreciation expense was $1.6 million, $1.5 million and $1.8 million,respectively, in 2006, 2005 and 2004.

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**NOTE 7. GOODWILL AND OTHER INTANGIBLE ASSETS**

The change in goodwill during 2006 was as follows (in thousands):
| Year Ended December 31, | ** ** | **2006** | ** ** |
|----------------------------------------|------------|----------|------------|
| Balance,  December 31, 2005            |       | $        | —     |   |
| Goodwill  acquired                     |       | 1,295    |       |
| Balance, December 31,  2006            |       | $        | 1,295      |   |

 

Included in other long-termassets on our balance sheet were certain identifiable intangible assets asfollows: (in thousands):
| December 31,                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Patents                                    |       | $        | 5,602      |     | $          | 3,945 |   |
| Accumulated  amortization                  |       | (2,889   | )          | (2,527   | )          |
|                                       |       | 2,713    |       | 1,418    |       |
|                                       |       |     |       |     |       |
| Developed  software technology             |       | 165      |       | —   |       |
| Accumulated  amortization                  |       | (14      | )          | —   |       |
|                                       |       | 151      |       | —   |       |
|                                       |       |     |       |     |       |
| Customer  relationships                    |       | 1,537    |       | —   |       |
| Accumulated  amortization                  |       | (61      | )          | —   |       |
|                                       |       | 1,476    |       | —   |       |
|                                       |       |     |       |     |       |
| Customer backlog                           |       | 77       |       | —   |       |
| Accumulated  amortization                  |       | (25      | )          | —   |       |
|                                       |       | 52       |       | —   |       |
| Total identifiable  intangible assets, net |       | $        | 4,392      |     | $          | 1,418 |   |

 

Amortization expense totaled $502,000, $311,000 and$255,000, respectively, in 2006, 2005 and 2004.

Amortization of the identifiable intangible assets isas follows over the next five years (in thousands):
|            | ** ** | **Patents** | ** ** | **Developed  Software  Technology** | ** ** | **Customer  Relationships** | ** ** | **Customer  Backlog** | ** ** |
|------------|------------|-------------|------------|-------------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| 2007       |       | $           | 400        |                                | $          | 55                          |       | $                     | 220        |   | $ | 52 |   |
| 2008       |       | 456         |       | 55                                  |       | 220                         |       | —                |       |
| 2009       |       | 450         |       | 41                                  |       | 220                         |       | —                |       |
| 2010       |       | 447         |       | —                              |       | 220                         |       | —                |       |
| 2011       |       | 399         |       | —                              |       | 220                         |       | —                |       |
| Thereafter |       | 561         |       | —                              |       | 376                         |       | —                |       |
|            |            |             |            |                                     |            |                             |            |                       |            |  |  |  |  |

 

**NOTE 8. ACCRUEDLIABILITIES**

Accrued liabilities consisted of the following (inthousands):
| December 31,                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Accrued  compensation and benefits |       | $        | 2,261      |     | $          | 1,775 |   |
| Income taxes  payable              |       | 1,072    |       | 3        |       |
| Accrued warranty                   |       | 536      |       | 488      |       |
| Sales return  reserve              |       | 473      |       | 157      |       |
| Other                              |       | 684      |       | 664      |       |
|                               |       | $        | 5,026      |     | $          | 3,087 |   |

** **

F-15

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**NOTE 9. INCOME TAXES**

Domestic and foreign pre-tax income was as follows (inthousands):
| Year ended December 31, | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Domestic                               |       | $        | 3,915      |     | $          | 9,215    |       | $ | 6,161 |   |
| Foreign                                |       | 1,190    |       | 277      |       | (67      | )          |
|                                   |       | $        | 5,105      |     | $          | 9,492    |       | $ | 6,094 |   |

 

The provision (benefit) for income taxes consisted ofthe following (in thousands):
| Year ended December 31, | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                               |       |     |       |     |       |     |       |
| Federal                                |       | $        | 1,222      |     | $          | 1,443    |       | $ | 1,318 |   |
| State                                  |       | 68       |       | 130      |       | 90       |       |
| Foreign                                |       | 407      |       | 5        |       | 139      |       |
| Total current                          |       | 1,697    |       | 1,578    |       | 1,547    |       |
|                                   |       |     |       |     |       |     |       |
| Deferred:                              |       |     |       |     |       |     |       |
| Federal                                |       | (292     | )          | (373     | )          | (188     | )          |
| State                                  |       | 48       |       | (23      | )          | 17       |       |
| Foreign                                |       | 42       |       | (9       | )          | 11       |       |
| Total deferred                         |       | (202     | )          | (405     | )          | (160     | )          |
| Provision for income  taxes            |       | $        | 1,495      |     | $          | 1,173    |       | $ | 1,387 |   |

 

The provision (benefit) for income taxes varies fromthe amounts computed by applying the Federal statutory rate of 34% to incomebefore income taxes as follows (in thousands):
| Year ended December 31,          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal income  tax computed at statutory rates |       | $        | 1,736      |     | $          | 3,228    |       | $ | 2,072 |   |
| Extraterritorial  income exclusion tax benefit  |       | (139     | )          | (286     | )          | (340     | )          |
| Difference in  foreign tax rate                 |       | 59       |       | —   |       | 34       |       |
| State income  taxes, net of federal benefit     |       | 64       |       | 209      |       | 172      |       |
| Stock-based  compensation                       |       | 508      |       | (30      | )          | 92       |       |
| Tax credits  (R&D and foreign tax credit)   |       | (508     | )          | (1,289   | )          | (848     | )          |
| Changes in  valuation allowance                 |       | 191      |       | (107     | )          | 35       |       |
| Tax exempt  interest income                     |       | (538     | )          | (338     | )          | —   |       |
| State net  operating loss utilized              |       | —   |       | (38      | )          | —   |       |
| Other                                           |       | 122      |       | (176     | )          | 170      |       |
| Provision for income  taxes                     |       | $        | 1,495      |     | $          | 1,173    |       | $ | 1,387 |   |

 

F-16

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Significant components of deferred income tax assetsand liabilities were as follows (in thousands):
| **December 31,**                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Current deferred tax  assets:              |       |     |       |     |       |
| Reserves and  allowances                   |       | $        | 465        |     | $          | 310 |   |
| Inventory  reserves                        |       | 686      |       | 672      |       |
| Accrued vacation                           |       | 302      |       | 291      |       |
| Deferred  intercompany profit              |       | 583      |       | 384      |       |
| Other current  deferred tax assets         |       | 6        |       | 42       |       |
| Total current  deferred tax assets         |       | 2,042    |       | 1,699    |       |
|                                       |       |     |       |     |       |
| Non-current deferred  tax assets:          |       |     |       |     |       |
| Retirement  allowance                      |       | 162      |       | 153      |       |
| State net  operating loss carryforwards    |       | —   |       | 1        |       |
| Federal and  state research tax credits    |       | 2,273    |       | 1,766    |       |
| Foreign tax  credits                       |       | —   |       | 244      |       |
| Other  non-current deferred tax assets     |       | 686      |       | 512      |       |
| Gross  non-current deferred tax assets     |       | 3,121    |       | 2,676    |       |
| Valuation  allowance                       |       | (1,972   | )          | (1,766   | )          |
| Total net non-current  deferred tax assets |       | 1,149    |       | 910      |       |
|                                       |       |     |       |     |       |
| Non-current deferred  tax liabilities:     |       |     |       |     |       |
| Patents                                    |       | 705      |       | 574      |       |
| Net deferred tax assets                    |       | $        | 2,486      |     | $          | 2,035 |   |

 

Deferred tax assets arise from the tax benefit ofamounts expensed for financial reporting purposes but not yet realized for taxpurposes and from unutilized tax credits and net operating loss carry forwards.We evaluate our deferred tax assets on a regular basis to determine if avaluation allowance is required. To the extent it is determined that it is morelikely than not that we will not realize the benefit of our deferred taxassets, we record a valuation allowance against deferred tax assets. In 2006,we increased the valuation allowance against State of Oregon research creditsby $206,000 as we believe that this portion of the tax credits are more likelythan not to not be utilized in the future. As of December 31, 2006, we believeit is more likely than not that the benefit of the remaining federal creditswill be realized in future periods based on anticipated future profits.

In 2005, we released $28,000 of valuation allowance related to thefuture realization of foreign tax credits and foreign net operating losses.

Our 2004 tax provision included the reversal of$726,000 of previously recorded valuation allowance based on our 2004performance. The reversal primarily related to U.S. research and engineeringcredits and state net operating loss carryforwards, which were utilized during2004. In addition, in 2004, we increased the valuation allowance by $761,000for excess foreign tax credits and State of Oregon research and engineeringcredits, which we believe are more likely than not to not be utilized in thefuture.  The net result was an increasein valuation allowance in 2004 of $35,000.

The net increase (decrease) in the total valuationallowance was $206,000, $(28,000) and $35,000, respectively, in 2006, 2005 and2004. The valuation allowance as of December 31, 2006 and 2005 was $2.0 millionand $1.8 million, respectively. As of December 31, 2006, the portion ofvaluation allowance for deferred tax assets for which subsequently recognizedtax benefits will be applied directly to contributed capital is approximately$94,000.

In 2006, 2005 and 2004,income tax benefits attributable to employee stock option transactions of$945,000, $855,000 and $2,000, respectively, were allocated to shareholders’equity.

F-17

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We had state net operating loss carryforwards andfederal and state research and experimentation credit carryforwards ofapproximately $20,000 and $2.3 million, respectively, at December 31, 2006to offset against future taxable income. These carryforwards expire beginning2007 through 2026.

We did not provide for U.S. income taxes on theremaining undistributed earnings of foreign subsidiaries because they wereconsidered permanently invested outside of the U.S. Upon repatriation, some ofthese earnings would generate foreign tax credits, which may reduce the U.S.tax liability associated with any future foreign dividend. At December 31,2006, the cumulative amount of earnings upon which U.S. income taxes have notbeen provided is approximately $3.9 million.

A provision of the Internal Revenue Code requires theutilization of net operating losses and research and experimentation credits belimited when we a change in ownership of more than 50% occurs. We believe thatsuch a change occurred with the issuance of common stock in our initial publicoffering (“IPO”) in December 2004. Accordingly, the utilization of the netoperating loss and credit carryforwards generated from periods prior toDecember 2004 may be limited in the timing of their utilization.

**NOTE 10. RESEARCH AND DEVELOMENT AGREEMENT WITH KEYCUSTOMER**

In 2002, we entered into a cooperative research anddevelopment agreement with a key customer. Pursuant to the terms of theagreement, this customer reimbursed us for certain research and developmentwork performed in relation to the development of certain probes. No amountswere received in 2006 or 2005 pursuant to this agreement and $94,000 wasreceived in 2004, which was netted with research and development expense on ourconsolidated statements of operations.

**NOTE 11. OTHER INCOME (EXPENSE), NET**

Other income (expense), net consisted of the following (in thousands):
| **Year ended December 31,**             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gains related to  foreign currency contracts           |       | $        | 253        |     | $          | 151      |       | $ | 74 |   |
| Remeasurement  related foreign currency gains (losses) |       | 97       |       | (34      | )          | 132      |       |
| Settlement  income from a service provider             |       | —   |       | 700      |       | —   |       |
| Other                                                  |       | (3       | )          | 131      |       | 9        |       |
|                                                   |       | $        | 347        |     | $          | 948      |       | $ | 215 |   |

 

**NOTE12.  SHAREHOLDERS’ EQUITY**

***Public Sale of Common Stock***

We completed our IPO of 3.3 million shares of ourcommon stock in December 2004 for net proceeds of $41.6 million. Offeringcosts of $4.7 million were offset against the proceeds. Upon completion of theIPO, all of the then outstanding shares of our Series A redeemableconvertible preferred stock (“Series A”) and Series B redeemableconvertible preferred stock (“Series B”) automatically converted to a total of2,346,486 shares of our common stock, and the common stock put agreement withone of our founders expired. Accordingly, the remaining $547,000 related to theput agreement was reclassified to common stock. In addition, our authorizedcommon stock increased from 12 million shares to 100 million shares.

***Registration Rights***

Upon completion of our IPO, certain holders of sharesof common stock have registration rights, including the right to require us toregister the sale of their shares and the right to include their shares inpublic offerings we undertake in the future. We registered all shares of commonstock that are issuable under our stock option plans and employee stockpurchase plan, and they may be freely sold in the public market, subject tocertain lock-up restrictions.

F-18

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***Repurchase Option***

We or our designee had the option to repurchase allshares held by any shareholder that such shareholder proposed to sell, assign,pledge, encumber, transfer, or otherwise dispose of for value to a competitor.Such repurchases were at the same terms and conditions specified in a bona fidethird party offer for any or all of such securities. The repurchase optionlapsed upon our IPO. During 2004, we repurchased 23,562 shares pursuant to thisrepurchase option during 2004 (including shares repurchased pursuant to theStock Put Agreement described below) at a weighted average per share purchaseprice of $8.40.

***Stock PutAgreement***

We had a common stock put agreement with one of ouroriginal founders, which expired upon our IPO in December 2004. As part of theagreement, at the founder’s annual option on or before July 1, we wererequired to purchase common shares valued at up to $150,000 based on our lastannual valuation. Additional common shares could be purchased at our discretionif so agreed to by the founder. In 2004, we purchased 15,790 shares at $9.50per share.

**NOTE13.  STOCK-BASED COMPENSATION ANDSTOCK-BASED PLANS**

Certain information regarding our stock-basedcompensation was as follows (in thousands, except per share amounts):
| **Year Ended December 31,**                                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Weighted average  grant-date fair value of share options granted                               |       | $        | 3,026      |     | $          | 2,468    |       | $ | 3,581 |   |
| Total intrinsic  value of share options exercised                                              |       | 2,397    |       | 3,990    |       | 823      |       |
| Stock-based  compensation recognized in results of operations                                  |       | 1,882    |       | 122      |       | 326      |       |
| Cash received  from options exercised and shares purchased under all share-based  arrangements |       | 2,176    |       | 2,179    |       | 168      |       |
| Tax benefit realized  related to stock options exercised                                       |       | 945      |       | 855      |       | 2        |       |
|                                                                                                |            |          |            |          |            |          |            |  |  |  |

 

No stock-based compensation was capitalized as a partof an asset during the years ended December 31, 2006, 2005 or 2004.

Our stock-based compensation was included in ourstatements of operations as follows (in thousands):
| **Year Ended December 31,** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cost of sales                              |       | $        | 443        |     | $          | 39       |       | $ | 67 |   |
| Research and development                   |       | 305      |       | 17       |       | 30       |       |
| Selling, general  and administrative       |       | 1,134    |       | 66       |       | 229      |       |
|                                       |       | $        | 1,882      |     | $          | 122      |       | $ | 326 |   |

 

F-19

----

To determine the fair value of stock-based awardsgranted, we used the Black-Scholes option pricing model and the followingweighted average assumptions:

 
| **Year Ended December 31,** | ** ** | **2006**                | ** ** | **2005**           | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|--------------------|------------|----------|------------|
| **Stock  Option Plan**                     |       |                    |       |               |       |     |       |
| Risk-free  interest rate                   |       | 4.53% - 5.07            | %          | 3.77% - 4.39       | %          | 3.6      | %          |
| Expected  dividend yield                   |       | 0.0                     | %          | 0.0                | %          | 0.0      | %          |
| Expected term                              |       | 4 years - 6.5 years     |       | 6 years            |       | 6 years  |       |
| Expected  volatility                       |       | 56.2% - 61.4            | %          | 67.4% - 68.9       | %          | 68.4     | %          |
|                                       |       |                    |       |               |       |     |       |
| **Employee  Stock Purchase Plan**          |       |                    |       |               |       |     |       |
| Risk-free  interest rate                   |       | 4.73% - 5.08            | %          | 4.73% - 4.79       | %          | —   |       |
| Expected  dividend yield                   |       | 0.0                     | %          | 0.0                | %          | —   |       |
| Expected term                              |       | 6 months — 2 years |       | 6 months - 2 years |       | —   |       |
| Expected volatility                        |       | 24.8% - 45.7            | %          | 34.6% - 45.7       | %          | —   |       |

The risk-free rate used is based on the U.S. Treasuryyield over the estimated term of the options granted. Our option pricing modelutilizes the simplified method accepted under Staff Accounting Bulletin No. 107to estimate the expected term. The expected volatility for options grantedpursuant to our stock incentive plans is calculated based on a weighted averageactual volatility of a peer group of companies over the prior 6.5 year period.The expected volatility for our employee stock purchase plan is calculatedbased on our historical volatility and consideration of peer group data. Wehave not paid dividends in the past and we do not expect to pay dividends inthe future and, therefore, the expected dividend yield is 0%.

We amortize stock-based compensation on astraight-line basis over the vesting period of the individual awards, which isthe requisite service period, with estimated forfeitures considered. Shares tobe issued upon the exercise of stock options will come from newly issuedshares.

The following table presents the impact of ouradoption of SFAS No. 123R on selected line items from the condensedconsolidated financial statements for the year ended December 31, 2006 (inthousands, except per share amounts):
| **Year Ended December 31, 2006** | ** ** | **As reported  following  SFAS No.  123R** | ** ** | **If reported  following  APB No. 25** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Income before  income taxes                          |       | $                                                    | 5,105      |                                                  | $          | 6,907 |   |
| Net income                                           |       | 3,610                                                |       | 5,412                                                 |       |
| Cash flow from  operating activities                 |       | 7,137                                                |       | 8,082                                                 |       |
| Cash flow from  financing activities                 |       | 3,113                                                |       | 2,168                                                 |       |
| Basic net income  per share                          |       | 0.31                                                 |       | 0.47                                                  |       |
| Diluted net income per  share                        |       | 0.30                                                 |       | 0.45                                                  |       |
|                                                      |            |                                                      |            |                                                       |            |  |  |

*** ***

***Stock IncentivePlans***

Our stock incentive plans include our 1993 StockIncentive Plan (the “1993 Plan”) and our 2000 Stock Incentive Plan (the “2000Plan”) (together, the “Plans”) and provide for the granting of  incentive stock options, nonqualified stockoptions and restricted stock units. Incentive stock options must be granted atan exercise price not less than 100% of the fair market value per share at thegrant date. Nonqualified stock options granted or shares sold under the Planscannot be granted or sold at a price less than 85% of the fair market value pershare at the date of grant or sale. The contractual term of options granted underthe Plans is 10 years, and the right to exercise options granted generallyvests as to 20% at the end of the first year and then as to 1.67% per monththereafter with full vesting occurring on the fifth anniversary. The 1993 Planexpired during 2003 and any remaining unissued options were canceled. The 2000Plan expires October 15, 2010. In addition, options currently outstandingunder the 1993 Plan will not be available for reissuance upon cancellation. Wehave authorized a total of 2.4 million shares of common stock for issuanceunder the 2000 Plan.

 

F-20

----

 

AtDecember 31, 2006, 659,296 shares were available for future grants, and we had2,407,412 shares of our common stock reserved for future issuance under thePlans.

Stockoption activity for the year ended December 31, 2006 was as follows:

|                                            | ** ** | **Options   Outstanding** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Outstanding at  December 31, 2005** |       | 1,721,438                      |       | $                                                      | 8.37       |   |
| Granted                                    |       | 347,900                        |       | 13.28                                                  |       |
| Exercised                                  |       | (297,826                       | )          | 4.48                                                   |       |
| Forfeited                                  |       | (43,396                        | )          | 11.29                                                  |       |
| **Outstanding at December 31, 2006**       |       | 1,728,116                      |       | 9.95                                                   |       |
|                                            |            |                                |            |                                                        |            |  |

 

Certaininformation regarding options outstanding as of December 31, 2006 was asfollows:

|                                             | ** ** | **Options   Outstanding** | ** **  | **Options   Exercisable** | ** ** |
|---------------------------------------------|------------|--------------------------------|-------------|--------------------------------|------------|
| Number                                      |       | 1,728,116                      |        | 971,356                        |       |
| Weighted average  exercise price            |       | $                              | 9.95        |                           | $          | 8.27 |   |
| Aggregate intrinsic  value                  |       | $                              | 6.0 million |                           | $          | 4.9 million |   |
| Weighted average remaining contractual term |       | 6.55 years                     |        | 4.95 years                     |       |

 

Theaggregate intrinsic value in the table above is based on our closing stockprice of $13.10 on December 31, 2006, which would have been received by theoptionees had all of the options with exercise prices less than $13.10 beenexercised on that date.

Restrictedstock unit activity during 2006 was as follows:

|                                            | ** ** | **Restricted   Stock   Units** | ** ** | **Weighted   Average  Grant Date  Per Share  Fair Value** | ** ** |
|--------------------------------------------|------------|------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| **Outstanding at  December 31, 2005** |       | —                                   |       | —                                                                        |       |
| Granted                                    |       | 20,000                                   |       | $                                                                             | 13.38      |   |
| Vested                                     |       | —                                   |       | —                                                                        |       |
| Forfeited                                  |       | —                                   |       | —                                                                        |       |
| **Outstanding at December 31, 2006**       |       | 20,000                                   |       | $                                                                             | 13.38      |   |

 

As ofDecember 31, 2006, total unrecognized stock-based compensation related tooutstanding, but unvested options and restricted stock units was $6.1 million,which will be recognized over the weighted average remaining vesting period of1.8 years.

***Employee Stock Purchase Plan***

InFebruary 2004, our board of directors approved the 2004 Employee Share PurchasePlan (the “2004 ESPP”) and the reservation of 400,000 shares of our commonstock thereunder. The 2004 ESPP consists of two-year offering periods with fourconsecutive, overlapping six-month purchase periods commencing on the firsttrading day on or after February 1 and August 1 each year (the “Enrollment Date”).Any eligible employee may participate in the 2004 ESPP by completing asubscription agreement which allows participants to purchase up to 5,000 sharesper six-month purchase period, at a purchase price of 85% of the fair marketvalue of a share of common stock on the Enrollment Date or on the exercisedate, whichever is lower. The exercise date is the last trading day of eachoffering period.  If the

F-21

----

purchase price is lower on the exercise date than onthe Enrollment Date, the two-year offering period will terminate and a new two-year offering period willbegin. Participating employees are automatically enrolled in the new offeringperiod. During the year ended December 31, 2006, we issued 90,836 sharespursuant to the 2004 ESPP at a weighted average price of $9.25 per share, whichrepresented a weighted average discount of $3.50 per share from the fair marketvalue on the dates of purchase, and 277,900 shares remained available forpurchase as of December 31, 2006.

**NOTE 14.  RELATED PARTY TRANSACTIONS**

***Agilent Technologies***

Priorto our IPO, Agilent Technologies held all of the outstanding shares ofSeries A and 87,500 shares of the Series B. Upon our IPO, the SeriesA and Series B were converted into a total of 1,424,819 shares of our commonstock. As of the end of January 2006, Agilent did not hold any shares of ouroutstanding common stock. Certain other financial information related toAgilent was as follows:

| Year Ended December 31,                                                                                                  | ** ** | **2005** | ** **  | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------|-------------|----------|------------|
| Sales to Agilent                                                                                                                        |       | $        | 2.5 million |     | $          | 2.0 million |   |
| Purchases from  Agilent                                                                                                                 |       | $        | 548,000     |     | $          | 327,000 |   |
| Royalties paid to  Agilent for non-exclusive license to use certain patented technology relating  to electrical measurement apparatuses |       | $        | 11,000      |     | $          | 9,000 |   |

 

| December 31,        | ** ** | **2005** | ** ** | ** ** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|
| Receivable from  Agilent |       | $        | 171,000    |       |       |   |
| Payable to Agilent       |       | $        | 35,000     |       |       |   |

 

***FEI Company***

During 2006, wepurchased certain equipment for $318,000 from FEI Company (“FEI”). In addition,FEI purchased certain equipment from us for a total of $122,000 during 2006. AtDecember 31, 2006, we owed FEI $4,000 and we had a receivable from FEI of$2,000. One of the members of our Board of Directors, Mr. Raymond A. Link, isthe Executive Vice President and Chief Financial Officer of FEI.

**NOTE 15.  EMPLOYEE BENEFIT PLAN**

Wesponsor a 401(k) savings plan which allows eligible employees to contribute acertain percentage of their salary. We match 40% of eligible employees’ contributions,up to a maximum of 2% of the employees’ earnings. Our matching contribution forthe savings plan was $271,000, $230,000 and $194,000, respectively, in 2006,2005 and 2004.

**NOTE 16.  COMMITMENTS AND CONTINGENCIES**

***Operating Leasesand Subleases***

We lease office and manufacturing space underoperating leases that expire at various dates through 2015. In addition tolease expense, we pay real property taxes, insurance and repair and maintenanceexpenses for our corporate office and manufacturing facility. We recognize rentexpense related to our operating leases based on a straight-line basis over thelife of the lease.

Future minimum lease payments under non-cancelableoperating leases with initial or remaining terms in excess of one year are asfollows (in thousands): 

| Year Ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2007                                    |       | $          | 1,995      |   |
| 2008                                    |       | 2,213      |       |
| 2009                                    |       | 2,004      |       |
| 2010                                    |       | 2,032      |       |
| 2011                                    |       | 2,091      |       |
| Thereafter                              |       | 7,969      |       |
| ** **                              |       | $          | 18,304     |   |

Lease expense was $2.6 million, $2.5 million and $2.5million, respectively, in 2006, 2005 and 2004.

F-22

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***Legal Proceedings***

We areinvolved in various claims and legal actions arising in the ordinary course ofbusiness. In the opinion of management, the ultimate disposition of thesematters will not have a material adverse effect on our financial position,results of operations or liquidity.

***NOTE17.  SEGMENT REPORTING ANDENTERPRISE-WIDE DISCLOSURES***

Thesegment data below is presented in the same manner that management organizesthe segments for assessing certain performance trends. Our Chief OperatingDecision Maker monitors the revenue streams of the engineering productsdivision (“EPD”) and the pyramid products division (“PPD”).

Thefollowing table summarizes revenue for each of our business segments. We do nottrack our financial results below the revenue line nor assets on a segmentlevel, and, accordingly, that information is not provided (in thousands):

| Year Ended December 31, | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| External revenue  from EPD             | ** ** | $        | 67,969     |     | $          | 63,566   |       | $ | 58,467 |   |
| External revenue  from PPD             |       | 16,883   |       | 10,071   |       | 5,948    |       |
|                                   |       | $        | 84,852     |     | $          | 73,637   |       | $ | 64,415 |   |

 

Nocustomer accounted for 10% or more of our total revenue in 2006, 2005 or 2004.

We arenot able to provide revenue by product line or group of similar products as itwould be impracticable to do so.

Our revenues by geographic area were as follows (inthousands):

| Year Ended December 31, | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States                          |       | $        | 32,220     |     | $          | 23,877   |       | $ | 24,762 |   |
| Japan                                  |       | 14,239   |       | 15,085   |       | 14,909   |       |
| Taiwan                                 |       | 6,856    |       | 7,612    |       | 6,853    |       |
| Other                                  |       | 31,537   |       | 27,063   |       | 17,891   |       |
|                                   |       | $        | 84,852     |     | $          | 73,637   |       | $ | 64,415 |   |

 

Long-lived assets, exclusive of long-term investmentsand deferred income taxes, by geographic area were as follows (in thousands):

| December 31, | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| United States     |       | $        | 12,392     |     | $          | 5,993 |   |
| Japan             |       | 224      |       | 108      |       |
| Other             |       | 199      |       | 18       |       |
|              |       | $        | 12,815     |     | $          | 6,119 |   |

 

F-23

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**SCHEDULE II**

**Cascade Microtech, Inc.Valuation and Qualifying AccountsYears Ended December 31, 2006, 2005 and 2004(in thousands)**

** **

** **

** **

** **
| **Column A**                     | ** ** | **Column B**                                          | ** ** | **Column C**                                         | ** ** | **Column D**                                                              | ** ** | **Column E**                              | ** ** |
|---------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| **Description**                       | ** ** | **Balance   at Beginning   of Period** | ** ** | **Charged   to Costs and   Expenses** | ** ** | **Charged to   Other Accounts -   Describe (a)** | ** ** | **Deductions -   Describe (b)** | ** ** | **Balance   at End   of Period** | ** ** |
| **Year  Ended December 31, 2004:**    | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Allowance for  uncollectible accounts |       | $                                                          | 101        |                                                      | $          | 15                                                                             |       | $                                              | 3          |   | $ | (33 | ) | $ | 86 |   |
| Inventory  reserves                   |       | $                                                          | 1,739      |                                                      | $          | 159                                                                            |       | $                                              | —     |   | $ | (96 | ) | $ | 1,802 |   |
|                                  |       |                                                       |       |                                                      |       |                                                                           |       |                                           |       |   |   |
| **Year  Ended December 31, 2005:**    | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Allowance for  uncollectible accounts |       | $                                                          | 86         |                                                      | $          | 15                                                                             |       | $                                              | (1         | ) | $ | (3 | ) | $ | 97 | ** ** |
| Inventory  reserves                   |       | $                                                          | 1,802      |                                                      | $          | 125                                                                            |       | $                                              | —     |   | $ | (67 | ) | $ | 1,860 | ** ** |
|                                  |       |                                                       |       |                                                      |       |                                                                           |       |                                           |       |   | ** ** |
| **Year  Ended December 31, 2006:**    | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** **                                                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Allowance for  uncollectible accounts |       | $                                                          | 97         |                                                      | $          | 114                                                                            |       | $                                              | —     |   | $ | (58 | ) | $ | 153 | ** ** |
| Inventory reserves                    |       | $                                                          | 1,860      |                                                      | $          | 285                                                                            |       | $                                              | —     |   | $ | (202 | ) | $ | 1,943 | ** ** |

----

(a) Charges to this account rotate to changes in foreign currencyexchanges rates.

(b) Charges to the accounts included in this column are for thepurposes for which the reserves were created.

 

F-24

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