** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D. C. 20549**

#### ** **

#### **FORM 10-K**

#### ** **

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| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     | ** ** |
|------------|-----------------------------------------------------------------------------------------------------|------------|
|       |                                                                                                |       |
| ** ** | **For the Fiscal Year Ended: December 31,  2004**                                              | ** ** |
|       |                                                                                                |       |
| ** ** | **OR**                                                                                              | ** ** |
|       |                                                                                                |       |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** | ** ** |

 

Commission File Number: **000-51072**

 

**CASCADE MICROTECH, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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’stelephone number, including area code: **(503) 601-1000**

 

Securities registeredpursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g)of the Act: **Common Stock, $0.01 par value**

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Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days: Yes  ý       No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K, or any amendment tothis Form 10-K.    o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act):

Yes o    No ý

 

Theaggregate market value of the voting and non-voting common equity held bynon-affiliates of the registrant was $68,945,336, computed by reference to thelast sales price ($13.43) as reported by the Nasdaq SmallCap System, as of thelast business day of the Registrant’s most recently completed fourth fiscalquarter (December, 31, 2004).

 

Thenumber of shares outstanding of the registrant’s common stock as of March 21,2005 was 10,864,693 shares.

 

**Documents Incorporated byReference**

Portionsof the registrant’s definitive Proxy Statement for the 2005 Annual Shareholders’Meeting are incorporated by reference into Part III.

 

 

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**CASCADE MICROTECH, INC.**

**2004 FORM 10-K ANNUAL REPORT**

**TABLE OF CONTENTS**

 
| * *   | **PART I**                                                                                                          | ** ** |
|------------|---------------------------------------------------------------------------------------------------------------------|------------|
|       |                                                                                                                |       |
| Item 1.    | Business                                                                                                            |       |
|       |                                                                                                                |       |
| 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  Consolidated Financial Data                                                                               |       |
|       |                                                                                                                |       |
| Item  7.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operation                          |       |
|       |                                                                                                                |       |
| Item  7A.  | Quantitative  and Qualitative Disclosures About Market Risk                                                         |       |
|       |                                                                                                                |       |
| Item  8.   | Consolidated  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  and Executive Officers of the Registrant                                                                 |       |
|       |                                                                                                                |       |
| 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                                                                     |       |
|       |                                                                                                                |       |
| 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**

 

**SpecialNote Regarding Forward-Looking Statements**

*ThisAnnual Report on Form 10-K and the documents incorporated herein by referencecontain forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. All statements other than statements ofhistorical fact made in this Annual Report on Form 10-K are forward-lookingincluding, but not limited to, statements regarding industry prospects; futureresults of operations or financial position; our expectations and beliefsregarding future revenue growth; the future capabilities and functionality ofour products and services, our strategies and intentions regardingacquisitions; the outcome of any litigation to which we are a party; ouraccounting and tax policies; our future strategies regarding investments,product offerings, research and development, market share, and strategicrelationships and collaboration; our dividend policies; and our future capitalrequirements. These statements relate to future events or our future financialperformance. In some cases, you can identify forward-looking statements byterminology, including “intend,” “could,” “may,” “will,” “should,” “expect,” “plan,”“anticipate,” “believe,” “estimate” “predict,” “potential,” “future,” or “continue,”the negative of these terms or other comparable terminology.  These statements are only predictions.  Actual events or results may differ materiallyfrom those expressed or implied in such forward-looking statements.  In evaluating these statements, you shouldspecifically consider various factors, including the risks described in greaterdetail in Item 1, Part I “Business – Risk Factors,” our registration statementon Form S-1 and reports filed with the Securities and Exchange Commission, andcontained in our press releases from time to time.*

 

*We do notguarantee future results, levels of activity, performance or achievements.  We do not intend to update any of theforward-looking statements after the date of this document to conform them toactual results or to changes in our expectations.*

 

**Overview**

We area worldwide leader in the design, development and manufacture of advanced waferprobing solutions for the electrical measurement and test of semiconductorintegrated circuits, or chips. Testing chips while they are still in waferform, or wafer probing, is critical to reduce the costs of design andproduction while accelerating time to market. Our customers use our engineeringprobe stations, analytical probes, software and services to develop a widevariety of chips. The engineering probing solutions of our Engineering ProductsDivision allow design and process engineers to perform precise electricalmeasurements, or electrical metrology, in order to decrease chip design costsand improve fabrication processes. We derive a large majority of our revenuefrom the sale of engineering probe stations. Our production probe cards,designed, manufactured and marketed by our Pyramid Probe Division, are usedduring the semiconductor manufacturing process to reduce test cost by enablinghigh speed testing of high performance chips in wafer form and testing multiplechips in parallel, while minimizing chip damage. We believe, that since 1984,our customer track record and technology leadership have earned us a reputationfor excellence.

 

**Where You Can Find More Information**

Wefile annual, quarterly and special reports, proxy statements and otherinformation with the Securities and Exchange Commission (“SEC”) under theSecurities Exchange Act of 1934 as amended (the “Exchange Act”). You caninspect and copy our reports, proxy statements, and other information filedwith the SEC at the SEC’s Public Reference Room in Washington, D.C. Please callthe SEC at 1-800-SEC-0330 for further information on the Public Reference Room.The SEC maintains an Internet Web site at http://www.sec.gov/ where you canobtain some of our SEC filings. In addition, you can inspect our reports, proxymaterials and other information at the offices of the Nasdaq Stock Market at1735 K Street NW, Washington D.C. 20006. We also make available free of chargeon our website at www.cascademicrotech.com our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments tothose reports filed or furnished pursuant to Section 13(a) or 15(d) of theExchange Act as soon as reasonably practicable

 

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afterthey are filed electronically with the SEC.  You can also obtain copies ofthese reports by contacting Investor Relations at 503-601-1000.

 

**Industry Background**

Duringthe last decade, growth in the computer, telecommunications, consumer andindustrial electronics markets has increased demand for chips. TheSemiconductor Industry Association estimates that worldwide semiconductor salestotaled $213 billion in 2004 and are expected to grow to $259 billionin 2007. To reduce the cost and increase the performance of electronicproducts, chips have become smaller and faster and incorporate greater levelsof functionality at a lower price. Advancements in manufacturing technologies,such as smaller chip elements, new materials, and larger wafer sizes havepermitted manufacturers to meet these requirements. However, these advancementsin chip manufacturing technologies have led to increasing challenges in thedesign, manufacturing and testing of chips.

 

Chipsare measured and tested multiple times throughout the design and manufacturingprocess to ensure the integrity of the chip design and the quality of themanufacturing process. Chip testing that occurs during design or in support ofproduction is referred to as engineering test. Chip testing that occurs duringmanufacturing is referred to as production test. Engineering test involvesperforming a wide variety of highly precise measurements during chip researchand development activities on a low volume of chips. Production test, incontrast, involves performing a targeted set of tests at a rapid rate on a highvolume of chips.

 

Waferprobing is critical to both engineering evaluations and production sortingtests. Because wafer probing requirements are substantially different forengineering versus production testing, the equipment and systems utilized areoptimized for each process.

 

•                  *Engineeringwafer probing systems.*  Engineering wafer probing systemsare used in chip design and process engineering to perform a wide variety ofhighly precise measurements on various chips and elements. An engineering waferprobing system, consisting of an engineering probe station, analytical probes,control software and other accessories, is typically connected to electricalmeasuring instruments that stimulate and measure the chips being probed. Anengineering probe station typically provides a light-tight, electricallyshielded or temperature controlled environment for the wafer under test andpositions analytical probes to make temporary electrical contacts tomicroscopic areas on a chip called bond pads.

 

•                  *Productionwafer probing systems.*  Production wafer probing systemsare used for pass/fail testing of production chips and are optimized for rapidthroughput. A typical production wafer probing system consists of a productionprober, a probe card and accessories. The system is connected to automatic testequipment that transmits electrical signals to the chip under test and rapidlyevaluates the responses to maximize throughput. A production prober is arobotic wafer handling and positioning machine. A wafer probe card is a complexprinted circuit board that contains a customized arrangement of probe needlesor tips used to establish electrical contact to one or more chips on a wafer.Probing more than one chip at a time, or parallel probe testing, increases testcapacity and reduces the capital investments required in equipment and floorspace. Probe cards must be custom-designed for each chip design and requireperiodic replacement as they wear out.

 

Researchand development wafers are probed through the use of an engineering probingsystem during the chip design and process development phases in engineeringtest for performance and reliability. As soon as production wafers exit thewafer fabrication facility, or fab, test elements on the wafers are probed atthe production parametric test step. Process control data for the wafer fab isderived from this testing and is used to refine the manufacturing process toimprove yields. Good wafers proceed to the production wafer sort test step,which is used to avoid the unnecessary expense of assembling and packagingdefective chips. The wafer is then diced into individual chips, and functionalchips are packaged. Packaged chips proceed to the production final test stepfor further functional or stress testing. In the production final test step,test sockets, analogous to probe 

 

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cards inthe wafer sort step, provide temporary electrical contact from the chip packageto the test equipment. Because test sockets are similarly customized for eachchip package type and consumed in the course of production testing, both probecards and test sockets are referred to as test consumables.

 

**Customers and Geographic Revenue**

Ourproducts are used by semiconductor manufacturers, test subcontractors, researchorganizations and designers. Fabless semiconductor suppliers do not manufacturetheir own semiconductors but they purchase our analytical probes andengineering probe stations for research and development and purchase, or directtheir foundries to purchase, our Pyramid Probe cards to test chips manufacturedfor them. We have built strong relationships with our customers throughfrequent interactions over the past 20 years. To foster stronger customer relationships,we conduct analyses for the needs of our customers’ new labs or products,seminars on topics such as measurement techniques, and proactive service calls.This close interaction has helped us build a consistently loyal customer base.More than 800 customers purchased our products in 2004. Our top 20 end-usercustomers during 2004 were:  AdvancedMicro Devices, Agilent, Chartered Semiconductor, Fujitsu, Hitachi, HynixSemiconductor, IBM, Infineon, Intel, Matsushita Electric Industry, NEC, RF MicroDevices, Samsung, Seiko Epson, Semiconductor Manufacturing InternationalCorporation, Sony, Taiwan Semiconductor Manufacturing Company, TexasInstruments, Toshiba and United Microelectronics Corporation.

 

Webelieve our customers consider timely customer service and support to be animportant aspect of our relationship. Our engineering probe stations areinstalled at customer sites either by us, our manufacturers’ representatives orour distributors, depending on the complexity of the installation and thecustomer’s geographic location. We assist our customers in the selection,integration and use of our products by providing engineering applicationsupport. We also provide worldwide on-site training, seminars and telephonesupport. Our manufacturers’ representatives and distributors provide additionalservice and support.

 

In2004, no single customer accounted for 10% or more of our total revenues.  In 2003, sales of our products to IBMrepresented 11% of our total revenue. No single customer accounted for 10% ormore of our total revenue in 2002. Our top 10 customers accounted forapproximately 34%, 34%, and 32% of our total revenue in each of 2004, 2003 and2002, respectively.

 

Internationalsales accounted for more than 50% of our total revenue in each of 2004, 2003and 2002.  No foreign country, other thanJapan and Taiwan, had revenues that totaled 10% or more of our total revenuesin 2004, 2003 or 2002.  Geographicrevenue was as follows (in thousands):

 
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| United States |       | $                                | 24,762     |   | $ | 24,708 |   | $ | 22,060 |   |
| Japan         |       | 14,909                           |       | 11,838 |   | 11,861 |   |
| Taiwan        |       | 6,853                            |       | 3,631 |   | 6,290 |   |
| Other         |       | 17,891                           |       | 10,379 |   | 10,896 |   |
|          |       | $                                | 64,415     |   | $ | 50,556 |   | $ | 51,107 |   |

 

**Technology**

We area leading innovator in developing electrical measurement, or metrology, andproduction test tools. We have focused our research and development efforts onenabling our customers to take more precise electrical measurements faster. Ourcore 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. These technologiesinclude, for example, computer modeling, scale modeling, rapid prototyping fordesign and proprietary in-house measurement

 

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and calibration fixturesfor verifications. We believe that these technologies provide a competitiveadvantage by allowing us to more effectively design and commercializeproduction probe cards and analytical 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. Our analytical probes usetechnologies that permit extremely low current and other electricalmeasurements across a wide temperature range.

•                  *Microfabrication.*  Since 1990, we have shippedproducts that utilize our proprietary lithographic manufacturing processes fordepositing, lithographic patterning, etching and plating probe structures onflexible substrates that are similar to the processes used in making chips. Aschip elements continue to shrink, we expect to be able to scale and evolve ourlithographic processes to continue to meet our customers’ requirements. Theseprocesses have allowed us to develop Pyramid Probe cores with high frequencyelectrical connections and probe tips that are close together to address narrowspacing requirements. These processes have also enabled us to develop ourproprietary MicroScrub probe tip design, which improves probe electricalcontact while minimizing mechanical bond pad damage. In addition to theselithography techniques, we have developed and use proprietary tools andassembly fixtures for micro assembly tasks in the production of our PyramidProbe cards and analytical probes.

 

**Products**

Wedesign, manufacture and sell four product lines: engineering probe stations,analytical probes, production probe cards and application software. Engineeringprobe stations are used in conjunction with certain consumable components totest chips in wafer form. Analytical probes and production probe cards are soldas consumable components of and are mounted into engineering probe stations andelectrically connect test equipment to the chips under test. Analytical probescan typically contact many different types of chips, and are consumablecomponents of the probing system. In addition, we offer several services to ourcustomers, including installation and maintenance.

 

*Engineering Probe Stations.*  Engineering probe stationsare highly configurable depending upon the size and type of wafer, theparticular characteristics of the chip that the customer is testing, therequired measurements, the temperatures at which the chip is tested and thetest equipment that the customer is using. Our engineering probe stations areavailable in either manual or semiautomatic versions. We also offer manyaccessories, including thermal control systems, special cables and connectors,microscopes, lasers, cameras and other items. We offer more than 10 distinctmodels of engineering probe stations in three relatively standardized productfamilies.

 

•                  *Summit.*  The Summit product familyincludes engineering probe stations used for a wide range of transistor andchip measurements, circuit element modeling, semiconductor process developmentand reliability tests on 150mm and 200mm wafers.

•                  *S300.*  The S300 product family issimilar to the Summit product family in its functionality, features andaccessories but is designed to test 300mm wafers and contains manyenhancements, such as a built-in anti-vibration base and ergonomic features to accommodateits larger scale.

•                  *Alessi.*  The Alessi product family isa versatile, general purpose engineering probe station used to test 150mm or200mm wafers, modules containing multiple chips, printed circuit boards, singlechips and optical devices.

 

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Inaddition to our three product families, we also design and build custom andspecialized engineering probe stations to meet our customers’ unique or lesscommon applications. Examples of these applications include testing printedcircuit boards or display panels as large as 24 by 24 inches and multi-chip oroptical modules. Custom-designed engineering probe stations occasionally resultin new, standard product features or additional sales to other customers.

 

*Analytical Probes.*  We offer over 50 differentanalytical probe models primarily for engineering test. The newer Infinityseries probes are designed with unique probe tips derived from our proprietarylithographic manufacturing technology for exceptional electrical contact onaluminum and copper pads. While our analytical probes are used primarily forengineering test, several of our analytical probes are also used in low-volumeproduction testing of some high-frequency devices.

 

*Production Probe Cards.* Our proprietary Pyramid Probe cards useunique, custom designed and lithographically defined microscopic probe tips andelectrical wiring. Electrical measurement features of Pyramid Probe cardsinclude test speeds ranging from low speed digital to well above 20 GHz forhigh-volume production testing and repeatable, high quality electricalinterconnections. Mechanical attributes include probe card life that oftenexceeds 2,000,000 touchdowns, long probe tip cleaning intervals to maximizethroughput, minimal damage to the chip during testing, the ability to probemultiple chips in parallel, design flexibility for probing peripheral bond padsor arrays, including irregular arrays or dense spacing, and the ability torepeatably contact very small bond pads. We design and sell Pyramid Probe cardsfor production test applications, ranging from very low current parametrictesting to sophisticated, high speed radio frequency testing. Thesecapabilities contribute to lower cost of production test and overall lower costof ownership of the probe card, enabling more cost effective wafer productiontest. The primary applications for Pyramid Probe cards include the productiontesting of wireless chips, high-speed logic chips, automotive chips, parametrictest, analog chips and broadband and telecom chips. We offer proprietaryPyramid Probe cards primarily for production testing, although they can also beused in engineering test.

 

*Application Software.*  Our proprietary WinCalsoftware is specifically designed to facilitate and improve the user’sproductivity during set-up, calibration and data-logging to performsophisticated high frequency measurements accurately and reliably. We also sellsoftware packages that integrate the control and data-management functions ofwafer probing test systems and to analyze and report wafer data. Newer versionsof the control software for our engineering probe stations are sold separatelyto our customers to upgrade older probe stations.

 

*Services.*  In addition to routine,essential installation services at the time of sale, we offer services toenable our customers to maintain and more effectively utilize our equipment,probes and software and to enhance our customer relationships.

 

**Sales and Marketing**

Wesell our engineering probe stations, analytical probes and production probecards through a combination of manufacturers’ representatives, distributors anddirect sales people. Manufacturers’ representatives are independent thirdparties that agree to sell our products at our prices and on terms set by us,in return for a commission based on sales. We typically use manufacturers’representatives in areas that we believe require greater levels of customersupport than we can deliver from our sales offices.  Distributors purchase our products and resellthem at prices and upon terms set by the particular distributor. We typicallyuse distributors where local regulations or business customs require localstocking of service parts, more immediate service support or other localservices. Finally, our direct sales force is made up of our salaried employees.

 

InNorth America and Asia, excluding Japan, Singapore and Malaysia, we sell ourproducts through manufacturers’ representatives. In Japan, we sell throughCascade Microtech Japan, K.K., our direct sales and service subsidiary. InSingapore and Malaysia, we sell through our branch office, Cascade MicrotechSingapore. In Europe, we primarily sell through distributors and manufacturers’representatives managed by Cascade Microtech Europe, Ltd., our directsales and service subsidiary in the United Kingdom. We also sell certainproducts directly in Germany, Austria and Switzerland.  In

 

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othercountries, we typically sell through manufacturers’ representatives ordistributors. Our sales managers oversee and manage these worldwide salesactivities.

 

Wework closely with our customers to select the most appropriate product or toconfigure a custom solution to best fit their applications. Sales of ourproduction test solutions require significant interaction with customerproduction test managers, knowledge of their specific product details andhands-on application support, particularly for new customers. Our productioncustomers generally undertake an extensive evaluation of new probe technologybefore adoption. 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. Our sales managers are experienced sales professionalswith in-depth technical training, customer knowledge and industry expertise.The technical sophistication of our products requires substantial training forour manufacturers’ representatives, distributors and sales staff. We devoteconsiderable effort and resources to developing a highly trained sales forcethat is responsive to our customers’ changing needs.

 

Wefocus our marketing efforts on building awareness of our products amongdesigners and manufacturers of complex semiconductors. We market our productsand capabilities by participating in trade shows, providing product andtechnical information in print and on our website, hosting technical and productseminars, advertising in trade publications, and using direct mailings. Inaddition, our marketing staff performs market research and product planning.

 

Weparticipate in joint sales and marketing activities with complementaryequipment and software vendors to offer our customers complete test solutions.These relationships benefit us because they can lead to broader awareness andincreased sales of our products. In particular, we have a longstandingrelationship with Agilent Technologies, in which we periodically jointly markettest system solutions comprised of compatible products from each company. Ourdirect sales force, manufacturers’ representatives and distributors often workwith Agilent sales personnel to identify, qualify and close orders worldwide.Our joint marketing efforts with Agilent Technologies are not subject to awritten agreement between the parties. As such, they may be discontinued byeither party at any time.

 

**Research and Development**

Ourindustry is subject to rapid technological change and new product introductionsand improvements. Our continued investment in research and development andtimely introduction of new products and services is critical to maintaining andimproving our competitive position. Our growth depends upon our ability torapidly develop new products that enable customers to improve their electrical,optical and mechanical measurements and increase their productivity. As aresult, we expect to continue to devote substantial resources to research anddevelopment. Our research and development expenses were $5.7 million in2004, $5.4 million in 2003, and $6.3 million in 2002. These amountsare net of customer reimbursements of $94,000, $248,000 and $90,000,respectively, in 2004, 2003 and 2002 for work on a joint project. We did notexpend material amounts on customer-sponsored research and development in 2004,2003 or 2002. In addition, we do not currently have any agreements with thirdparties for joint research and development projects, nor do we have anyagreements for customer-sponsored research and development projects. We arecurrently devoting substantial resources to projects such as releasing newPyramid Probe products and manufacturing processes, developing faster, higheraccuracy analytical probes and enhancing the functionality of our 300mmengineering probe stations. At December 31, 2004, we employed 39 researchand development engineers. We conduct research and development for all of ourproduct lines at our Beaverton, Oregon facilities.

 

**Manufacturing and Assembly**

Ourmanufacturing and assembly operations consist of the production of highlycomplex and sophisticated components and assemblies, some of which arecustomized to meet customers’ needs and specifications. We perform nearly allof our manufacturing and assembly in Beaverton, Oregon at

 

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ourmanufacturing facility within our headquarters building, at ourmicrofabrication and Pyramid Probe assembly facility and at our machine shop.Our microfabrication facility includes a 10,000 square foot clean room, most ofwhich is Class 100, meaning not more than 100 particles per cubic meter.Our manufacturing strategy is to purchase components from vendors to the extentpossible. However, we manufacture key components that we deem to be proprietaryor that provide us with a competitive advantage. We depend on limited sourcesuppliers for some materials, components and subassemblies used in ourproducts.

 

Ourproduct design and manufacturing process activities emphasize accurateelectrical measurements, precise and reliable mechanical components andassemblies, and compliance with industry and governmental safety requirements.We prototype and test our new standard product designs and components to ensurehigh electrical signal integrity, mechanical accuracy and safety. In ourmanufacturing operations, we perform electrical, mechanical and chemical testsand use statistical process control methods, internally developed manufacturinginformation systems and inspections of purchased components and products tomonitor our product quality throughout the various stages of our manufacturingprocess.

 

**Competition**

Themarkets for engineering probe stations, analytical probes and production probecards are highly competitive. We anticipate that the markets for our productswill continually evolve and be subject to rapid technological change.

 

*Engineering Probe Stations.*  Our primary competitor in theengineering probe station market is Suss MicroTec AG (Karl Suss), but we alsocompete with Bekutasemikon K.K., Lucas/Signatone Corporation, TheMicromanipulator Company Inc., and Wentworth Laboratories Inc., among others.We believe that the primary competitive factors in the engineering probestation market are measurement accuracy and versatility, measurement speed,automation features, completeness of the measurement solutions, applicationssupport, delivery time and price. We compete favorably withrespect to these factors, except in smallniche markets where customers seek solutions that provide highly specializedtesting environments.

 

*Analytical Probes.*  Our primary competitor in theanalytical probe market is GGB Industries. We believe that the primarycompetitive factors in this market are breadth of probe types, probe frequencyand electrical signal integrity, contact integrity and the related cleaningrequired, calibration support, applications support, delivery time and price.  We compete favorably with respect to thesefactors, except in small niche markets where customers seek solutions thatprovide highly specialized testing environments.

 

*Production Probe Cards.*  Competition in the productionprobe card market is fragmented and characterized by many suppliers offeringproducts based on differing technologies. Our Pyramid Probe cards compete withproduct offerings of other probe card vendors including Feinmetall GmbH,FormFactor Inc., GGB Industries Inc., Japan Electronic Materials Corporation,Kulicke & Soffa Inc., Mesatronics S.A., Micronics Japan Company, Ltd., MicroProbeInc., Micro Square Technology Inc., PHICOM Corporation, SV Probe Inc.,Technoprobe S.r.l., Tokyo Cathode Laboratory Company Ltd., WentworthLaboratories Inc., and others. At least three probe card vendors, FormFactorInc., Mesatronics S.A. 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.  Webelieve that we generally compete favorably in probe cards for high frequenciesand high-speed signals, and in probe cards for parallel testing of chips withdensely-packed bond pads. We generally do not compete in applications thatrequire very large probe areas, such as memory test, or that

 

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requiredelivery times of less than two weeks, or that require very high currents, suchas some microprocessors.

 

**Intellectual Property**

Oursuccess in large part depends on our proprietary technology. We do not dependon any one individual patent, instead relying on intellectual property,including patents and trade secrets, covering electrical measurementreliability and integrity, electrical shielding and the Pyramid Probe contactstructure and production process. As of December 31, 2004, we had 76issued patents and 45 pending patent applications in the U.S. and 49 issuedforeign patents and 55 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.

 

Oneimportant group of our patents claims technology relating to electricalshielding and other inventions required to measure extremely small signals onwafers. Most of these U.S. patents will expire between 2012 and 2015. Anotherimportant group of our patents claims designs and construction methods forprobe tips on Pyramid probes. These patents will expire beginning in 2016.

 

Ourpolicy is to seek patents where appropriate on inventions involving newproducts and improvements to existing products as part of our ongoingengineering and research and development activities. We cannot assure you thatany of our pending patent applications will be approved, that we will developadditional proprietary technology that is patentable, that any patents owned byor issued to us will provide us with competitive advantages or that thesepatents will not be challenged by third parties. Furthermore, there can be noassurance that third parties will not design around our patents.

 

Wealso use certain patented technology of third parties in the manufacture of ourproducts pursuant to license agreements. Pursuant to an agreement withMicronics Japan Company Ltd. and Hewlett-Packard Japan Ltd. (nowAgilent Technologies), our subsidiary, Cascade Microtech Japan, Inc. andits affiliates, have been granted a non-exclusive worldwide license to make,have made, use, lease, sell, or otherwise transfer certain products that makeuse of patented technology relating to electric circuit measurementapparatuses. In exchange for the rights granted under the license, we payroyalties to Micronics Japan Company Ltd. and Agilent Technologies basedon the number of products sold or leased. Our license will expire upon theexpiration of the patent covering the licensed technology, which will occur in June 2013.

 

**Employees**

As of December 31,2004, we had a total of 272 employees: 39 in engineering and research anddevelopment; 157 in manufacturing; and 76 in selling, general andadministrative functions. Of these employees, 241 were located in the U.S., 18were in Japan, 7 were in Great Britain, 5 were in Singapore and 1 was inCanada. Many of our employees are highly skilled and our future performancedepends largely on our ability to continue to attract, train and retainqualified technical, sales, service, marketing and managerial personnel. Noneof our employees is subject to a collective bargaining agreement. We have notexperienced any work stoppages and consider our relations with our employees tobe good.

 

**Environmental Matters**

Aspart of our manufacturing operations, we have handled and continue to handlematerials that are considered hazardous or toxic under federal, state and locallaws and regulations, and we are subject to environmental laws and regulationsrelated to the use, storage, discharge, disposal and human exposure to suchmaterials. We believe we are in material compliance with the environmental lawsand regulations applicable to the conduct of our business and operations.However, there can be no assurance that violations of environmental laws orregulations will not occur in the future as a result of human error, equipmentfailure or other causes. The risk of a release of hazardous or toxic materialscannot be completely eliminated, and if such a release occurs, we could be heldfinancially responsible for the cleanup or other consequences of the release.We are not aware of any releases at any of our facilities that could reasonablybe expected to result in any material liabilities to us.

 

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Inaddition, the European Parliament has finalized the Restriction on Use ofHazardous Substances Directive, or RoHS Directive, which restricts the sale ofnew electrical and electronic equipment containing certain hazardous substancesincluding lead which is currently used in some of the products we manufacture.We are working to modify our manufacturing processes to eliminate lead fromproducts we put on the market by July 1, 2006 as required by the RoHSDirective. This may require us to make additional capital expenditures. Inaddition the costs associated with compliance may negatively impact our earningand competitive position. We are also working with our suppliers to redesign orreformulate their components containing lead to reduce or eliminate lead in ourproducts. Based upon current information available to us, we believe that wewill be able to comply with RoHS Directive within the applicable time period.However, if we do not comply with this Directive, we may suffer a loss ofrevenue, be unable to sell in certain markets or countries and suffercompetitive disadvantage.

 

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. Because the EU member states havenot fully implemented the WEEE Directive, the nature and extent of the costs tocomply and fees or penalties associated with non-compliance are 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 of political,business and environmental groups and governmental priorities concerningenvironmental laws and regulations. We may be required to incur substantialcosts to comply with current or future environmental laws or regulations, andour operations, business or financial condition could be adversely affected bysuch 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, 2004 our backlog was $12.1 millioncompared with $7.8 million at December 31, 2003. We generally shipour products within two months of receipt of a customer’s purchase order.Accordingly, we expect to deliver nearly all of our December 31, 2004backlog in 2005. Customers may cancel or delay delivery on previously placedorders, although our standard terms and conditions include penalties forcancellations made close to the scheduled delivery date. As a result, thetiming of the receipt of orders or the shipment of products could have asignificant impact on our backlog at any date. In addition, a significantportion of our revenue is generated from orders received and products shippedwithin a quarter. For this and other reasons, the amount of backlog at any dateis not necessarily indicative of revenue in future periods.

 

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**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 salesmix and average selling prices;

•                  timing, cancellation or delay of customerorders;

•                  seasonality, which has caused our firstquarter revenue typically to decline compared to our fourth quarter revenue ofthe previous year;

•                  customer demand, which is influenced, in part,by conditions in the electronics and semiconductor industry, demand forproducts that use semiconductors and market acceptance of our products andthose of our customers;

•                  fluctuations in foreign currency exchangerates;

•                  competition, such as competitivepressures on the price, performance and reliability of our products, theintroduction or announcement of new products by us or our competitors and ourcompetitors’ intellectual property rights, which could prevent us fromintroducing products that compete effectively with their products;

•                  our production capacity and availabilityand cost of materials, components and subassemblies;

•                  our ability to deliver reliable productsin a timely manner, including as a result of fluctuations in yield on some ofour product lines;

•                  our customers’ decisions regarding thelevel and timing of research and development spending;

•                  our product development costs, includingresearch and development and sales and marketing expenses associated with newproducts or product enhancements and the costs of transitioning to new orenhanced products; and

•                  economic conditions in the United Statesand the worldwide 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 2004. For example,our revenue increased approximately 37% from 1999 to 2000. In contrast ourrevenue decreased approximately 29% from 2001 to 2002 and increasedapproximately 27% from 2003 to 2004. Given this history, there is no reason toexpect that our customers’ business and, therefore, their demand for ourproducts, will be less cyclical 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

 

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responseto these cycles has been generally unpredictable. In the past, our operatingresults have been adversely affected by the cyclical downturns in thesemiconductor 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 of the industrythat our products target, will adversely affect our ability to generate revenueand could cause us to experience operating losses.

 

**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 sale of our products in the third monthof each quarter, and, if we do not generate enough revenue in the third monthof each quarter to meet the earnings expectations of analysts or investors, theprice of our common stock could decline.**

 

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 $300,000 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 ourcommon stock 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.

 

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**Although our production probe cards have not yet been widelyadopted, we have continued to devote significant effort and resources to thegrowth and development of these products, which has had, and could continue tohave, an adverse effect on our operating margins.**

 

Ourfuture growth depends in part on market adoption of, and demand for, ourproduction probe cards. We have devoted significant resources to thedevelopment and growth of these products. To date, these investments haveexceeded the revenue generated by the sale of these products. Large-scalemarket adoption of these products will depend on our ability to demonstrate thereliability and cost effectiveness of these products to potential customers andon the continued growth of the market for high-speed or complex chips.Production customers are generally very reluctant to adopt new technologiesthat could affect their production output. Additionally, many potentialcustomers have witnessed the failure of new probe card technologies from othercompanies, which increases their reluctance to adopt or evaluate newtechnologies. In addition, because we are the sole source supplier of theseproducts that incorporate our proprietary technology, potential customers maybe unwilling to accept a sole source supplier relationship for a product ascritical as a production probe card. If our production probe cards are not adoptedin the market at a level that is sufficient to offset the costs and resourcesthat we have devoted to the development and promotion of these products, thefuture growth of our overall business and our operating margins would continueto be adversely affected.

 

**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.**

 

Wemust continue to invest in research and development to improve our competitiveposition and to meet the testing needs of our customers. Our future growthdepends, in significant part, on our ability to work effectively with andanticipate the testing needs of our customers and on our ability to develop andsupport new products and product enhancements to meet these needs on a timelyand cost-effective basis. Our customers’ testing needs are becoming morechallenging as the semiconductor industry continues to experience rapidtechnological change driven by the demand for complex chips that have smallerelement sizes and at the same time are increasing in speed and functionalityand becoming less expensive to produce. Our customers expect that they will beable to integrate our wafer probing products into their design and productionprocesses as soon as they are deployed. Therefore, to meet these expectationsand remain competitive, we must continually design, develop and introduce on atimely basis new products and product enhancements with improved features.Successful product development and introduction on a timely basis require thatwe:

•                  design innovative andperformance-enhancing features that differentiate our products from those of ourcompetitors;

•                  identify emerging technological trends inour target markets;

•                  respond effectively to technologicalchanges or product announcements by others; and

•                  adjust to changing market conditionsquickly and cost-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.

 

**Our growth depends on the growth of the markets for faster,smaller and lower cost chips, such as radio frequency chips, telecommunicationschips and graphics processors.**

 

Wemarket our products to semiconductor designers and manufacturers that are workingwith increasingly complex chips, such as radio frequency chips,telecommunications chips and graphic processors, in both the engineering andproduction test environments. We cannot assure you that the markets for ourcustomers’ products will continue to grow at historical rates or at all. Ifthese markets

 

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do notcontinue to grow, or if they grow at a lower rate than anticipated, growth inthe demand for our customers’ products would diminish, which would adverselyaffect the sales of our products to these customers and harm our business,financial condition and results of operations.

 

**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 Bekutasemikon, K.K., Lucas/Signatone Corporation,The Micromanipulator Company Inc., and Wentworth Laboratories Inc., amongothers. Our Pyramid Probe cards compete with product offerings of other probecard vendors including Feinmetall GmbH, FormFactor Inc., GGB Industries Inc.,Japan Electronic Materials Corporation, Kulicke & Soffa Inc.,Mesatronics S.A., Micronics Japan Company, Ltd., MicroProbe, Inc., Micro SquareTechnology Inc., PHICOM Corporation, SV Probe, Technoprobe S.r.l., TokyoCathode Laboratory Company, Ltd., Wentworth Laboratories Inc., and others. Atleast three probe card vendors, FormFactor Inc., Mesatronics S.A. and PHICOMCorporation, are also offering probe cards built using types of lithographicpatterning. Our primary competitor in the analytical probe market is GGBIndustries. These competitors or other potential competitors may have developedor may be developing technology of which we are unaware that may render ourproducts uncompetitive. Some of our competitors have significantly greaterfinancial, technical and marketing resources than we do. As a result, thesecompetitors may be able to respond more quickly to new or emerging technologiesand changes in customer requirements, to devote greater resources to thedevelopment, promotion and sale of their products or to deliver competitiveproducts at lower prices. We cannot assure you that we will maintain ourcurrent competitive position or that our production probe cards will achievewidespread acceptance in the market. Finally, increased competition couldresult in pricing pressures, reduced sales, reduced margins or failure toachieve or maintain widespread market acceptance for our products, any of whichcould prevent 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. Approximately 13% of thedollar value of our product purchases for 2004 were from sole source suppliers,including Agilent Technologies, Micro-Coax, Inc., Resin Systems, Inc.,Thales-Optem, Inc. and WL Gore & Associates.  Although we were not forced to delay shipmentof any product due to delays in 2004 related to such suppliers, from time totime, we may experience difficulties in obtaining these materials, componentsand subassemblies from some suppliers, especially during periods of high demandfor semiconductor capital equipment. The manufacture of some of the materials,components and subassemblies that we use in our products, such as thermalchucks and microscopes, is a complex process, and in the event that we cannotobtain an adequate supply of these components, it would be difficult andtime-consuming to identify and qualify new suppliers. If some of the materialsused in our lithographic probe manufacturing process become unavailable, itwould be costly and time consuming to identify and qualify new suppliers.Moreover, many of these suppliers are small companies that may be moresusceptible to downturns in general economic conditions, thereby increasing therisks of product and shipment delays, increased costs or loss of suppliers.Finally, we do not have written agreements with any of these suppliers toguarantee 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 or lostorders for our products and damage to our customer relationships, which wouldharm our results of operations. Furthermore, a significant

 

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increasein the price of one or more of these materials, components or subassembliescould materially 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 our engineeringprobe stations. We anticipate that sales of our engineering probe stations willcontinue to represent a large majority of our revenue for the foreseeablefuture. Our business depends in large part upon continued demand in currentmarkets for, and adoption in new markets of, current and future generations ofour engineering probe stations. In addition, while our consumable products,analytical probes and production probe cards are sometimes sold to serve ascomponents of test equipment manufactured by third parties, they are most oftensold for use with our engineering probe stations. Continued market adoptiondepends upon our ability to increase customer awareness of the benefits of ourengineering probe stations 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 overall semiconductor industry,consistent with historical patterns, our revenue would decline, which couldresult 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, difficultto integrate with our operations, divert management resources and diluteshareholder value.**

 

Aspart of our business strategy, we may make acquisitions of, or investments in,companies, products or technologies that complement our current product offerings,enhance our technical capabilities, expand our operations into new markets oroffer other growth opportunities. If we fail to successfully integrate anyacquired businesses, products or technologies, we would not achieve anticipatedrevenue and cost benefits. While we have no current agreements and no activenegotiations underway with respect to any such acquisitions or investments, wemay acquire companies, products or technologies in the future, which could poserisks to our operations including:

•                  difficulties assimilating the acquiredoperations, personnel, technologies or products into our company;

•                  diversion of management’s attention fromour existing business; and

•                  adverse effects on relationships with ourexisting suppliers, customers or partners.

 

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**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. Noindividual country within Asia, except Japan and Taiwan, and no individualcountry within Europe represented 10% or more of total revenue in 2004, 2003 or2002. Geographic revenue was as follows (in thousands):

 
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| United States |       | $                                | 24,762     |   | $ | 24,708 |   | $ | 22,060 |   |
| Japan         |       | 14,909                           |       | 11,838 |   | 11,861 |   |
| Taiwan        |       | 6,853                            |       | 3,631 |   | 6,290 |   |
| Other         |       | 17,891                           |       | 10,379 |   | 10,896 |   |
|          |       | $                                | 64,415     |   | $ | 50,556 |   | $ | 51,107 |   |
|               |            |                                  |            |  |  |  |  |  |  |  |  |

 

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 andmanaging international operations across different geographic areas;

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

•                  changes in domestic or foreign law orpolicy resulting in the need to comply with potentially burdensome governmentcontrols, regulations, tariffs, embargoes or export license requirements;

•                  longer payment cycles;

•                  differing and more burdensome laborregulations and practices in Europe;

•                  the aftermath of the war in Iraq or otherarmed conflicts in the Middle East;

•                  the effects of Severe Acute RespiratorySyndrome or other sudden outbreaks of epidemics in Asia; and

•                  the effects of terrorist attacks in theUnited States and 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 US. In multiple Asian countries outsideof Japan, our sales have been affected by the SARS epidemic and by radicalcurrency fluctuations that caused our customers to delay purchase decisions.

 

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,

 

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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 2004, 2003 and2002 includes the following currency related gains and losses (in thousands):

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Gains (losses) related to foreign currency hedges |       | $                                | 74,000     |   | $ | 49,000 |   | $ | (324,000 | ) |
| Translation related foreign currency gains        |       | 132,000                          |       | 318,000 |   | 304,000 |   |
|                                              |       | $                                | 206,000    |   | $ | 367,000 |   | $ | (20,000 | ) |

 

**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.**

 

Approximately68% of our revenue for 2004 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.

 

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

 

The 2001to 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 fabricationfacility is made by each manufacturer based upon both internal and externalfactors, such as:

•                  current and projected prices forsemiconductors;

•                  projected price erosion for themanufacturer’s particular semiconductors;

•                  supply and demand levels forsemiconductors;

•                  overall manufacturing capacity within themanufacturer’s target market(s);

•                  the availability of funds to themanufacturer;

•                  the technology roadmap of themanufacturer; and

•                  the price and availability of equipmentneeded within the 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. Wehave invested significant resources to develop technology that addresses themarket for 300mm wafers. Although beginning in 2003 and continuing into 2004,we began to see an acceleration in the transition from 200mm to 300mmtechnology, if manufacturers delay or discontinue

 

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thetransition to 300mm wafers, or make the transition more slowly than wecurrently expect, our growth and profitability could be affected.

 

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

 

Oursuccess depends on the continued services of our executive officers and otherkey management, technical, and sales and marketing personnel and on our abilityto continue to attract, retain and motivate qualified personnel. Currently, ourkey personnel include Eric Strid, our Chairman, President and Chief ExecutiveOfficer, Bruce McFadden, our Vice President and General Manager, Pyramid ProbeDivision, Steven Sipowicz, our Chief Financial Officer, John Pence, our VicePresident and General Manager, Engineering Products Division and K. ReedGleason, our Vice President of Advanced Technology. Following the completion ofour initial public offering in December 2004, our executive officers andother key employees will be able to exercise stock options and sell theunderlying stock, which may reduce their incentive to continue their employmentwith us. The loss of key personnel could limit our ability to develop newproducts and adapt existing products to our customers’ evolving requirementsand may result in lost sales and a diversion of management resources.Furthermore, much of our competitive advantage and intellectual property is basedon the expertise, experience and know-how of our key personnel. We do not haveemployment agreements or non-competition agreements with any of our employeesexcept for an employment agreement with our Chief Financial Officer. To supportour future growth, we will need to attract and retain additional qualifiedmanagement, technical, and sales and marketing employees. Competition for suchpersonnel in our industry is intense, and we cannot assure you that we will besuccessful in attracting and 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 thecustomer;

•                  the complexity of the customer’sengineering or production processes;

•                  the internal technical capabilities andsophistication of the customer; and

•                  the capital expenditure budgets of thecustomer.

 

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

 

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besignificantly damaged and our customers to be reluctant to buy our products,any or all of which could result in a decline in revenue, an increase inproduct returns, higher field service costs, the loss of existing customers orthe failure to attract new customers. Our warranty expense totaled $639,000,$679,000 and $409,000, for 2004, 2003 and 2002, respectively. Our warrantyexpense over the past two years has increased in large part due to failures incomponents purchased from third parties, a substantial portion of which has notbeen reimbursed by the vendors. 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 and unauthorizeduse of our technologies. Furthermore, our existing and future patents may notbe sufficiently broad to protect our proprietary technologies, may not provideus with competitive advantages and may be circumvented by the designs of thirdparties.

 

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. We are notcurrently involved in any such litigation. However, an adverse outcome in anyintellectual property litigation might result in the loss of our proprietaryrights, subject us to significant

 

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liabilities,require us to spend significant resources to develop non-infringing technology,require us to seek licenses from third parties, prevent us from manufacturingand selling our products or require us to discontinue the use of certaintechnology in our products, any of which could have an adverse effect on ourbusiness, financial condition and results of operations. License agreements, ifrequired, 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.**

 

Ourgrowth has placed and will continue to place significant demands on ourmanagement, operational, financial and technical resources and on our internalcontrol, management information and reporting systems. Our success will depend,in part, upon the ability of our senior management to manage this growtheffectively. To manage the expected growth of our operations and personnel, wewill need to:

•                  continue to improve our operational,financial and management controls and our reporting systems and procedures;

•                  manage the growth of different productlines with different cost structures; and

•                  recruit, train, manage and motivate ouremployees to support our expanded operations.

 

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

 

Wewill continue to make investments in research and development to sustain andimprove our competitive position and meet our customers’ needs. Theseinvestments currently include refining Pyramid Probe fabrication processes,developing higher performance Pyramid Probe cards and enhancing engineeringprobe stations for 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 orlabor difficulties or destruction of or damage to the facilities as a result ofan earthquake, fire or any other reason, could materially and adversely affectour business, financial condition and results of operations.

 

**A disruption in our strategic relationship with AgilentTechnologies could have a negative effect on our ability to market our productsand could result in a decline in the price of our common stock.**

 

Wehave a longstanding relationship with Agilent Technologies in which we jointlymarket selected probing solutions, comprised of products from both companies.Consequently, our relationship with Agilent is an important factor in ourability to market our products. Our joint marketing relationship with Agilentis not governed by a contract. Therefore, Agilent could terminate itsrelationship with us or announce a strategic relationship with one of ourcompetitors at any time. While we do not track the portion of our revenue thatis attributable to our joint marketing relationship with Agilent, we believethat a termination of our relationship with Agilent could harm our ability tomarket our products and could result in a decline in the price of our commonstock.

 

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Furthermore,in those situations in which a customer purchases our products alongsideAgilent’s products, we depend on Agilent’s ability to timely deliver itsproducts to complete the installation of our product. To the extent that thereis a delay in the shipment of Agilent’s products, the timing of our revenuecould be adversely affected, which could cause us to miss the earningsexpectations of analysts and investors and result in a decline in the price ofour common stock.

 

**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 andregulations could result in enforcement actions, substantial liabilities andsuspension of production or cessation of operations in extreme situations.Compliance with current or future environmental laws and regulations couldrestrict our ability to expand our facilities or build new facilities orrequire us to acquire additional expensive equipment, modify our manufacturingprocesses, or incur other substantial expenses which could harm our business,financial condition and results of operation. For example, the EuropeanParliament has finalized the Restriction on Use of Hazardous SubstancesDirective, or RoHS Directive, which restricts the sale of new electrical andelectronic equipment containing certain hazardous substances including leadwhich is currently used in some of the products we manufacture. We are workingto modify our manufacturing processes to eliminate lead from products we put onthe market by July 1, 2006 as required by the RoHS Directive. We areworking with our suppliers to redesign or reformulate their componentscontaining lead to reduce or eliminate lead in our products. For some of ourproducts, substitutions of lead-free components or processes may be difficultor costly, or redesign efforts could result in production delays. The EuropeanParliament has also recently finalized the Waste Electrical and ElectronicEquipment Directive, or WEEE Directive, which makes producers of electrical andelectronic equipment financially responsible for specified collection,recycling, treatment and disposal of past and future covered products. As aproducer of industrial electronic equipment, we may incur financialresponsibility for the collection, recycling, treatment or disposal of productscovered under the WEEE Directive. These environmental laws and regulationscould become more stringent over time, imposing even greater compliance costsand increasing risks and penalties associated with violations, which couldseriously harm our business, financial condition and results of operation.There can be no assurance that violations of environmental laws or regulationswill not occur in the future as a result of the inability to obtain permits,human error, equipment failure or other causes.

 

**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 telecommunications infrastructure,military, medical and aerospace equipment. Defects or other problems with theperformance of our products could result in financial or other damages to ourcustomers. In addition, some of our engineering probe stations that use highpowered lasers or operate at high voltage or extreme temperatures may causedeath or injury to persons utilizing such equipment due to undetected design ormanufacturing defects or due to improper use or maintenance by our customers.Although our product invoices and sales contracts generally contain provisionsdesigned to limit our exposure to product liability claims, existing or futurelaws or unfavorable judicial decisions could negate these provisions. Productliability litigation against us, even if it were unsuccessful, could be timeconsuming and costly to defend. Additionally, although we carryproduct liability insurance, in somecircumstances it may not cover certain claims or be adequate to cover allclaims.

 

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**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.**

 

IBMaccounted for 11% of our revenue in 2003 and four customers, including IBM, accountedfor 18% and 23% of our revenue in 2004 and 2003, respectively. Our customersare not obligated by long-term contracts to purchase our products and maydiscontinue purchasing our products at any time. The semiconductor industry ishighly concentrated and a small number of semiconductor manufacturers generallyaccount for a substantial portion of the purchases of semiconductor testequipment, including our products. Consequently, our business and operatingresults would be materially, adversely affected by the loss of any of oursignificant 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 products fromthat vendor for that generation of chips, as well as subsequent generations ofchips. We therefore place great emphasis on relationships with our currentcustomers because these customers are difficult to replace. In addition, wefocus on leveraging our relationships with current customers to sell intoadditional engineering labs and production lines in the same company andsimilar 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.

 

**Our employment costs in the short-term are, to a large extent,fixed, and therefore, any shortfall in sales would harm our operating results.**

 

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 becoming apublic company will affect our operating results.**

 

Wewill incur incremental costs as a public company for additional expenses suchas increased auditing and legal fees and director and officer liabilityinsurance, which will increase our operating expenses and will make it moredifficult for us to offset any future revenue shortfalls by offsetting expensereductions in the short term. In addition, the Sarbanes-Oxley Act of 2002, aswell as new rules and regulations subsequently enacted by the Securities andExchange Commission, or the SEC, and the Nasdaq National Market have imposednew corporate governance requirements for listed companies. We expect theserules to increase our legal and financial compliance costs and to make someactivities more difficult, time consuming and costly. We also expect these newrules and regulations to make it more difficult and more expensive for us toobtain director and officer liability insurance, and we may be required toaccept reduced coverage or incur substantially higher costs to obtain coverage.These new rules and regulations could also make it more difficult for us toattract and retain qualified members of our board of directors and qualifiedexecutive officers.

 

##### **Unanticipated changes inour tax rates or exposure to additional income tax liabilities could affect ourprofitability.**

 

##### **We are subject to income taxes inboth the United States and various foreign jurisdictions, and our domestic andinternational tax liabilities are subject to the allocation of expenses indifferent jurisdictions.  Our effectivetax rate could be adversely affected by changes in the mix of earnings in**

##### ** **

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##### **countries with differentstatutory tax rates, changes in the valuation of deferred tax assets andliabilities, changes in tax laws, including pending tax law changes, such asthe benefit from export sales and the research and development credit bymaterial audit assessments.  Inparticular, the carrying value of deferred tax assets, which are predominantlyin the United States, is dependent on our ability to generate future taxable incomein the United States.  In addition, theamount of income taxes we pay could be subject to ongoing audits in variousjurisdictions and a material assessment by a governing tax authority couldaffect our profitability.**

 

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

 

Ourexecutive officers and directors and their affiliates beneficially ownapproximately 35% of our outstanding shares of common stock. Consequently,these shareholders will have control over the election of our directors and theoutcome of corporate actions requiring shareholder approval, such as a mergeror a sale of our company or a sale of all or substantially all of our assets.This concentration of voting power and control could have a significant effectin delaying, deferring or preventing an action that might otherwise bebeneficial to our other shareholders and be disadvantageous to our shareholderswith interests different from those of our officers, directors and affiliates.These shareholders will also have significant control over our business,policies and affairs. Additionally, this significant concentration of shareownership may adversely affect the trading price for our common stock becauseinvestors often perceive disadvantages in owning stock in companies withcontrolling shareholders.

 

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

 

Provisionsof our articles of incorporation and bylaws and provisions of Oregon law mayhave the effect of delaying or preventing a merger or acquisition of us, makinga merger or acquisition of us less desirable to a potential acquirer orpreventing a change in our management, even if the shareholders consider themerger or acquisition favorable or if doing so would benefit our shareholders.In addition, these provisions could limit the price that investors would bewilling to pay in the future for shares of our common stock. The following areexamples of such provisions in our articles of incorporation or bylaws:

•                  We have a staggered board of directors,which will make it more difficult for a group of shareholders to quickly changethe composition of our board.

•                  Our board of directors is authorized,without prior shareholder approval, to create and issue preferred stock withvoting or other rights or preferences that could impede the success of anyattempt to acquire us or change our control, commonly referred to as “blankcheck” preferred stock.

•                  Members of our board of directors canonly be removed for cause.

•                  The board of directors may alter ourbylaws without obtaining shareholder approval.

•                  Shareholders are required to provideadvance notice for nominations for election to the board of directors or forproposing matters to be acted upon at a 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.

 

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##### **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.   Our lease for space in an adjoining building,totaling 23,000 square feet, is available for sub-lease. This lease expires in June 2008.The lease on the remaining space in a third building expires at the end of January 2007.Under the terms of the lease, current rent on the primary site is approximately$107,000 per month. 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 in August 2009and current rent is approximately $63,000 per month. Approximately 20,000square feet of this facility is available for sub-lease. We lease small salesand service offices in Tokyo, Japan, Banbury, England and Singapore.

 

##### **Item 3.**                                   LEGALPROCEEDINGS

 

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; however, until now we have successfully defended our intellectualproperty in three lawsuits and successfully defended ourselves in one case ofalleged infringement.

 

##### **Item4.**                                   SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

##### ** **

The following items weresubmitted to a vote of shareholders in the fourth quarter of the year ended December 31,2004 and were approved by written consent of shareholders holding a majority ofthe capital stock (including a majority of the then outstanding shares ofSeries A and Series B Preferred Stock).

 

1.               *Adoption of Second Amended and Restated Articles of Incorporation*.  The shareholders adopted the Second Amendedand Restated Articles of Incorporation to:

 

(i)             deletereferences in the Articles of Incorporation to the rights and preferences ofthe Series C Preferred Stock, all of the previously outstanding shares of whichwere repurchased by us in December 2003;

(ii)          providethat the Board of Directors would consist of a minimum of three directors and amaximum of nine, rather than the previous minimum of four and maximum of seven;

(iii)       provide that if the number of directors is fixedat six or more, the directors will be divided into three classes, with eachclass of directors to serve for a three year term, except that the directorsfirst elected to Class I will serve for a term ending on the annual meeting ofshareholders for fiscal year 2005, the directors first elected to Class II willserve for a term ending on the annual meeting of shareholders for fiscal year2006, and the directors first elected to Class III will serve for a term endingon the annual meeting of shareholders for fiscal year 2007.

 

2.               *Adoption of Third Amended and Restated Articles of Incorporation. *The shareholders adopted the ThirdAmended and Restated Articles of Incorporation to:

 

(i)             deletereferences in the Articles of Incorporation to the rights and preferences ofthe Series A and B Preferred Stock, all of the previously outstanding shares ofwhich automatically converted into shares of our common stock, on a one-for-onebasis, immediately following the completion of our initial publicoffering;  and

(ii)          cancelthe ability of shareholders to take action by less than unanimous writtenconsent.

 

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3.               *Amendment of 2000 Stock Incentive Plan*.  The shareholders approved an amendment to the2000 Stock Incentive Plan to increase the number of shares of our Common Stockthat may be issued pursuant to the 2000 Stock Incentive Plan from 1,200,000 to1,800,000

 

4.               *Adoption of 2004 Employee Stock Purchase Plan*.  The shareholders approved the adoption of the2004 Employee Stock Purchase Plan.

 

5.               *Election of Board of Directors*.  The following individuals were elected to theBoard of Directors, effective as of the filing of the Third Restated Articles,each to serve in the class and for the period set forth in the table below:

 
| **Class I  Directors****(term expires 2005)** | ** ** | ** ** | **Class II Directors  (term expires 2006)** | ** **      | **Class III Directors  (term expires 2007)** |
|-----------------------------------------------|------------|------------|---------------------------------------------|-----------------|----------------------------------------------|
| William R.  Spivey                            | ** ** | ** ** | K. Reed Gleason                             | ** **      | George O’Leary                          |
| F. Paul Carlson                               | ** ** | ** ** | Keith Barnes                                | ** **      | Eric Strid                                   |
|                                          |       |       |                                        | Raymond A. Link |

 

6.               *Ratification of all Actions Taken by Board of Directors and Officers*.  The shareholders ratified and approved allactions taken by the board of directors and officers from the date of our lastannual meeting through December 10, 2004.

 

#### **Thewritten consent was executed by holders of an aggregate of 3,484,624 shares ofCommon Stock; 1,424,819 shares of Series A Preferred Stock; and 921,667 sharesof Series B Preferred Stock.**

#### ** **

#### **PART II**

#### ** **

**Item5.**                                   MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

** **

Our common stock began tradingon the Nasdaq National Market System under the symbol “CSCD” on December 15,2004.  The high closing sale price of ourcommon stock was $14.14 per share and the low closing sale price of our commonstock was $13.29 per share during the period December 15, 2004 through December 31,2004.

 

As of March 21, 2005,there were 144 shareholders of record. Many shareholders hold their shares in street name.  We believe we have approximately 1,600beneficial shareholders.

 

We have not declared or paid any cash dividendson our common stock in the past two years. We currently expect to retain anyfuture earnings to fund the operation and expansion of our business, andtherefore, we do not currently expect to pay cash dividends in the foreseeablefuture.

 

We filed a registration statement on Form S-1,File No. 333-113256 for an initial public offering of common stock, which wasdeclared effective by the Securities and Exchange Commission on December 15,2004.  In that offering, we sold anaggregate of 3.3 million shares of our common stock with net offering proceedsof $41.7 million.  As of December 31,2004, we had used approximately $5.5 million of those proceeds for therepayment of indebtedness.  No paymentswere made to our directors or officers or their associates, holders of 10% ormore of any class of our equity securities or to any affiliates.

 

See Item 12. for Equity Compensation PlanInformation.

 

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##### **Item6.**            SELECTEDCONSOLIDATED FINANCIAL DATA

 

The consolidated statement of operations and balance sheet data setforth below have been derived from our consolidated financial statements. Theselected consolidated financial data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and with the consolidated financial statements andnotes thereto included elsewhere in this Form 10-K.

 
| **IN THOUSANDS  (except per share amounts)**                           | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                             | **2004**   | ** **                               | **2003**   | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Statement  of Operations Data**                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Revenue                                                                |       | $                                        | 64,415     |   | $ | 50,556 |   | $ | 51,107 |   | $ | 72,296 |   | $ | 70,526 |   |
|                                                                   |       |                                     |       |   |   |   |   |   |   |   |   |
| Cost of  sales                                                         |       | 35,625                                   |       | 30,433 |   | 33,357 |   | 42,055 |   | 37,529 |   |
| Deferred  stock-based compensation                                     |       | 67                                       |       | 19 |   | 6 |   | 19 |   | 11 |   |
| Gross profit                                                           |       | 28,723                                   |       | 20,104 |   | 17,744 |   | 30,222 |   | 32,986 |   |
| Operating  expenses:                                                   |       |                                     |       |   |   |   |   |   |   |   |   |
| Research and  development                                              |       | 5,651                                    |       | 5,407 |   | 6,265 |   | 7,801 |   | 7,711 |   |
| Selling,  general and administrative                                   |       | 16,602                                   |       | 15,293 |   | 16,180 |   | 17,894 |   | 18,667 |   |
| Deferred  stock-based compensation                                     |       | 259                                      |       | 158 |   | (14 | ) | 115 |   | 64 |   |
| Total  operating expenses                                              |       | 22,512                                   |       | 20,858 |   | 22,431 |   | 25,810 |   | 26,442 |   |
| Income  (loss) from operations                                         |       | 6,211                                    |       | (754 | ) | (4,687 | ) | 4,412 |   | 6,544 |   |
| Other income  (expense), net                                           |       | (117                                     | )          | 553 |   | 385 |   | 429 |   | 304 |   |
| Income  (loss) before income taxes                                     |       | 6,094                                    |       | (201 | ) | (4,302 | ) | 4,841 |   | 6,848 |   |
| Provision  (benefit) for income taxes                                  |       | 1,387                                    |       | 248 |   | (2,244 | ) | 950 |   | 2,664 |   |
| Net income  (loss)                                                     |       | 4,707                                    |       | (449 | ) | (2,058 | ) | 3,891 |   | 4,184 |   |
| Accretion of  redeemable stock and loss on redemption                  |       | 113                                      |       | 583 |   | 362 |   | 358 |   | 353 |   |
| Net income  (loss) attributed to common shareholders                   |       | $                                        | 4,594      |   | $ | (1,032 | ) | $ | (2,420 | ) | $ | 3,533 |   | $ | 3,831 |   |
| Basic net  income (loss) per share attributed to common shareholders   |       | $                                        | 0.84       |   | $ | (0.20 | ) | $ | (0.48 | ) | $ | 0.70 |   | $ | 0.77 |   |
| Diluted net  income (loss) per share attributed to common shareholders |       | $                                        | 0.56       |   | $ | (0.20 | ) | $ | (0.48 | ) | $ | 0.41 |   | $ | 0.43 |   |
| Shares used  in basic per share calculations                           |       | 5,439                                    |       | 5,089 |   | 5,015 |   | 5,015 |   | 5,004 |   |
| Shares used  in diluted per share calculations                         |       | 8,452                                    |       | 5,089 |   | 5,015 |   | 9,482 |   | 9,622 |   |

 
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Balance Sheet Data**                                              |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term marketable securities        |       | $                     | 43,747     |   | $ | 10,717 |   | $ | 8,632 |   | $ | 10,950 |   | $ | 5,401 |   |
| Working  capital                                                    |       | 63,538                |       | 24,415 |   | 25,645 |   | 26,846 |   | 23,444 |   |
| Total assets                                                        |       | 79,016                |       | 37,766 |   | 40,815 |   | 43,775 |   | 45,473 |   |
| Current  portion of long-term debt and capital lease obligations    |       | 21                    |       | 2,043 |   | 21 |   | 122 |   | 685 |   |
| Long-term  debt and capital lease obligations, less current portion |       | 14                    |       | 5,038 |   | 25 |   | 43 |   | 176 |   |
| Other  long-term liabilities                                        |       | 1,372                 |       | 1,585 |   | 1,694 |   | 1,045 |   | 852 |   |
| Redeemable  stock                                                   |       | —                |       | 584 |   | 10,152 |   | 10,864 |   | 10,656 |   |
| Shareholders’  equity                                          |       | 70,188                |       | 22,960 |   | 23,848 |   | 25,432 |   | 21,689 |   |

 

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**Item7.**            MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

** **

*You shouldread the following discussion in conjunction with our consolidated financialstatements and notes thereto appearing elsewhere in this Form 10-K. In additionto historical consolidated financial information, the following discussion andanalysis contains forward-looking statements that involve risks, uncertaintiesand assumptions. Our actual results could differ materially from thoseanticipated by these forward-looking statements as a result of many factors,including those discussed under Item 1, Part I, “Business – Risk Factors,” andelsewhere in this Form 10-K.  See Part I– Item 1, “Business – Special Note Regarding Forward Looking Statements.”  We do not guarantee future results, levels ofactivity, performance or achievements. We do not intend to update any of the forward-looking statements afterthe date of this document to conform them to actual results or to changes inour expectations.*

 

**Overview**

 

We are a worldwide leader in the design, developmentand manufacture of advanced wafer probing solutions for the electricalmeasurement of high performance chips. We design, manufacture and assemble ourproducts in Beaverton, Oregon, with global sales, service and support centersin North America, Europe, Japan and Singapore. We were incorporated andintroduced our first commercial products in 1984.

 

Our products include engineering probe stations,analytical probes, production probe cards, application software and services.Analytical probes and production probe cards are sold to serve as components ofour engineering probe stations, or less often, to serve as components of testequipment manufactured by third parties. We also generate revenue through thesale of service contracts to our customers. We refer to analytical probes andproduction probe cards as consumables, as they are routinely replaced duringthe testing process. Engineering probe stations address the need for preciseand accurate measurement of semiconductor electrical characteristics duringchip design or when optimizing the chip fabrication process. Our engineeringprobe stations are highly configurable and are typically sold with variousaccessories, including our analytical probes and application software, as wellas accessories from third parties, such as the following:

•      probe micropositioners, which are mechanismswhich help align probe tips to particular locations on the wafer;

•      chucks, which are assemblies that hold thewafers during testing; and

•      thermal controllers, which areheating/refrigeration units that control the wafer temperature during testing.

 

In addition, we design and build custom engineeringprobe stations to address the specific requirements of our customers. To date,we have derived the large majority of our revenue from the sale of ourengineering probe stations, and we expect to continue to do so for theforeseeable future.

 

Our engineering probe stations, analytical probes,probing accessories and application software are sold through our EngineeringProducts Division. Our production probe cards are sold through our PyramidProbe Division. These two divisions are presented as segments in accordancewith Statement of Financial Accounting Standard (“SFAS”) No. 131, “DisclosuresAbout Segments of an Enterprise and Related Information,” because certaininformation related to their activities is provided to the Chief OperatingDecision Maker.

 

The segment data included for each division under “Resultsof Operations” below and in Note 17 to the Consolidated FinancialStatements is not prepared in accordance with accounting principles generallyaccepted in the United States of America and does not represent the stand-aloneperformance, revenue, cost of sales, gross profit (loss) or operating resultsof each segment. In preparing this financial information, certain operatingexpenses were allocated between the segments based on management estimateswhile others were based on specific factors such as headcount. Some operatingexpenses were not allocated at all because it was impractical to do so. Forexample,

 

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certain indirect costs related to the manufacture ofkey components by the Pyramid Probe Division on behalf of the EngineeringProducts Division have been fully allocated to the Pyramid Probe Division inthe data included in this discussion of financial results. In addition, noadjustments have been made to reflect the sale of these components by thePyramid Probe Division to the Engineering Products Division. These factors havea significant impact on the amount of gross profit (loss) and operating income(loss) for each segment. Assignment of other reasonable cost allocations toeach segment would result in much different segment operating results. As of January 2005,we primarily collect revenue information for each division because we believethat the segment data included for each division in “Results of Operation”below and in Note 17 to the Consolidated Financial Statements is notuseful for understanding our business and is not useful information on which tobase operating decisions. Accordingly, beginning in the first quarter of 2005,the financial statements may only present revenue data for each segment.

 

Our business and operating results depend insignificant part on the level of capital expenditures related to semiconductorresearch and development, which, in turn, depends upon current and anticipatedmarket demand for chips. Historically, the semiconductor industry has beenhighly cyclical with recurring periods of over-supply, which has often resultedin a reduction in demand for our products. While our financial results areimpacted by cycles within the semiconductor industry, we believe our businesscycles are typically less pronounced than those of other semiconductorequipment companies. We believe this is due to our greater reliance on ourcustomers’ research and development capital spending and usage of testconsumables rather than on our customers’ spending to increase productioncapacity. Capital spending aimed at increasing production capacity is one ofthe first areas in which most semiconductor manufacturers reduce spending in anindustry downturn.

 

As a result of the 2001 to 2003 downturn in thesemiconductor industry, we have taken steps to reduce our fixed expenses. Wereduced headcount from a peak of 350 in 2001 to 243 as of December 31,2003, which resulted in a savings related to salaries and benefits ofapproximately $3.0 million in 2003 and 2002 combined, as compared to 2001.As of December 31, 2004, we had 272 employees.  In addition to the headcount reductions, wehave realized other annualized cost reductions, which we expect to besustainable.

 

Although during the downturn in the semiconductorindustry some wafer manufacturers, including some of our customers, delayed,cancelled or postponed their conversion to 300mm technology, the transition inthe size of the standard semiconductor wafer from 200mm to 300mm accelerated inthe later half of 2003 and continued in 2004 as 300mm technology results inreduced per unit manufacturing costs by more than doubling the available area ona wafer, significantly increasing the number of chips per wafer. Thistransition has impacted our revenue mix as sales of our 300mm engineering probestations, which have higher average selling prices than our 200mm engineeringprobe stations, have steadily increased as a percentage of total engineeringprobe station units shipped.

 

Revenue from our 300mm engineering probe stations,including all probes, accessories and other items sold therewith, represented50.8%, 44.1% and 34.4% of our total engineering probe station revenue for theyears ended December 31, 2004, 2003 and 2002, respectively.

 

We sell our products both directly through our ownsales force and indirectly through a combination of manufacturers’representatives and distributors. In North America and Asia, excluding Japan,Singapore and Malaysia, we sell our products through manufacturers’representatives. In Japan, Singapore and Malaysia, we sell through CascadeMicrotech Japan, K.K. and Cascade Microtech Singapore, our direct sales and servicesubsidiary and branch office, respectively. In Europe, we sell primarilythrough distributors and manufacturers’ representatives, except in the 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. Our distributors typicallyplace orders 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 anygiven date is not material.

 

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Our business experiences seasonality. Typically, ourrevenue is lower in our fiscal first quarter than in our fiscal fourth quarterpreceding it. In addition, as is typical in our industry, we recognize a largepercentage of our quarterly revenue in the last month of the quarter.

 

We sell our solutions to most segments of thesemiconductor industry, including manufacturers of communications, wireless,microprocessors and other logic and memory chips.  A substantial portion of our revenue isgenerated from sales of our engineering probe stations and analytical probes toresearch and development laboratories of semiconductor manufacturers as well asto fabless semiconductor companies and academic institutions. As a result, wesell to a geographically diversified customer base, with more than 50% of ourrevenue in 2004, 2003 and 2002 generated outside of North America, primarily inJapan, other Asian countries and, to a lesser extent, Europe.

 

Cost of sales includes purchased materials,fabrication, assembly, test and installation labor and overhead,customer-specific engineering costs, warranty costs, royalties and provisionsfor inventory valuations.

 

Fluctuations in gross profit as a percentage ofrevenue, or gross margin, primarily result from changes in geographic mix,product mix, general pricing dynamics and yields in some of our production lines.Sales in Europe typically have a lower margin than sales in North America andJapan due to our use of third-party distributors in Europe. We typicallyachieve higher margins on our consumables than on our engineering probestations. Gross margin will also vary depending on our revenue levels, thelevel of overhead absorption, and, to a lesser extent, the success of ourongoing productivity improvements and component prices.

 

Research and development expenses are expensed asincurred and include compensation and related expenses for personnel,materials, consultants and overhead. From time to time, we enter intoarrangements that provide for the reimbursement of research and developmentexpenses. Such reimbursements are netted against gross research and developmentexpenses. In addition, our research and development expenses fluctuate fromquarter to quarter depending on the usage level of our production probe fab forresearch and development activity. Research and development expenses do notinclude costs to obtain patents or defend our intellectual property rights,consisting of patents and trademarks, or amortization of capitalized patentsand trademarks. Such expenses are included with selling, general andadministrative. Research and development expenses also do not include expensesfor design work on custom orders that do not result in reusable technology.Such expenses are included as a component of cost of sales.

 

Selling, general and administrative, or SG&A,expenses include compensation and related expenses for personnel, travel,outside services, manufacturers’ representative commissions, patent andtrademark amortization and overhead incurred in our sales, marketing, customersupport, management, legal and other professional and administrative supportfunctions.

 

Deferred stock-based compensation includes theamortization of value attributed to stock options granted during the one-yearperiod prior to filing our registration statement for our initial publicoffering in 2004, as well as amortization of deferred stock-based compensationrelated to option grants at the time we filed a registration statement for ourplanned initial public offering in 2000. The stock options granted during theseperiods were granted at the fair market value of our common stock on the dateof grant, as determined by our Board of Directors, and are accounted for usingthe intrinsic value method as prescribed by Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees.” Given the lack of anactive public market for our outstanding common stock at the time, our Board ofDirectors established estimates of fair value for our common stock, as well asfor options to purchase our common stock, based on factors such as recentnegotiated transactions, our financial condition and recent operating results,our competitive position and future prospects and analysis of financial data ofcomparable public companies.

 

For example, during the period from January 1,2003 through December 31, 2003, we granted options to purchase a total of380,450 shares of common stock at exercise prices ranging from $5.00 to $5.50

 

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per share. We did not obtain contemporaneousvaluations by an unrelated valuation specialist during the period. Indetermining the fair value of common stock for these grants, we considered thefactors described above as well as the following factors:

•      overall economic conditions in general and inthe semiconductor industry, which were adverse at the beginning of the period,and gradually improved during the period, while our product sales increased aseconomic conditions improved;

•      the repurchase, in June 2003, of ourcommon stock from a former employee at a negotiated price of $5.00 per share;

•      the repurchase, in July 2003, of ourcommon stock from a co-founder and former employee pursuant to a stock-putagreement at a negotiated price of $5.00 per share;

•      increases in the valuation of semiconductorcapital equipment companies in the second half of 2003; and

•      bookings, as an indicator of futureperformance.

 

Although we believed that the exercise price of theoptions granted during this period reflected the fair market value of ourcommon stock on each grant date, in anticipation of our initial public offeringin 2004 we re-evaluated the fair market value of our common stock for thethree-year period immediately preceding the filing of the registrationstatement. Based on such re-evaluation we determined that the fair market valueof our common stock during the one-year period prior to the filing of theregistration statement exceeded the exercise price of options granted duringsuch period. We therefore recorded deferred compensation expense totaling theamount by which the re-assessed fair market value of our common stock exceededthe exercise price of the options granted during the period. The $310,000 ofdeferred stock-based compensation as of December 31, 2004 will beamortized through September 30, 2008. We anticipate greater amortizationof deferred stock-based compensation in the first few years due to our use ofthe accelerated method of expense recognition for stock-based compensation,under which more expense is recognized in earlier periods, and to reversals ofdeferred stock-based compensation that result from employee terminations overtime. We performed a similar re-evaluation of the fair market value of ourcommon stock prior to our planned initial public offering in 2000. Thatre-evaluation resulted in deferred stock-based compensation of $373,000, whichwas fully amortized as of December 31, 2003.

 

During the period from January 1, 2004 through December 31,2004, we granted options to purchase a total of 223,000 shares of common stockwith an exercise price of $9.50 per share and 273,250 at $13.52 per share. Indetermining the fair value of the common stock for purposes of these optiongrants, the factors identified above were taken into account. We alsoconsidered other material factors and business developments, including thefollowing:

•      we redeemed our Series C preferred stockin December 2003 at a negotiated price of $8.00 per share;

•      in the first quarter of 2004, our Board ofDirectors authorized management to investigate the possibility of initiating aninitial public offering, conditions in the capital markets were improving andwe were able to attract prospective underwriters for this offering;

•      we determined that market conditions in thesecond and third quarters of 2004 were not sufficiently favorable for aninitial public offering and delayed the initial public offering;

•      in the fourth quarter of 2004, marketconditions improved and we received a pricing range of $11.00 to $13.00 for ourinitial public offering in November 2004;

•      also in the fourth quarter of 2004, there wasan improvement in the financial performance, projections and valuationparameters of comparable companies; and

•      in December 2004, we completed ourinitial public offering at $14.00 per share.

 

Based on the factors considered, we believe that theoptions granted during 2004 were at fair value and therefore, we have notrecorded any deferred compensation for options granted during 2004.

 

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Other income (expense) primarily includes interestincome, interest expense, gains and losses on sales of investments andtransaction and translation related foreign currency gains and losses.Transaction related foreign currency gains and losses result from gains andlosses recognized on foreign exchange forward contracts and on certain of ouraccounts receivable that are denominated in Japanese yen. Translation relatedforeign currency gains result from the translation of foreign currencydenominated accounting records into U.S. dollars.

 

Accretion of redeemable stock and loss on redemptionincludes the accretion of certain costs related to the issuance of ourSeries C convertible preferred stock and the cost of redeeming certainshares of our common stock. In December 2003, we redeemed ourSeries C convertible preferred stock for cash and a three-year note and,accordingly, we recognized the remaining unaccreted costs of $219,000 as a lossupon the redemption.

 

**Results of Operations**

The following table sets forth our consolidatedstatement of operations data for the periods indicated as a percentage ofrevenue.(1)

 
| **IN THOUSANDS  (except per share amounts)**          | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                            | **2004**   | ** **                               | **2003**   | ** ** | **2002** | ** ** |
| **Statement  of Operations Data**                     |       |                                     |       |   |   |   |   |
| Revenue                                               |       | 100.0                                    | %          | 100.0 | % | 100.0 | % |
| Cost of  sales and deferred stock-based compensation  |       | 55.4                                     |       | 60.2 |   | 65.3 |   |
| Gross profit                                          |       | 44.6                                     |       | 39.8 |   | 34.7 |   |
| Operating  expenses:                                  |       |                                     |       |   |   |   |   |
| Research and  development                             |       | 8.8                                      |       | 10.7 |   | 12.3 |   |
| Selling,  general and administrative                  |       | 25.8                                     |       | 30.2 |   | 31.6 |   |
| Deferred  stock-based compensation                    |       | 0.4                                      |       | 0.3 |   | — |   |
| Total  operating expenses                             |       | 34.9                                     |       | 41.3 |   | 43.9 |   |
| Income  (loss) from operations                        |       | 9.6                                      |       | (1.5 | ) | (9.2 | ) |
| Other income  (expense), net                          |       | (0.2                                     | )          | 1.1 |   | 0.8 |   |
| Income  (loss) before income taxes                    |       | 9.5                                      |       | (0.4 | ) | (8.4 | ) |
| Provision  (benefit) for income taxes                 |       | 2.2                                      |       | 0.5 |   | (4.4 | ) |
| Net income  (loss)                                    |       | 7.3                                      |       | (0.9 | ) | (4.0 | ) |
| Accretion of  redeemable stock and loss on redemption |       | 0.2                                      |       | 1.1 |   | 0.7 |   |
| Net income  (loss) attributed to common shareholders  |       | 7.1                                      | %          | (2.0 | ) % | (4.7 | ) % |

 

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

 

**Year Ended December 31,2004 and 2003**

 

***Revenue***

Revenue increased $13.9 million, or 27.4%, to $64.4 millionin 2004 compared to $50.6 million in 2003.

 

Revenue in the Engineering Products Division increased$11.2 million, or 23.5%, to $58.5 million in 2004 compared to$47.3 million in 2003. Average order total in the Engineering ProductsDivision increased 26.9% in 2004 compared to 2003. Average order total includesthe sales price of all analytical probes, production probe cards and otheraccessories purchased with an engineering probe station. The increase inaverage order total was primarily attributable to a 40.4% increase in the unitvolume of sales of our 300mm engineering probe stations, which have a higheraverage selling price than our 200mm engineering probe stations. While wecurrently sell a larger number of 200mm engineering probe stations than 300mmengineering probe stations, we expect the trend of increased sales of 300mmprobe stations to continue into 2005 as the industry continues to shift to 300mmfabrication facilities. Offsetting the increase in 300mm unit volume, was a4.2% decrease in unit

 

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volume sales of our 200mm engineering probe stations in 2004 comparedto 2003, for an overall increase in total unit volume sales of 4.6%. Theincrease in average order total was also attributable to an increase in salesof accessories and options ordered by customers with their engineering probestations in 2004 compared to 2003.

 

Revenue in the Pyramid Probe Division increased $2.7 million, or85.2%, to $5.9 million in 2004 compared to $3.2 million in 2003 dueto an increase in the number of production probe cards that we sold.

 

***Cost of Sales andGross Profit***

Cost of sales increased $5.2 million, or 17.1%, to$35.6 million in 2004 compared to $30.4 million in 2003. The increasein cost of sales was primarily due to the increase in unit volume sales of ourengineering probe stations discussed above, partially offset by productionimprovements made during 2003 primarily related to our probe station productplatforms.

 

Cost of sales for the Engineering Products Division increased$3.8 million, or 14.2%, to $30.7 million in 2004 compared to$26.9 million in 2003. Cost of sales for the Pyramid Probe Division increased$1.4 million, or 39.8%, to $5.0 million in 2004 compared to$3.6 million in 2003.

 

Our gross profit increased $8.6 million, or 42.9%, to$28.7 million in 2004 compared to $20.1 million in 2003. Gross profitas a percentage of revenue increased to 44.6% in 2004 compared to 39.8% in2003. The increase in our gross profit was primarily due to the productionimprovements mentioned above, efficiencies gained as production volumesincreased, approximately $166,000 of savings due to improved component pricingwith certain vendors, a $172,000 decrease in inventory write-downs and a$40,000 decrease in warranty expense. The decrease in inventory write-downs wasdue to $180,000 of write-downs in 2003 related to the poor adoption of one ofour product lines that was discontinued compared to only $9,000 of suchwrite-downs in 2004.

 

Gross profit for the Engineering Products Division increased$7.3 million, or 35.7%, to $27.8 million, or a gross profit margin of47.5%, in 2004 compared to $20.5 million, or a gross profit margin of43.2%, in 2003. The increase was due to production improvements, efficienciesgained as a result of an increase in production volumes, improved componentpricing and decreases in inventory write-downs.

 

Gross profit for the Pyramid Probe Division increased $1.3 million to$948,000 in 2004 compared to a negative gross margin of $365,000 in 2003. Theincrease was due to production improvements and efficiencies gained asproduction volumes increased.

 

***Research andDevelopment***

Research and development expenses increased $244,000, or 4.5%, to$5.7 million in 2004 compared to $5.4 million in 2003. The 2004 expense isnet of $94,000 received from a key customer as reimbursement of our researchand development expenses on a joint project, compared to $248,000 of suchreimbursements in 2003. The remainder of the increase resulted from contractlabor related to development of reusable technology from customer specificorders.

 

***Selling, General andAdministrative***

SG&A expense increased $1.3 million, or 8.6%, to $16.6 millionin 2004 compared to $15.3 million in 2003. Included in SG&A for 2004is $180,000 of severance related to the termination of our former ChiefFinancial Officer in the second quarter of 2004 compared to $98,000 of severancein 2003.  Representative commissions andemployee commissions increased $661,000, which is in line with the revenueincrease of 27.4%. Employee compensation and related benefits increased$526,000 in 2004 compared to 2003, resulting from 2004 salary increases and headcountincreases. Unfavorable changes in the exchange rate between the U.S. dollar andthe Japanese yen in 2004 compared to 2003 contributed $236,000 to the increasein 2004. We anticipate that SG&A expenses will increase in 2005 due toadditional legal, accounting, insurance and reporting expenses related to beinga public company and to complying with the Sarbanes-Oxley Act.

 

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***Deferred Stock-BasedCompensation***

Total deferred stock-based compensation was $326,000 in 2004 comparedto $177,000 in 2003. Deferred stock-based compensation in 2004 includes $86,000due to accelerated vesting of stock options related to the termination of ourformer Chief Financial Officer and is net of reversals for employee terminationsof $117,000 and $32,000 in 2004 and 2003, respectively. Deferred stock-basedcompensation in 2004 includes the amortization of value attributed to stockoptions issued in the one-year period prior to filing the registrationstatement related to our 2004 initial public offering, whereas deferred stockcompensation in 2003 includes amortization of deferred costs related to thegrant of stock options at the time we filed a registration statement for ourplanned initial public offering in 2000.

 

***Other Income(Expense)***

Interest income represents interest earned on cash and cash equivalentsand investments in marketable securities and totaled $133,000 and $164,000 in2004 and 2003, respectively. The decrease was primarily due to lower interestrates in 2004 compared to 2003 and lower invested cash balances due to thepayment of $3.0 million in the fourth quarter of 2003 for the conversionof our Series C preferred stock and the repayment of $7.0 million ofa note payable in 2004.

 

Interest expense of $465,000 in 2004 primarily represents interest onour $7.0 million note payable, which resulted from the conversion of ourSeries C preferred stock in the fourth quarter of 2003. As of December 31,2004, the note was paid in full.

 

Other income, net totaled $215,000 in 2004 compared to $390,000 in2003. The 2004 amount includes a $132,000 gain related to foreign currencytranslation and a $74,000 gain related to foreign currency transactions. The2003 amount includes a $318,000 translation related gain and a $49,000 gain onforeign currency hedging contracts and other foreign currency transactions.

 

***Income Taxes***

Our provision for income taxes totaled $1.4 million, or 22.8% of incomebefore income taxes, and $248,000, or 123.4%, of loss before income taxes in2004 and 2003, respectively.

 

Deferred tax assets arise from the tax benefit of amounts expensedfor financial reporting purposes but not yet realized for tax purposes and fromunutilized tax credits and net operating loss carry forwards.  We evaluate our deferred tax assets on aregular basis to determine if a valuation allowance is required.  To the extent it is determined that it ismore likely than not that we will not realize the benefit of our deferred taxassets, we record a valuation allowance against deferred tax assets.  At both December 31, 2004 and 2003, wehad valuation allowances of $1.8 million. In 2004, we reversed $726,000 of previously recorded valuation allowancebased on our 2004 performance.  The reversalprimarily related to U.S. research and engineering credits and state netoperating loss carryforwards, which were utilized during 2004. In addition, in2004, we increased the valuation allowance by $761,000 for excess foreign taxcredits and State of Oregon research and engineering credits, which we believeare more likely than not to not be utilized in the future.  The net result was an increase in valuationallowance in 2004 of $35,000.

 

Tax expense, net of associated tax credits for taxes paid in Japan, of$41,000 was recognized on the declaration of a $1.5 million dividend from ourJapanese subsidiary and is reflected in the tax provision for 2004. We have notprovided for United States income taxes on the remaining undistributed earningsof foreign subsidiaries because they are considered permanently investedoutside of the United States. Upon repatriation, some of these earnings wouldgenerate foreign tax credits which may reduce the United States tax liabilityassociated with any future foreign dividend.

 

At December 31, 2004, we had a net deferred tax asset on ourbalance sheet totaling $1.6 million, primarily related to timingdifferences in the recognition of certain reserves and accruals.

 

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***Accretion ofRedeemable Stock***

Accretion of redeemable stock decreased to $113,000 in 2004 from$583,000 in 2003 due to the conversion of our Series C convertiblepreferred stock in the fourth quarter of 2003. Accordingly, the 2004 amountonly included accretion of the redeemable common stock, whereas the 2003 amountincluded accretion of both the redeemable common and preferred stock. Inaddition, the 2003 amount includes the remaining $219,000 of unaccreted costsrelated to the Series C convertible preferred stock as a loss onredemption, which occurred in the fourth quarter of 2004.

 

**Years endedDecember 31, 2003 and 2002**

 

***Revenue***

Revenue decreased $551,000, or 1.1%, to $50.6 million in 2003compared to $51.1 million in 2002.

 

Revenue in the Engineering Products Division decreased $925,000, or1.9%, to $47.3 million in the year ended December 31, 2003 comparedto $48.2 million in the year ended December 31, 2002. This decreaseprimarily resulted from a 13.4% decrease in the number of engineering probestations sold in 2003 compared to 2002 as customers continued to curtail theircapital expenditures during the economic downturn. In addition, we experienceda 1.7% and a 4.9% decrease, respectively, in the average order total for our200mm and our 300mm engineering probe stations due to a decrease in accessoriesordered with these stations. These decreases were mostly offset by an 8.4%increase in the overall average order total for our engineering probe stationsin 2003 compared to 2002. The increase in the overall average order totalresulted from an increase in the proportion of sales of our 300mm probestations compared to sales of our less expensive 200mm engineering probestations.

 

Revenue in the Pyramid Probe Division increased $374,000, or 13.4%, to$3.2 million in the year ended December 31, 2003 compared to$2.8 million in the year ended December 31, 2002 due to an increasein the number of production probe cards that we sold.

 

***Cost of Sales andGross Profit***

Cost of sales decreased $3.0 million, or 8.8%, to$30.4 million in 2003 compared to $33.4 million in 2002. Our grossprofit increased $2.4 million, or 13.3%, to $20.1 million in 2003from $17.7 million in 2002. This increase was primarily a result of a$998,000 decrease in salaries and related costs due to head count reductions,$320,000 in savings related to improved production efficiency resulting frominvestments made during 2003 and 2002, a $295,000 decrease in inventorywrite-downs, and an $824,000 decrease in other fixed overhead costs due to costreduction measures implemented in 2002 and 2003. As a result of these factors,our overall gross margin increased to 39.8% in 2003 compared to 34.7% in 2002.

 

Cost of sales for the Engineering Products Division decreased$1.6 million, or 5.6%, to $26.9 million in 2003 compared to$28.5 million in 2002. Cost of sales for the Pyramid Probe Divisiondecreased $1.3 million, or 26.5%, to $3.6 million in 2003 compared to$4.9 million in 2002.

 

Gross profit for the Engineering Products Division increased $683,000,or 3.5%, to $20.5 million, or a gross profit margin of 43.2%, in 2003compared to $19.8 million, or a gross profit margin of 41.0%, in 2002.Gross profit for the Pyramid Probe Division increased $1.7 million to anegative gross profit of $365,000, or a negative gross profit margin of 11.4%,in 2003 compared to a negative gross profit of $2.0 million, or negativegross profit margin of 72.0%, in 2002. The increase in gross profit for theEngineering Products Division was due to all the factors mentioned above. Theincrease in gross profit for the Pyramid Probe Division was primarily due toheadcount reductions and savings from improved production efficiency.

 

Inventory write-downs decreased to $377,000 in 2003 from $672,000 in2002 primarily as a result of $623,000 of write-downs related to the pooradoption of one of our product lines that was discontinued in 2002 compared toonly $180,000 of such write-downs in 2003.

 

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Investments made to improve our production efficiency during 2003 and2002 included investments in our manufacturing capabilities and our productplatforms. We anticipate that these investments will result in more efficientproduction processes and a higher gross profit margin if we are able toincrease sales of our 300mm engineering probe stations.

 

***Research andDevelopment***

Research and development expenses decreased $858,000, or 13.7%, to$5.4 million in 2003 compared to $6.3 million in 2002. This decreasewas primarily a result of $200,000 of savings due to reductions in headcount, a$153,000 decrease in consulting fees and a $263,000 decrease in expenses forproject supplies. In addition, during 2003 and 2002, we received $248,000 and$90,000, respectively, from a key customer as reimbursement of our research anddevelopment expenses on a joint project. These amounts have been netted againstour gross research and development expenses.

 

***Selling, General andAdministrative***

SG&A expenses decreased $887,000, or 5.5%, to $15.3 million in2003 compared to $16.2 million in 2002. This decrease was primarily due toa $382,000 decrease in salaries and benefits due to lower headcount and adecrease in consulting fees, an $87,000 decrease in commissions, a $147,000decrease in bad debt expense due to a large write-off in 2002 for a single customerthat declared bankruptcy in that year and a $116,000 decrease in outsideaccounting fees. The decrease in outside accounting fees resulted from anincrease in such fees in 2002 as a result of an IRS examination that wascompleted during the year, preparation of amended returns as a result ofadjustments made to our foreign sales corporation allowances, and a federal andstate research and experimentation credit study.

 

***Deferred Stock-BasedCompensation***

Deferred stock-based compensation was $177,000 in 2003 compared to abenefit of $8,000 in 2002. Deferred stock-based compensation in 2003 includesthe amortization of value attributed to stock options issued in the one-yearperiod prior to filing this registration statement, as well as amortization ofdeferred costs related to the grant of stock options at the time we filed aregistration statement for our planned initial public offering in 2000. The$8,000 benefit recognized in 2002 resulted from employee terminations and theresulting reversal of the related deferred compensation.

 

***Other Income(Expense)***

Interest income represents interest earned on cash and cash equivalentsand investments in marketable securities and totaled $164,000 and $350,000 in2003 and 2002, respectively. Decreases in interest rates and average cash andinvestment balances resulted in lower interest income in 2003 compared to 2002.The lower average cash and investment balances resulted from the net use ofcash in 2003 and 2002 totaling approximately $677,000 and $2.3 million,respectively.

 

Other income, net totaled $390,000 in 2003 compared to $38,000 in 2002.The increase in 2003 resulted from a $49,000 gain related to foreign exchangeforward contracts compared to a $324,000 loss related to such contracts in2002. Both periods include approximately $300,000 of translation relatedforeign currency gains.

 

***Income Taxes***

Our provision (benefit) for income taxes totaled $248,000 and ($2.2)million in 2003 and 2002, respectively. The tax provision (benefit) in 2003 and2002 includes the recognition of valuation allowances of $781,000 and $646,000,respectively, against our deferred tax assets as a result of management’sconclusion that, given recent losses, certain of our research andexperimentation credits and state net operating loss credit carryforwards mayexpire before we are able to recognize them.

 

Our benefit for income taxes in 2002 includes a $1.5 millionbenefit related to carry-back of current year losses, amendments to prior yeartax returns resulting from adjustments made to our foreign

 

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sales corporation allowances and research and experimentation credits,based on a study performed during 2002.

 

***Accretion ofRedeemable Stock And Loss on Redemption***

Accretion of redeemable stock increased $221,000 in 2003 to $583,000from $362,000 in 2002 due to the redemption of our Series C convertiblepreferred stock and recording the remaining $219,000 of unaccreted costsrelated to the Series C convertible preferred stock as a loss on redemption.

 

**Liquidity and Capital Resources**

 

We anticipate meeting our cash requirements for thenext 12 months and for the foreseeable future from existing cash andshort-term marketable securities, which totaled $43.7 million at December 31,2004, as well as from cash expected to be generated from operations. Ourinitial public offering in December 2004 generated net proceeds of $41.7million, after deducting the underwriters discounts and commissions andoffering expenses. We used $5.5 million of the proceeds to repay the remainingprincipal balance of our outstanding note payable in December 2004.

 

Net cash provided by operating activities in 2004was $2.6 million and consisted of net income of $4.7 million andnon-cash expenses of $2.4 million, offset by net changes in our operatingassets and liabilities. These changes are described below.

 

Accounts receivable, net increased to$13.6 million at December 31, 2004 from $10.6 million at December 31,2003 primarily due to increased sales. Our days sales outstanding wasapproximately 68 days at December 31, 2004 compared to 71 days at December 31,2003.

 

Inventories increased to $10.2 million at December 31,2004 compared to $8.1 million at December 31, 2003, primarily due tothe building up of inventory to support anticipated sales increases in thefirst half of 2005. We believe that our inventory levels at December 31,2004 are adequate given our revenue projections for the first half of 2005.

 

Prepaid expenses increased to $1.6 million at December 31,2004 from $765,000 at December 31, 2003 primarily due to costs incurredfor director and officer insurance.

 

Accounts payable increased to $4.0 million at December 31,2004 compared to $2.8 million at December 31, 2003 primarily due tothe increase in raw material purchases.

 

Accrued liabilities increased to $2.6 millionat December 31, 2004 compared to $2.0 million at December 31,2003 primarily due to a $562,000 increase in accrued wages, commissions,bonuses, vacation and related accruals due to the timing of our payroll andrelated payments.  In addition, warrantyreserves have increased in line with revenue increases in 2004 compared to2003.

 

Net cash used in investing activities of$38.6 million in 2004 primarily resulted from $46.6 million used for thepurchase of marketable securities, $926,000 used for the purchase of fixedassets and $484,000 related to obtaining patents, trademarks and otherassets.  Offsetting these purchases wereproceeds from the sale of marketable securities of $9.4 million.

 

Net cash provided by financing activities in 2004was $34.6 million and primarily consisted of $41.7 million of net proceedsfrom our initial public offering of our common stock in December 2004 and$201,000 of proceeds from the exercise of options for common stock pursuant toour stock plans, partially offset by $7.0 million of principal payments onour term note and $198,000 for the repurchase of common stock.

 

At December 31, 2004, we had an unused $150,000standby letter of credit to be utilized in the event a customer requirescertain guarantees. This letter of credit is collateralized by $150,000 of ourcash and cash equivalents and expires August 14, 2005.

 

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**Contractual Commitments**

 

The following is a summary of our contractualcommitments and obligations as of December 31, 2004 (in thousands):

 
| ** **                  | ** ** | **Payments  Due By Period** | ** ** |
|-----------------------------|------------|-----------------------------|------------|
| **Contractual  Obligation** | ** ** | **Total**                   | ** ** | **2005** | ** ** | **2006 and  2007** | ** ** | **2008 and  2009** | ** ** | **2010 and  beyond** | ** ** |
| Capital Leases              |       | $                           | 35         |   | $ | 21 |   | $ | 14 |   | $ | — |   | $ | — |   |
| Operating Leases            |       | 8,778                       |       | 2,271 |   | 4,405 |   | 2,102 |   | — |   |
| Purchase Order Commitments  |       | 6,616                       |       | 5,754 |   | 862 |   | — |   | — |   |
|                        |       | $                           | 15,429     |   | $ | 8,046 |   | $ | 5,281 |   | $ | 2,102 |   | $ | — |   |

 

**Critical Accounting Policies andthe Use of Estimates**

 

The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions. These estimates and assumptionsaffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amount of revenue and expenses during the reporting period. It ispossible that the estimates we make may change in the future.

 

***RevenueRecognition***

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 element arrangementsis allocated based on the fair value of each element. A typical multipleelement arrangement may include some or all of the following components:product shipments, accessories, installation services and extended warrantycontracts. The total sales price is allocated based on the relative fair valueof each component when sold separately.

 

***Allowance forDoubtful Accounts***

The allowance for doubtful accounts is estimatedbased on 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 incredit quality. Our allowance for doubtful accounts totaled $86,000 and$101,000, respectively, at December 31, 2004 and 2003 and our bad debtexpense totaled $15,000, $6,000 and $152,000, respectively, in 2004, 2003 and2002. The bad debt expense in 2002 was substantially due to one optoelectronicscustomer that declared bankruptcy.

 

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***Valuation ofExcess and Obsolete Inventory***

We regularly analyze the value of our inventorybased on 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 substantial supply of parts for possible use in futurerepairs and customer field service. As these service parts become older, weapply a higher write-down against the recorded balance, recognizing that theolder the part, the less likely it will be used. If circumstances related to ourinventories change, our estimates of the value of inventory could materiallychange. We record estimated inventory write-downs quarterly as a component ofcost of sales. Total write-downs to inventory were $159,000, $377,000 and$672,000, respectively, in 2004, 2003, and 2002. The write-downs include$9,000, $180,000 and $623,000, respectively, related to inventory write-downsdue to poor adoption of one of our product lines, which was discontinued.  To determine the amount of the write-downrelated to this product line each quarter, we analyzed the current salesforecast at the end of each quarter, which was based on specific customer data,and compared it against existing inventory. We began taking write-downs forthis product line in the fourth quarter of 2001, while continuing to market theproduct. However, in the fourth quarter of 2002, we recorded an additionalwrite-down of $475,000 based on a determination that certain sales that we hadpreviously anticipated would not materialize. The additional write-downs in2003 and 2004 resulted from further reductions to our sales forecasts. Theinventory related to the discontinued product line was either transferred toservice inventory, discarded or donated to universities or other organizations.

 

***Lives andRecoverability of Equipment and Other Long-Lived Assets***

We evaluate the remaining lives and recoverabilityof equipment 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 asset to its estimated fair value. We have not recorded anyimpairment charges for long-lived assets during the years ended 2004, 2003 or2002.

 

***WarrantyLiabilities***

Warranty costs include labor to repair the systemand replacement 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. Accordingly, in 2003 and in 2002 weincreased our warranty reserve accrual rate to reflect our recent experienceregarding actual warranty charges as a percentage of revenue. We anticipate ourfuture warranty reserve accrual rate to be approximately 1% of revenue. Changesto the reserve occur as volume, product mix and actual warranty costsfluctuate. Our warranty reserve totaled $365,000 and $178,000, respectively, atDecember 31, 2004 and 2003. These amounts are estimates of warranty costsfor our installed base during the 12-month period. Warranty expense totaled$639,000, $679,000 and $409,000, respectively, during 2004, 2003 and 2002.

 

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***Deferred TaxAsset Valuation Allowance***

We record deferred tax assets for the estimatedfuture benefit of research and development tax credits, net operating losscarryforwards and other temporary differences to the extent management believesthese assets will be realized.  Avaluation allowance is recorded when management can not reach the conclusionthat it is more likely than not that the deferred tax assets will be realized.During 2004, we reversed $726,000 of a previously recorded valuation allowanceagainst our deferred tax assets based on our 2004 performance. The reversalprimarily related to research and engineering credits and state net operatingloss carryforwards that were utilized based on 2004 income.  During2004, we recorded a valuation allowance against our deferred tax assetstotaling $761,000 as a result of management’s conclusion that certain of ourforeign tax credits and state research and development credits may expirebefore we are able to recognize them. At December 31, 2004, we had a netdeferred tax asset on our balance sheet totaling $1.6 million, primarilyrelated to timing differences in the recognition of certain reserves andaccruals. We believe it is more likely than not that the benefits of theseassets will be realized. We may record additional valuation allowances in thefuture.

 

**New Accounting Pronouncements**

 

***SFAS No. 123R***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (Revised 2004), “Share-BasedPayment” (“SFAS No. 123R”), which replaces SFAS No. 123, “Accounting forStock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees.” SFAS No. 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with the firstinterim or annual period after June 15, 2005, with early adoptionencouraged.  The pro forma disclosurespreviously permitted under SFAS No. 123 no longer will be an alternative tofinancial statement recognition.  We arerequired to adopt SFAS No. 123R in the third quarter of 2005, beginning July 1,2005. Under SFAS No. 123R, we must determine the appropriate fair value modelto be used for valuing share-based payments, the amortization method forcompensation cost and the adoption method to be used at the date of adoption.We are evaluating the requirements of SFAS No. 123R and expect that theadoption of SFAS No. 123R will have a material impact on our results of operations.  We have not yet determined the method ofadoption or the effect of adopting SFAS No. 123R, and have not determinedwhether adoption will result in amounts that are similar to the current proforma disclosures under SFAS No. 123.

 

***SFAS No. 151***

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs: an amendment of ARB No. 43,Chapter 4,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs and wasted material.  SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  While we have not completed our analysis ofthe impact of SFAS No. 151, we do not currently believe the provisions of SFASNo. 151, when applied, will have a material impact on our financial position,results of operations or cash flows.

 

***SFAS No. 153***

In December 2004,the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets.”  SFAS No.153 amends APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” byreplacing the exception for exchanges of similar productive assets with anexception for exchanges that do not have commercial substance.  Atransaction has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange.  SFAS No.153 is effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of SFAS No. 153 to have any effect on ourfinancial position, results of operations or cash flow.

 

***FSP No. 109-2***

In December,2004, the FASB issued FASB Staff Position (“FSP”) No. 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provisions within theAmerican Jobs Creation Act of 2004” (the Jobs Act). FSP No. 109-2 providesguidance with respect to reporting the

 

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potentialimpact of the repatriation provisions of the Jobs Act on an enterprise’s incometax expense and deferred tax liability. The Jobs Act was enacted on October 22,2004, and provides for a temporary 85% dividends received deduction on certainforeign earnings repatriated during a one-year period. The deduction wouldresult in an approximate 5.25% federal tax rate on the repatriated earnings. Toqualify for the deduction, the earnings must be reinvested in the United Statespursuant to a domestic reinvestment plan established by a company’s chiefexecutive officer and approved by a company’s board of directors. Certain othercriteria in the Jobs Act must be satisfied as well. FSP No. 109-2 states thatan enterprise is allowed time beyond the financial reporting period to evaluatethe effect of the Jobs Act on its plan for reinvestment or repatriation offoreign earnings. Although we have not yet completed our evaluation of theimpact of the repatriation provisions of the Jobs Act, we do not expect thatthese provisions will have a material impact on our financial position, resultsof operations or cash flow. Accordingly, as provided for in FSP No. 109-2, wehave not adjusted our tax expense or deferred tax liability to reflect therepatriation provisions of the Jobs Act.

 

**Off-Balance Sheet Arrangements**

 

We do not have any off-balance sheet arrangementsthat have or are reasonably likely to have a material current or future effecton our financial condition, changes in financial condition, revenue orexpenses, results of operations, liquidity, capital expenditures or capitalresources.

 

##### **Item7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

***ForeignCurrency 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, 2004, we had 7contracts outstanding for the purchase of Japanese yen totaling approximately$4.7 million, which mature through May 10, 2005.

 

Historically, we have not attempted to mitigate theimpact of foreign currency fluctuations on the translation of our subsidiaries’net assets and results of operations, nor do we enter into derivative financialinstruments for speculative purposes.

 

***Interest RateRisk***

Our exposure to market risk from changes in interestrates relates primarily to our investments. Because we have no variableinterest rate debt outstanding at December 31, 2004, we would notexperience a material impact on our results of operations, financial positionor cash flows as the result of a one percent increase in interest rates. Theprimary objective of our investment activities is to preserve principal whilemaximizing yields without significantly increasing risk. This is accomplishedby investing in diversified investments, consisting only of investment gradesecurities.

 

As of December 31, 2004, we held cash, cashequivalents and current marketable securities of $43.7 million. Declinesof interest rates over time would reduce our interest income from our highlyliquid short-term investments. A decrease in interest rates of one percentwould cause a corresponding decrease in our annual interest income related toour cash, cash equivalents and marketable securities of approximately $0.4million, assuming our December 31, 2004 balances remained constant. Due tothe nature of our highly liquid cash equivalents, a change in interest rateswould not materially affect the fair market value of our cash and cashequivalents.

 

As of December 31, 2004, we held long-termfixed rate investments of $2.8 million that consisted of municipal andcorporate notes and money market securities. An increase or decrease ininterest rates would not have a material impact on our results of operations,financial position or cash flows, as we have classified our securities asavailable-for-sale and, therefore, may choose to sell or hold them as

 

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changes in the market occur. Declines in interestrates over time would reduce our interest income from our long-terminvestments, as it is re-invested at current market interest rates.

 

###### **Item8.**            CONSOLIDATEDFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The financial statements and notes thereto required by this item beginon page F-1 of this document, as listed in Item 15 of Part IV.  Unaudited quarterly financial data**for each of the eight quarters in the two-year period endedDecember 31, 2004 is as follows:

 
| **In thousands, except per share data**               | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|-------------------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| **2003**                                              |       |            |       |            |       |            |       |            |       |
| Revenue                                               |       | $               | 12,041     |            | $          | 12,140          |       | $               | 12,818     |   | $ | 13,557 |   |
| Gross margin                                          |       | 4,457           |       | 4,748           |       | 5,042           |       | 5,857           |       |
| Net income (loss)                                     |       | (642            | )          | (359            | )          | (67             | )          | 619             |       |
| Accretion of  redeemable stock and loss on redemption |       | 90              |       | 91              |       | 91              |       | 311             |       |
| Net income  (loss) attributed to common shareholders  |       | (732            | )          | (450            | )          | (158            | )          | 308             |       |
| Basic net  loss per share                             |       | (0.14           | )          | (0.09           | )          | (0.03           | )          | 0.06            |       |
| Diluted net  loss per share                           |       | (0.14           | )          | (0.09           | )          | (0.03           | )          | 0.05            |       |
|                                                  |       |            |       |            |       |            |       |            |       |
| **2004**                                              |       |            |       |            |       |            |       |            |       |
| Revenue                                               |       | $               | 13,834     |            | $          | 15,120          |       | $               | 17,059     |   | $ | 18,402 |   |
| Gross margin                                          |       | 5,880           |       | 6,547           |       | 7,640           |       | 8,656           |       |
| Net income  (loss)                                    |       | 373             |       | 1,239           |       | 1,428           |       | 1,667           |       |
| Accretion of  redeemable stock                        |       | 38              |       | 37              |       | 38              |       | —          |       |
| Net income  (loss) attributed to common shareholders  |       | 335             |       | 1,202           |       | 1,390           |       | 1,667           |       |
| Basic net  income (loss) per share                    |       | 0.07            |       | 0.23            |       | 0.27            |       | 0.27            |       |
| Diluted net  income (loss) per share                  |       | 0.05            |       | 0.15            |       | 0.17            |       | 0.19            |       |

 

**Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

 

None.

 

**Item9A. CONTROLS AND PROCEDURES**

 

**DisclosureControls and Procedures**

Our management has evaluated, under the supervision and with theparticipation of our President and Chief Executive Officer and Chief FinancialOfficer, the effectiveness of our disclosure controls and procedures as of theend of the period covered by this report pursuant to Rule 13a-15(b) under theSecurities Exchange Act of 1934 (the “Exchange Act”). Based on that evaluation,our President and Chief Executive Officer and Chief Financial Officer haveconcluded that, as of the end of the period covered by this report, ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed in our Exchange Act reports is (1) recorded,processed, summarized and reported in a timely manner, and (2) accumulated andcommunicated to our management, including our President and Chief ExecutiveOfficer and Chief Financial Officer, as appropriate to allow timely decisionsregarding required disclosure.

 

**Internal Control Over Financial Reporting**

Management of Cascade Microtech, Inc. is responsible for establishingand maintaining adequate internal control over financial reporting. Ourinternal control system was designed to provide reasonable assurance to ourmanagement and board of directors regarding the reliability and fairpresentation of financial reporting and the preparation of financial statementsfor external purposes in accordance with U.S. generally accepted accountingprinciples.

 

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Internal control over financial reporting includes controls themselves,monitoring and internal auditing practices and actions taken to correctdeficiencies as identified.

 

All internal control systems, no matter how well designed, haveinherent limitations.  Because of theseinherent limitations, even those systems determined to be effective can provideonly reasonable assurance that misstatements with respect to financialreporting and financial statement preparation will be detected.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

 

There has been no change in our internal control over financialreporting that occurred during our last fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**Item9B. OTHER INFORMATION**

 

None.

 

**PART III**

 

We have omitted from Part III the information that will appear in ourdefinitive proxy statement for our 2005 Annual Meeting of Shareholders (the “ProxyStatement”), which will be filed within 120 days after the end of our yearended December 31, 2004 pursuant to Regulation 14A.

 

**Item10.  DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

Information with respect to directors and executive officers isincluded under “Election of Directors,” “Executive Officers,” “Section 16(a)Beneficial Ownership Reporting Compliance,” “Audit Committee Financial Expert,”“Audit Committee Report” and “Code of Ethics” in our definitive proxy statementfor our 2005 Annual Meeting of Shareholders and is incorporated herein byreference.

 

##### **Item11.  EXECUTIVE COMPENSATION**

 

Information with respect to executive compensation is included under “DirectorCompensation,” “Executive Compensation” “Employment Contracts and Terminationof Employment and Change-in-Control Arrangements” and “Compensation CommitteeInterlocks and Insider Participation,”**“StockPerformance Graph” in our definitive proxy statement for our 2005 AnnualMeeting of Shareholders and is incorporated herein by reference.

 

##### **Item12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The information required by this item is included under “SecurityOwnership of Certain Beneficial Owners and Management” and “Equity CompensationPlan Information” in our definitive proxy statement for our 2005 Annual Meetingof Shareholders and is incorporated herein by reference.

 

##### **Item13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this item is included under “Certain Relationshipsand Related Transactions” in our definitive proxy statement for our 2005 AnnualMeeting of Shareholders and is incorporated herein by reference.

 

##### **Item14.  PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

The information required by this item is included under “Ratificationof Appointment of Independent Auditors” in our Proxy Statement for our 2005Annual Meeting of Shareholders and is incorporated herein by reference.

 

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##### **PARTIV**

##### ** **

##### **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:

 
| Report  of Independent Registered Public Accounting Firm                                                                              |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                  |   |
| Consolidated Balance Sheets  as of December 31, 2004 and 2003                                                                    |   |
|                                                                                                                                  |   |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and  2002                                     |   |
|                                                                                                                                  |   |
| Consolidated  Statements of Redeemable Stock and Shareholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |   |
|                                                                                                                                  |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                                     |   |
|                                                                                                                                  |   |
| Notes to  Consolidated Financial Statements                                                                                           |   |
|                                                                                                                                  |   |
| Report  of KPMG LLP on Schedule II – Valuation and Qualifying Accounts                                                      |   |
|                                                                                                                                  |   |
| Schedule II  – Valuation and Qualifying Accounts                                                                            |   |

 

**Exhibits**

The following exhibits are filed herewith and this list is intended toconstitute the exhibit index.  Exhibitnumbers marked with an asterisk (*) represent management or compensatoryarrangements.

 
| **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             |       | Restated Bylaws of Cascade Microtech, Inc. Incorporated by  reference to Exhibit 3.4 to our Registration Statement on Form S-1,  File No. 333-47100.                                                                                                                                                                                                                                     |
| 3.3             |       | Form of Second Amended and Restated Bylaws of Cascade  Microtech, Inc. Incorporated by reference to Exhibit 3.5 to our  Registration Statement on Form S-1, File No. 333-113256.                                                                                                                                                                                                         |
| 4.1             |       | Reference is made to Exhibit 3.1                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2             |       | Investor Rights’ Agreement for Series C Preferred Stock  Investors, dated December 16, 1999. Incorporated by reference to  Exhibit 4.3 to our Registration Statement on Form S-1, File  No. 333-47100.                                                                                                                                                                         |
| 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.                                                                                                                                                                                |
| 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 Exhibit 10.3 to our Registration Statement  on Form S-1, File No. 333-113256.                                                                                                                                                                                                               |
| 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 Eric Blachno. Incorporated by reference to  Exhibit 10.8 to our Registration Statement on Form S-1, File  No. 333-113256.                                                                                                                                                                                                                                             |
| 10.6            |       | Employment Agreement of Steven Sipowicz. Incorporated by reference to  Exhibit 10.12 to our Registration Statement on Form S-1, File  No. 333-113256.                                                                                                                                                                                                                                         |
| 10.7            |       | 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            |       | 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.                                                                                                                                                    |

 

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| 10.9  |   | 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.         |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10 |   | Stock Sale and Note Purchase Agreement between Cascade  Microtech, Inc. and Teachers Insurance and Annuity Association of  America, dated December 29, 2003. Incorporated by reference to  Exhibit 10.9 to our Registration Statement on Form S-1, File  No. 333-113256. |
| 10.11 |   | Senior Unsecured Note due December 29, 2006. Incorporated by  reference to Exhibit 10.10 to our Registration Statement on  Form S-1, File No. 333-113256.                                                                                                                     |
| 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. 2005 Incentive Compensation Plan for the  Six-Month Period Ending June 30, 2005. Incorporated by reference to  Exhibit 10.1 to our Form 8-K filed February 17, 2005.                                                                                       |
| 14    |   | Code of Ethics                                                                                                                                                                                                                                                                                    |
| 21    |   | List of Subsidiaries. Incorporated by reference to Exhibit 21.1  to our Registration Statement on Form S-1, File No. 333-113256.                                                                                                                                                   |
| 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

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, Cascade Microtech, Inc. has duly caused thisreport to be signed on its behalf by the undersigned, thereunto duly authorizedon March 29, 2005:

 
|   | 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, thisreport has been signed below on behalf of the Registrant and in the capacitiesindicated on March 29, 2005.

 
| **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/ K. REED GLEASON        |       |                                                       | Vice President of Advanced Development and |
| K. Reed Gleason            |       | Director                                                   |
|                       |       |                                                       |
| /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 of Independent Registered Public Accounting Firm**

 

The Board of DirectorsCascade Microtech, Inc.

 

We have audited the accompanying consolidatedbalance sheets of Cascade Microtech, Inc. and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of operations,redeemable stock and shareholders’ equity, and cash flows for each of the yearsin the three-year period ended December 31, 2004. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

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 financialstatements referred to above present fairly, in all material respects, thefinancial position of Cascade Microtech, Inc. and subsidiaries as of December 31,2004 and 2003, and the results of their operations, and their cash flows foreach of the years in the three-year period ended December 31, 2004 inconformity with U.S. generally accepted accounting principles.

 
| /s/ KPMG LLP           |   |
|------------------------|--------|
| Portland, Oregon       |
| February 11, 2005 |

 

F-1

----

 

**CascadeMicrotech, Inc.**

**ConsolidatedBalance Sheets**

**(Inthousands, except share par value)**

 
| ** **                                                                                                                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Assets**                                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current  Assets:                                                                                                                              |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                                    |       | $                     | 2,033      |   | $ | 3,461 |   |
| Short-term  marketable securities                                                                                                             |       | 41,714                |       | 7,256 |   |
| Accounts  receivable, net of allowances of $86 and $101                                                                                       |       | 13,640                |       | 10,603 |   |
| Inventories,  net                                                                                                                             |       | 10,180                |       | 8,065 |   |
| Prepaid  expenses and other                                                                                                                   |       | 1,579                 |       | 765 |   |
| Deferred  income taxes                                                                                                                        |       | 1,552                 |       | 1,453 |   |
| Total  Current Assets                                                                                                                         |       | 70,698                |       | 31,603 |   |
|                                                                                                                                          |       |                  |       |   |   |
| Long-term  marketable securities                                                                                                              |       | 2,779                 |       | — |   |
| Fixed  assets, net                                                                                                                            |       | 4,008                 |       | 4,866 |   |
| Deferred  income taxes                                                                                                                        |       | 65                    |       | 4 |   |
| Other  assets, net                                                                                                                            |       | 1,466                 |       | 1,293 |   |
| Total Assets                                                                                                                                  |       | $                     | 79,016     |   | $ | 37,766 |   |
|                                                                                                                                          |       |                  |       |   |   |
| **Liabilities,  Redeemable Stock and Shareholders’ Equity**                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current  Liabilities:                                                                                                                         |       |                  |       |   |   |
| Current  portion of long-term debt and capital leases                                                                                         |       | $                     | 21         |   | $ | 2,043 |   |
| Accounts  payable                                                                                                                             |       | 3,951                 |       | 2,822 |   |
| Deferred  revenue                                                                                                                             |       | 579                   |       | 276 |   |
| Accrued  liabilities                                                                                                                          |       | 2,609                 |       | 2,047 |   |
| Total  Current Liabilities                                                                                                                    |       | 7,160                 |       | 7,188 |   |
|                                                                                                                                          |       |                  |       |   |   |
| Long-term  debt and capital leases                                                                                                            |       | 14                    |       | 5,038 |   |
| Deferred  revenue                                                                                                                             |       | 282                   |       | 411 |   |
| Other  long-term liabilities                                                                                                                  |       | 1,372                 |       | 1,585 |   |
| Total  Liabilities                                                                                                                            |       | 8,828                 |       | 14,222 |   |
|                                                                                                                                          |       |                  |       |   |   |
| Commitments  and Contingencies (Note 16)                                                                                                      |       |                  |       |   |   |
|                                                                                                                                          |       |                  |       |   |   |
| Redeemable Stock:                                                                                                                             |       |                  |       |   |   |
| Common  stock, $0.01 par value. 100,000 shares authorized, 0 shares and 442 shares  issued and outstanding at December 31, 2004 and 2003 |       | —                |       | 584 |   |
| Shareholders’  Equity:                                                                                                                   |       |                  |       |   |   |
| Convertible  preferred stock:                                                                                                                 |       |                  |       |   |   |
| Series A,  $0.01 par value. Authorized, issued and outstanding 0 shares and 1,337 shares  at December 31, 2004 and 2003                  |       | —                |       | 13 |   |
| Series B,  $0.01 par value. Authorized, issued and outstanding 0 shares and 1,009 shares  at December 31, 2004 and 2003                  |       | —                |       | 10 |   |
| Common  stock, $0.01 par value. Authorized 100,000 shares; issued and outstanding:  10,864 and 4,653 at December 31, 2004 and 2003       |       | 109                   |       | 47 |   |
| Additional  paid-in capital                                                                                                                   |       | 55,402                |       | 13,335 |   |
| Deferred  stock-based compensation                                                                                                            |       | (310                  | )          | (902 | ) |
| Accumulated  other comprehensive income (loss) - unrealized holding gains (losses) on  investments                                            |       | (17                   | )          | 6 |   |
| Retained  earnings                                                                                                                            |       | 15,004                |       | 10,451 |   |
| Total  Shareholders’ Equity                                                                                                              |       | 70,188                |       | 22,960 |   |
| Total  Liabilities, Redeemable Stock and Shareholders’ Equity                                                                            |       | $                     | 79,016     |   | $ | 37,766 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-2

----

 

**CascadeMicrotech, Inc.Consolidated Statements ofOperations(In thousands, except per share amounts)**

 
| ** **                                                                                                                                | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                                                                                   |       | $                                        | 64,415     |   | $ | 50,556 |   | $ | 51,107 |   |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Cost of  sales                                                                                                                            |       | 35,625                                   |       | 30,433 |   | 33,357 |   |
| Deferrred  stock-based compensation                                                                                                       |       | 67                                       |       | 19 |   | 6 |   |
| Gross profit                                                                                                                              |       | 28,723                                   |       | 20,104 |   | 17,744 |   |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Operating  expenses:                                                                                                                      |       |                                     |       |   |   |   |   |
| Research and  development (excludes $30, $15 and $9, respectively, of amortization of  deferred stock-based compensation)                 |       | 5,651                                    |       | 5,407 |   | 6,265 |   |
| Selling,  general and administrative (excludes $229, $143 and $(23), respectively, of  amortization of deferred stock-based compensation) |       | 16,602                                   |       | 15,293 |   | 16,180 |   |
| Deferred  stock compensation                                                                                                              |       | 259                                      |       | 158 |   | (14 | ) |
|                                                                                                                                      |       | 22,512                                   |       | 20,858 |   | 22,431 |   |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Income  (loss) from operations                                                                                                            |       | 6,211                                    |       | (754 | ) | (4,687 | ) |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Other income  (expense):                                                                                                                  |       |                                     |       |   |   |   |   |
| Interest  income                                                                                                                          |       | 133                                      |       | 164 |   | 350 |   |
| Interest  expense                                                                                                                         |       | (465                                     | )          | (1 | ) | (3 | ) |
| Other, net                                                                                                                                |       | 215                                      |       | 390 |   | 38 |   |
|                                                                                                                                      |       | (117                                     | )          | 553 |   | 385 |   |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Income  (loss) before income taxes                                                                                                        |       | 6,094                                    |       | (201 | ) | (4,302 | ) |
| Provision  (benefit) for income taxes                                                                                                     |       | 1,387                                    |       | 248 |   | (2,244 | ) |
| Net income (loss)                                                                                                                         |       | 4,707                                    |       | (449 | ) | (2,058 | ) |
| Accretion of  redeemable stock and loss on redemption                                                                                     |       | 113                                      |       | 583 |   | 362 |   |
| Net income  (loss) attributed to common shareholders                                                                                      |       | $                                        | 4,594      |   | $ | (1,032 | ) | $ | (2,420 | ) |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Basic net  income (loss) per share attributed to common shareholders                                                                      |       | $                                        | 0.84       |   | $ | (0.20 | ) | $ | (0.48 | ) |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Diluted net  income (loss) per share attributed to common shareholders                                                                    |       | $                                        | 0.56       |   | $ | (0.20 | ) | $ | (0.48 | ) |
|                                                                                                                                      |       |                                     |       |   |   |   |   |
| Shares used  in per share calculations:                                                                                                   |       |                                     |       |   |   |   |   |
| Basic                                                                                                                                     |       | 5,439                                    |       | 5,089 |   | 5,015 |   |
| Diluted                                                                                                                                   |       | 8,452                                    |       | 5,089 |   | 5,015 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-3

----

 

**CascadeMicrotech, Inc.Consolidated Statements ofRedeemable Stock and Shareholders’ EquityFor The Years Ended December 31, 2004, 2003 and 2002(In thousands)**

 
| ** **                                                                                 | ** ** | **Redeemable Stock**      | ** ** | ** **       | ** ** | ** **                      | ** ** | ** **       | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------|------------|------------------|------------|---------------------------------|------------|------------------|------------|------------|------------|
| ** **                                                                                 | ** ** | **Convertible Preferred** | ** ** | ** **       | ** ** | ** **                      | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                 | ** ** | **Stock and Warrant**     | ** ** | **Common Stock** | ** ** | **Convertible Preferred Stock** | ** ** | **Common Stock** | ** ** |
| ** **                                                                                 | ** ** | **Shares**                | ** ** | **Amount**       | ** ** | **Shares**                      | ** ** | **Amount**       | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| **Balance at December 31, 2001**                                                      |       | 1,250                     |       | $                | 10,280     |                            | 494        |             | $          | 584        |       | 2,346 |   | $ | 23 |   | 4,539 |   | $ | 45 |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | 33 |   | — |   |
| Common stock repurchased                                                                   |       | —                    |       | —           |       | (22                             | )          | (150             | )          | —     |       | — |   | (35 | ) | — |   |
| Accretion of common stock redemption                                                       |       | —                    |       | —           |       | —                          |       | 150              |       | —     |       | — |   | — |   | — |   |
| Accretion of preferred stock redemption                                                    |       | —                    |       | 212              |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Expiration of stock warrant unexercised                                                    |       | —                    |       | (924             | )          | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Notes receivable payment                                                                   |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Deferred stock-based compensation                                                          |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Amortization of deferred stock-based  compensation, net                               |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Unrealized holding loss on investments                                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Net loss                                                                                   |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| **Balance at December 31, 2002**                                                      |       | 1,250                     |       | 9,568            |       | 472                             |       | 584              |       | 2,346      |       | 23 |   | 4,537 |   | 45 |   |
|                                                                                       |       |                      |       |             |       |                            |       |             |       |       |       |   |   |   |   |   |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | 148 |   | 2 |   |
| Common stock repurchased                                                                   |       | —                    |       | —           |       | (30                             | )          | (150             | )          | —     |       | — |   | (32 | ) | — |   |
| Accretion of common stock redemption                                                       |       | —                    |       | —           |       | —                          |       | 150              |       | —     |       | — |   | — |   | — |   |
| Accretion of preferred stock redemption                                                    |       | —                    |       | 214              |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Conversion of preferred stock to debt and loss on redemption                               |       | (1,250                    | )          | (9,782           | )          | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Deferred stock-based compensation                                                          |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Amortization of deferred stock-based compensation, net                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Unrealized holding loss on investments                                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Net loss                                                                                   |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| **Balance at December 31, 2003**                                                      | ** ** | **—**                |       | —           |       | 442                             |       | 584              |       | 2,346      |       | 23 |   | 4,653 |   | 47 |   |
|                                                                                       |       |                      |       |             |       |                            |       |             |       |       |       |   |   |   |   |   |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | 146 |   | 2 |   |
| Common stock issued in IPO, net of IPO costs of $4,572                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | 3,300 |   | 33 |   |
| Common stock repurchased                                                                   |       | —                    |       | —           |       | (16                             | )          | (150             | )          | —     |       | — |   | (7 | ) | — |   |
| Accretion of common stock redemption                                                       |       | —                    |       | —           |       | —                          |       | 113              |       | —     |       | — |   | — |   | — |   |
| Amortization of deferred stock-based compensation, net                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Termination of the redemption feature of the redeemable common stock                       |       | —                    |       | —           |       | (426                            | )          | (547             | )          | —     |       | — |   | 426 |   | 4 |   |
| 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                                                      |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Unrealized holding loss on investments                                                     |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| Net income                                                                                 |       | —                    |       | —           |       | —                          |       | —           |       | —     |       | — |   | — |   | — |   |
| **Balance at December 31, 2004**                                                      |       | —                    |       | $                | —     |                            | —     |             | $          | —     |       | — |   | $ | — |   | 10,864 |   | $ | 109 |   |
|                                                                                            |            |                           |            |                  |            |                                 |            |                  |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                                 | ** ** | ** **     | ** ** | ** **   | ** ** | **Notes**      | ** ** | ** **        | ** ** | ** **   | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------|------------|--------------|------------|----------------|------------|-------------------|------------|--------------|------------|------------------------|------------|
| ** **                                                                                 | ** ** | ** **     | ** ** | **Deferred** | ** ** | **Receivable** | ** ** | **Accumulated**   | ** ** | ** **   | ** ** | ** **             | ** ** |
| ** **                                                                                 | ** ** | **Additional** | ** ** | **Stock-**   | ** ** | **for**        | ** ** | **Other**         | ** ** | ** **   | ** ** | **Total**              | ** ** |
| ** **                                                                                 | ** ** | **Paid-In**    | ** ** | **Based**    | ** ** | **Common**     | ** ** | **Comprehensive** | ** ** | **Retained** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                 | ** ** | **Capital**    | ** ** | **Comp.**    | ** ** | **Stock**      | ** ** | **Income(Loss)**  | ** ** | **Earnings** | ** ** | **Equity**             | ** ** |
| **Balance at December 31, 2001**                                                      |       | $              | 11,428     |         | $          | (158           | )          | $                 | (153       | )            | $          | 68                     |       | $ | 14,179 |   | $ | 25,432 |   |
| Common stock issued                                                                        |       | 31             |       | —       |       | —         |       | —            |       | —       |       | 31                     |       |
| Common stock repurchased                                                                   |       | (30            | )          | —       |       | —         |       | —            |       | (209         | )          | (239                   | )          |
| Accretion of common stock redemption                                                       |       | —         |       | —       |       | —         |       | —            |       | (150         | )          | (150                   | )          |
| Accretion of preferred stock redemption                                                    |       | —         |       | —       |       | —         |       | —            |       | (212         | )          | (212                   | )          |
| Expiration of stock warrant unexercised                                                    |       | 924            |       | —       |       | —         |       | —            |       | —       |       | 924                    |       |
| Notes receivable payment                                                                   |       | —         |       | —       |       | 153            |       | —            |       | —       |       | 153                    |       |
| Deferred stock-based compensation                                                          |       | (107           | )          | 107          |       | —         |       | —            |       | —       |       | —                 |       |
| Amortization of deferred stock-based compensation, net                                     |       | —         |       | (8           | )          | —         |       | —            |       | —       |       | (8                     | )          |
| Unrealized holding loss on investments                                                     |       | —         |       | —       |       | —         |       | (25               | )          | —       |       | (25                    | )          |
| Net loss                                                                                   |       | —         |       | —       |       | —         |       | —            |       | (2,058       | )          | (2,058                 | )          |
| **Balance at December 31, 2002**                                                      |       | 12,246         |       | (59          | )          | —         |       | 43                |       | 11,550       |       | 23,848                 |       |
|                                                                                       |       |           |       |         |       |           |       |              |       |         |       |                   |       |
| Common stock issued                                                                        |       | 161            |       | —       |       | —         |       | —            |       | —       |       | 163                    |       |
| Common stock repurchased                                                                   |       | (92            | )          | —       |       | —         |       | —            |       | (67          | )          | (159                   | )          |
| Accretion of common stock redemption                                                       |       | —         |       | —       |       | —         |       | —            |       | (150         | )          | (150                   | )          |
| Accretion of preferred stock redemption                                                    |       | —         |       | —       |       | —         |       | —            |       | (214         | )          | (214                   | )          |
| Conversion of preferred stock to debt and loss on redemption                               |       | —         |       | —       |       | —         |       | —            |       | (219         | )          | (219                   | )          |
| Deferred stock-based compensation                                                          |       | 1,020          |       | (1,020       | )          | —         |       | —            |       | —       |       | —                 |       |
| Amortization of deferred stock-based compensation, net                                     |       | —         |       | 177          |       | —         |       | —            |       | —       |       | 177                    |       |
| Unrealized holding loss on investments                                                     |       | —         |       | —       |       | —         |       | (37               | )          | —       |       | (37                    | )          |
| Net loss                                                                                   |       | —         |       | —       |       | —         |       | —            |       | (449         | )          | (449                   | )          |
| **Balance at December 31, 2003**                                                      | ** ** | 13,335         |       | (902         | )          | —         |       | 6                 |       | 10,451       |       | 22,960                 |       |
|                                                                                       |       |           |       |         |       |           |       |              |       |         |       |                   |       |
| Common stock issued                                                                        |       | 166            |       | —       |       | —         |       | —            |       | —       |       | 168                    |       |
| Common stock issued in IPO, net of IPO costs of $4,572                                     |       | 41,628         |       | —       |       | —         |       | —            |       | —       |       | 41,661                 |       |
| Common stock repurchased                                                                   |       | (7             | )          | —       |       | —         |       | —            |       | (41          | )          | (48                    | )          |
| Accretion of common stock redemption                                                       |       | —         |       | —       |       | —         |       | —            |       | (113         | )          | (113                   | )          |
| Amortization of deferred stock-based compensation, net                                     |       | (265           | )          | 592          |       | —         |       | —            |       | —       |       | 327                    |       |
| Termination of the redemption feature of the redeemable common stock                       |       | 543            |       | —       |       | —         |       | —            |       | —       |       | 547                    |       |
| Conversion of all outstanding shares of our convertible preferred  stock into common stock |       | —         |       | —       |       | —         |       | —            |       | —       |       | —                 |       |
| 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**                                                      |       | $              | 55,402     |         | $          | (310           | )          | $                 | —     |         | $          | (17                    | )          | $ | 15,004 |   | $ | 70,188 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-4

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

 
| ** **                                                                                                 | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Cash  flows from operating activities:**                                                                 |       |                                     |       |   |   |   |   |
| Net income  (loss)                                                                                         |       | $                                        | 4,707      |   | $ | (449 | ) | $ | (2,058 | ) |
| Adjustments  to reconcile net income (loss) to net cash flows provided by (used in)  operating activities: |       |                                     |       |   |   |   |   |
| Depreciation  and amortization                                                                             |       | 2,031                                    |       | 2,230 |   | 2,218 |   |
| Amortization  of deferred stock-based compensation, net                                                    |       | 326                                      |       | 177 |   | (8 | ) |
| Loss on  disposal of fixed assets                                                                          |       | 9                                        |       | 11 |   | 17 |   |
| Gain on  marketable securities                                                                             |       | —                                   |       | (3 | ) | (29 | ) |
| Deferred  income taxes                                                                                     |       | (160                                     | )          | (295 | ) | (205 | ) |
| Tax benefit  of stock option exercises                                                                     |       | 2                                        |       | — |   | — |   |
| (Increase)  decrease in:                                                                                   |       |                                     |       |   |   |   |   |
| Accounts  receivable, net                                                                                  |       | (3,037                                   | )          | (1,284 | ) | 755 |   |
| Inventories                                                                                                |       | (2,115                                   | )          | 1,343 |   | (343 | ) |
| Prepaid  expenses and other                                                                                |       | (814                                     | )          | 1,464 |   | (232 | ) |
| Increase  (decrease) in:                                                                                   |       |                                     |       |   |   |   |   |
| Accounts  payable                                                                                          |       | 1,129                                    |       | (88 | ) | 577 |   |
| Deferred  revenue                                                                                          |       | 174                                      |       | 287 |   | 120 |   |
| Accrued and  other long-term liabilities                                                                   |       | 349                                      |       | 192 |   | (1,103 | ) |
| Net cash  provided by (used in) operating activities                                                       |       | 2,601                                    |       | 3,585 |   | (291 | ) |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Cash  flows from investing activities:**                                                                 |       |                                     |       |   |   |   |   |
| Purchase of  marketable securities                                                                         |       | (46,583                                  | )          | (7,911 | ) | (12,381 | ) |
| Proceeds  from sale of marketable securities                                                               |       | 9,379                                    |       | 9,513 |   | 11,795 |   |
| Purchase of  fixed assets                                                                                  |       | (926                                     | )          | (759 | ) | (1,765 | ) |
| Proceeds  from disposal of fixed assets                                                                    |       | —                                   |       | 7 |   | 14 |   |
| Investment  in patents and other assets                                                                    |       | (484                                     | )          | (342 | ) | (303 | ) |
| Net cash  provided by (used in) investing activities                                                       |       | (38,614                                  | )          | 508 |   | (2,640 | ) |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Cash  flows from financing activities:**                                                                 |       |                                     |       |   |   |   |   |
| Principal  payments on capital lease obligations                                                           |       | (46                                      | )          | (24 | ) | (15 | ) |
| Principal  payments on long-term debt                                                                      |       | (7,000                                   | )          | — |   | (104 | ) |
| Cash paid  upon redemption of Series C preferred stock                                                     |       | —                                   |       | (3,000 | ) | — |   |
| Proceeds  from issuance of common stock in IPO, net of offering costs of $4,572                            |       | 41,661                                   |       | — |   | — |   |
| Proceeds from  other issuances of common stock, net                                                        |       | 168                                      |       | 163 |   | 31 |   |
| Payments to  repurchase common stock                                                                       |       | (198                                     | )          | (309 | ) | (389 | ) |
| Payment of  notes recivable for common stock                                                               |       | —                                   |       | — |   | 153 |   |
| Net cash  provided by (used in) financing activities                                                       |       | 34,585                                   |       | (3,170 | ) | (324 | ) |
|                                                                                                       |       |                                     |       |   |   |   |   |
| Increase  (decrease) in cash and cash equivalents                                                          |       | (1,428                                   | )          | 923 |   | (3,255 | ) |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Cash and  cash equivalents:**                                                                            |       |                                     |       |   |   |   |   |
| Beginning of  year                                                                                         |       | 3,461                                    |       | 2,538 |   | 5,793 |   |
| End of year                                                                                                |       | $                                        | 2,033      |   | $ | 3,461 |   | $ | 2,538 |   |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                                     |       |                                     |       |   |   |   |   |
| Cash paid  for interest                                                                                    |       | $                                        | 480        |   | $ | 1 |   | $ | 3 |   |
| Cash paid  for income taxes, net                                                                           |       | 2,893                                    |       | 99 |   | 857 |   |
|                                                                                                       |       |                                     |       |   |   |   |   |
| **Noncash  investing and financing activities:**                                                           |       |                                     |       |   |   |   |   |
| Reversal of  deferred stock compensation                                                                   |       | $                                        | 265        |   | $ | 21 |   | $ | — |   |
| Equipment  acquired under capital lease                                                                    |       | —                                   |       | 59 |   | — |   |
| Note issued  upon redemption of Series C preferred stock                                                   |       | —                                   |       | 7,000 |   | — |   |
| Termination  of redemption feature on redeemable common stock                                              |       | 547                                      |       | — |   | — |   |
| Conversion  of convertible preferred stock to common stock                                                 |       | 23                                       |       | — |   | — |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-5

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**Cascade Microtech,Inc.Notes to ConsolidatedFinancial Statements**

 

**NOTE 1.  SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

***Nature of Business***

Our products are involved in the development,manufacturing and selling of wafer probing solutions for the electricalmeasurement and test of integrated circuits, or ICs. We design, manufacture andassemble products in Beaverton, Oregon, with global sales, service and supportcenters in North America, Europe, Japan and Singapore.

 

***Principles ofConsolidation***

The consolidated financial statements include theaccounts of Cascade Microtech, Inc. and its wholly owned subsidiaries,Cascade Microtech Foreign Sales Inc., Cascade Microtech Japan, K.K. andCascade Microtech Europe, Ltd. All significant intercompany accounts andtransactions have been eliminated.

 

The functional currency of our foreign subsidiariesis the U.S. dollar. Nonmonetary balance sheet items are remeasured athistorical rates and monetary balance sheet items are remeasured at currentrates. Exchange gains and losses from remeasurement of monetary assets andliabilities are recognized currently in our consolidated statements ofoperations.

 

***Use of Estimatesin Financial Reporting***

The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, as well as revenues and expensesreported for the periods presented. Significant estimates include allowancesfor doubtful accounts, inventory valuation, the lives and recoverability ofequipment and other long-lived assets, warranty reserves and deferred tax assetvaluation allowances. We regularly assess these estimates and, while actualresults may differ, management believes that the estimates are reasonable.

 

***Cash Equivalents***

Cash equivalents of $1.0 million and $237,000at December 31, 2004 and 2003, respectively, consist of money marketfunds, which are stated at cost, which approximates market value. We considerall highly liquid investments with an original maturity of three months or lessto be cash equivalents.

 

***Letterof Credit***

At December 31, 2004, we had an unused $150,000standby letter of credit to be utilized in the event a customer requirescertain guarantees. This letter of credit is collateralized by $150,000 of ourcash and cash equivalents and expires August 14, 2005.

 

***MarketableSecurities***

We classify our marketable securities asavailable-for-sale and, accordingly, record them at current market value.Unrealized holding gains and losses are excluded from earnings and are reportedas a separate component of shareholders’ equity until realized. Dividend andinterest income is recognized when earned. Realized gains and losses areincluded in earnings and are derived using the specific identification methodfor determining the cost of securities sold.

 

F-6

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*** ***

***Trade AccountsReceivable***

Trade accounts receivableare recorded at their invoiced amount and do not bear interest. The allowancefor doubtful accounts is our best estimate of the amount of probable creditlosses in our existing accounts receivable. We determine our allowance fordoubtful accounts utilizing historical collection percentages considering theaging of the accounts and known trends with current customers, including recentsignificant changes in their financial position.

 

The provision for doubtfulaccounts totaled $15,000, $6,000 and $152,000, respectively, in 2004, 2003 and2002. The $152,000 provision in 2002 includes the write-off of one customer’saccount in the amount of $146,000, as a result of its filing for bankruptcy.Other than this one account, write-offs have historically been insignificant.

 

***Inventories***

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. We analyze the cost basis of our inventory quarterly, considering acombination of factors including, but not limited to, the following: forecastedsales or usage, historical usage rates, estimated service period, productend-of-life dates, estimated current and future market values, serviceinventory requirements and new product introductions. We estimate market valuebased on factors including, but not limited to, replacement cost and estimatedresale value.

 

***Fair Value ofFinancial Instruments***

The carrying value ofcash and cash equivalents, marketable securities, accounts receivable, accountspayable and accrued liabilities approximate fair value due to their shortmaturities. The fair value of our capital lease obligations approximatecarrying value as such instruments’ stated interest rates do not differsignificantly from current market rates. There was no public trading market forour long-term, fixed rate debt, and we believed that the interest rate beingpaid on the debt approximated rates we would have been able to achieve in themarket. Accordingly, the fair value of our long-term fixed rate debt approximatedmarket at December 31, 2003.

 

***Fixed Assets***

Equipment and leaseholdimprovements are stated at cost. Equipment under capital lease is recorded atthe net present value of the future minimum lease payments at the inception ofthe lease. Maintenance and repairs are expensed as incurred. Depreciation ofowned equipment is primarily provided using the straight-line method over theestimated 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.

 

***Other Assets***

Other assets, whichconsist primarily of patents and trademarks, are stated at historical cost lessaccumulated amortization and reserve. Capitalized patent costs relate to legalfees incurred to obtain the patents. Costs incurred for patent relatedlitigation are expensed as incurred. The intangible assets are amortized usingthe straight-line method over estimated useful lives of five to seven years.

 

***Accounting for the Impairment of Long-LivedAssets***

Long-lived assets heldand used by us 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

 

F-7

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value of the assets basedupon estimates of discounted future cash flows that the assets are expected togenerate. We did not record any impairment charges against our long-livedassets during 2004, 2003 or 2002.

 

***RevenueRecognition***

We sell or deliver ourproducts to the end-user through distributors, manufacturers’ representativesand integrators:

 

•                  distributors purchase our products directly from usand pay us directly according to our standard terms and conditions. They thenresell the products to end users at prices and terms set by them;

•                  manufacturers’ representatives are independentcompanies that agree to sell our products at our prices and on our terms andthey are paid a commission based on a percentage of their sales of ourproducts; and

•                  integrators design and assemble application specificmeasurement solutions consisting of products from two or more companies. Theytypically do not purchase our products directly from us. The end user is billeddirectly and is liable to us for the purchase of the products. The integratoris paid a fee by the end user.

 

Revenue from productsales to customers that do not have special acceptance criteria, includingproduct sales to distributors and manufacturers’ representatives, is recognizedwhen a written purchase order has been obtained, the price is fixed and determinable,the product is shipped, title has transferred and collectibility is reasonablyassured. Generally, we ship our products FOB shipping point. For any shipmentswith FOB destination terms, we defer revenue until delivery to the customer.Revenue from customers who have special acceptance criteria is not recognizeduntil all acceptance criteria are satisfied. Revenue for installation services,consisting of assembly and testing, is recognized when the services areperformed.

 

Our transactions may involvethe sale of systems and services under multiple element arrangements. A typicalmultiple element arrangement may include some or all of the following: productshipments, accessories, installation services or extended warranty contracts.For any arrangements with multiple elements, we recognize revenue only after wehave determined that elements with stand alone value have been delivered tocustomers and any undelivered elements have objective and reliable evidence offair value.

 

We record deferred revenuefor service contracts and for custom engineering probe stations and othersystems requiring special acceptance criteria from the customer. Deferredrevenue related to service contracts is recognized over the life of thecontract, typically one to two years. For systems shipped to integrators, norevenue is recognized until shipment to the end user. Deferred revenue relatedto shipped systems requiring acceptance by the customer is recognized uponreceipt of such acceptance.

 

***SignificantCustomers***

No customers in 2004accounted for 10% or more of our total sales.

 

In 2003, one customeraccounted for approximately 11.0% of our total sales and, at December 31,2003, it represented approximately 2.6% of our accounts receivable balance. Inaddition, three other customers each accounted for between 6.0% and 8.5% of ouraccounts receivable balance, for a total of 20.8% of our accounts receivablebalance, at December 31, 2003.

 

No customers in 2002accounted for 10% or more of our total sales.

 

F-8

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***Product Warranty***

We estimate a liabilityfor costs to repair or replace products under warranties ranging from90 days to one-year and technical support costs when the related productrevenue is recognized. The products are sold without a right of return or priceprotection rights. The liability for product warranties is calculated as apercentage of sales. The percentage is based on historical actual productrepair costs.

 

Product warranty activitywas as follows (in thousands):

 
| **Warranty accrual, December 31, 2001** |   | $    | 240    |   |
|----------------------------------------------|--------|------|--------|--------|
| Reductions  for warranty charges             |   | (460 | )      |
| Additions  to warranty reserve               |   | 409  |   |
| **Warranty accrual, December 31, 2002** |   | 189  |   |
| Reductions  for warranty charges             |   | (690 | )      |
| Additions  to warranty reserve               |   | 679  |   |
| **Warranty accrual, December 31, 2003** |   | 178  |   |
| Reductions  for warranty charges             |   | (452 | )      |
| Additions  to warranty reserve               |   | 639  |   |
| **Warranty accrual, December 31, 2004** |   | $    | 365    |   |

 

***Advertising***

Advertising costs areexpensed as incurred and amounted to $7,000, $32,000, and $54,000 in 2004,2003, and 2002, respectively.

 

***Research andDevelopment***

Research and developmentcosts are expensed as incurred. See Note 10.

 

***Forward ExchangeContracts***

We account for forwardexchange contracts in accordance with SFAS No. 138, “Accounting forCertain Derivative Instruments and Certain Hedging Activities-an amendment ofFASB Statement No. 133” and SFAS No. 137, “Accounting for DerivativeInstruments and Hedging Activities.” SFAS No. 137 is an amendment to SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activities.”SFAS Nos. 133, 137 and 138 establish accounting and reporting standardsrequiring that every derivative instrument (including certain derivativeinstruments embedded in other contracts) be recorded on the balance sheet aseither an asset or liability measured at its fair value. SFAS Nos. 137 and 138require that changes in the derivative’s fair value be recognized currently inearnings unless specific hedge accounting criteria are met. Special accountingfor qualifying hedges allows a derivative’s gains and losses to offset relatedresults on the hedged item in the income statement, and requires that a companymust formally document, designate and assess the effectiveness of transactionsthat receive hedge accounting.

 

In the past, we haveentered into, and we may enter into in the future, 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, 2004 and 2003, we had $4.7million and $0, respectively, of forward exchange contracts outstanding. Theestimated fair value of the contracts outstanding at December 31, 2004 was$4.9 million.

 

F-9

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***Income Taxes***

We account for incometaxes in accordance with SFAS No. 109 “Accounting for Income Taxes.”Accordingly, deferred income taxes are established for the difference betweenthe financial reporting and income tax basis of assets and liabilities as wellas operating loss and tax credit carryforwards. Deferred tax assets are reducedby a valuation allowance when, in the opinion of management, it is more likelythan not that some portion of the deferred tax assets will not be realized.Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect on deferredtaxes of a change in tax rates is recognized in income in the period thatincludes the enactment date.

 

***Net Income (Loss)Per Share***

We compute net income(loss) per share in accordance with SFAS No. 128, “Earnings Per Share.”Under the provisions of SFAS No. 128, basic net income (loss) per share iscomputed by dividing the net income (loss) attributed to common shareholdersfor the period by the weighted average number of shares of common stockoutstanding during the period. Diluted net income (loss) per share incorporatesthe incremental shares issuable upon the assumed exercise of stock options andwarrants using the treasury stock method and assumed conversions of preferredstock, if dilutive. In addition, upon assumed conversion of the preferredstock, the accretion of redeemable stock is added back to net income.Accordingly, the net income used for calculating net income per share for 2004is $4.7 million.

 

Thefollowing table reconciles the shares used in calculating basic earnings pershare to the shares used in calculating diluted earnings per share (inthousands):

 
| **Year Ended December 31,**                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares  used to calculate basic earnings per share                        |       | 5,439    |       | 5,089    |       | 5,015    |       |
|                                                                      |       |     |       |     |       |     |       |
| Dilutive  effect of:                                                      |       |     |       |     |       |     |       |
| Outstanding  stock options                                                |       | 776      |       | —   |       | —   |       |
| Outstanding  warrants                                                     |       | —   |       | —   |       | —   |       |
| Redeemable  and convertible preferred stock                               |       | 2,237    |       | —   |       | —   |       |
| Shares  used to calculate diluted earnings per share                      |       | 8,452    |       | 5,089    |       | 5,015    |       |
|                                                                      |       |     |       |     |       |     |       |
| Dilutive  securities not considered as they would have been antidilutive: |       |     |       |     |       |     |       |
| Outstanding  stock options                                                |       | 273      |       | 1,773    |       | 1,826    |       |
| Outstanding  warrants                                                     |       | —   |       | —   |       | 25       |       |
| Redeemable  and convertible preferred stock                               |       | —   |       | 2,346    |       | 3,596    |       |
|                                                                      |       | 273      |       | 4,119    |       | 5,447    |       |

 

***Stock-BasedCompensation***

We account for stockoptions issued to employees using the intrinsic value method as prescribed byAccounting Principles Board (APB) Opinion No. 25, “Accounting for StockIssued to Employees.” Pursuant to Statement of Financial Accounting Standards(SFAS) No. 148 “Accounting for Stock-Based Compensation—Transition andDisclosure,” we have computed, for pro forma disclosure purposes, the impact onnet income (loss) and net income (loss) per share as if we had accounted for 

 

F-10

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our stock-basedcompensation plans in accordance with the fair value method prescribed by SFASNo. 123 “Accounting for Stock-Based Compensation” as follows (inthousands, except per share amounts):

 
| **Year Ended December 31,**                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net  income (loss) attributed to common shareholders, as reported                |       | $        | 4,594      |     | $          | (1,032   | )          | $ | (2,420 | ) |
| Add  stock-based compensation included in reported net income (loss), net of tax |       | 252      |       | 105      |       | (4       | )          |
| Fair  value of stock-based employee compensation, net of tax                     |       | (1,585   | )          | (657     | )          | (504     | )          |
| Net  income (loss), pro forma                                                    |       | $        | 3,261      |     | $          | (1,584   | )          | $ | (2,928 | ) |
|                                                                             |       |     |       |     |       |     |       |
| Net  income (loss) per share – basic, as reported                           |       | $        | 0.84       |     | $          | (0.20    | )          | $ | (0.48 | ) |
| Net  income (loss) per share – basic, pro forma                             |       | $        | 0.60       |     | $          | (0.31    | )          | $ | (0.58 | ) |
|                                                                             |       |     |       |     |       |     |       |
| Net  income (loss) per share – diluted, as reported                         |       | $        | 0.56       |     | $          | (0.20    | )          | $ | (0.48 | ) |
| Net  income (loss) per share – diluted, pro forma                           |       | $        | 0.40       |     | $          | (0.31    | )          | $ | (0.58 | ) |

 

To determine stock-basedcompensation included in reported net income (loss), net of tax, we used a taxrate approximating our effective tax rate of 22.8% for 2004 and 52.2% for 2002.For 2003, we used a statutory tax rate of 40% due to the significant variancein our effective tax rate from the statutory tax rate.

 

Expense associated withstock-based compensation is amortized on an accelerated basis over the vestingperiod of the individual award, consistent with the method described inFinancial Accounting Standards Board Interpretation No. 28 “Accounting forStock Appreciation Rights and Other Variable Stock Option Award Plans, an Interpretationof APB Opinion No. 15 and 25” (“FIN 28”).

 

Using the Black-Scholesmethodology, the total value of stock awards and options granted during 2004,2003 and 2002 was $3.0 million, $1.1 million and $0.8 million,respectively, which would be amortized on a pro forma basis over the vestingperiod of the options, typically five years. The per share weighted averagefair value of stock options granted during the years ended December 31,2004, 2003, and 2002 was $7.39, $3.40 and $4.32, respectively, using theBlack-Scholes option-pricing model with the following weighted averageassumptions:

 
| **Year ended December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  life in years          |       | 6 years  |       | 6 years  |       | 6 years  |       |
| Risk-free  interest rate         |       | 3.60     | %          | 3.27     | %          | 3.03     | %          |
| Expected  volatility             |       | 68.4     | %          | 70.0     | %          | 70.0     | %          |
| Expected  dividend yield         |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

We account for stockoptions issued to consultants and other service providers pursuant to SFASNo. 123 and EITF 96-18, “Accountingfor Equity Instruments that are Issued to Other Than Employees forAcquiring, or in Conjunction With, Selling Goods or Services.” Accordingly, thevalue of the stock options is determined based on the fair value of theservices or other consideration received or the fair value of the stock optionsissued, whichever is more reliably measurable. The value is recognized asexpense over the period the service is provided or upon receipt of the otherconsideration. There were no stock options granted to consultants or otherservice providers during 2004, 2003 or 2002.

 

F-11

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***In December 2004, the FASB issued SFAS No. 123 (Revised2004), “Share-Based Payment” (“SFAS No. 123R”), which replaces SFAS No. 123, “Accountingfor Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” SFAS No. 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values beginning with the firstinterim or annual period after June 15, 2005, with early adoptionencouraged.  The pro forma disclosurespreviously permitted under SFAS No. 123 no longer will be an alternative tofinancial statement recognition.  We arerequired to adopt SFAS No. 123R in the third quarter of 2005, beginning July 1,2005.  Under SFAS No. 123R, we mustdetermine the appropriate fair value model to be used for valuing share-basedpayments, the amortization method for compensation cost and the adoption methodto be used at the date of adoption. We are evaluating the requirements of SFASNo. 123R and expect that the adoption of SFAS No. 123R will have a materialimpact on our results of operations.  Wehave not yet determined the method of adoption or the effect of adopting SFASNo. 123R, and have not determined whether adoption will result in amounts thatare similar to the current pro forma disclosures under SFAS No. 123.***

 

***ComprehensiveIncome***

We have adopted theprovisions of SFAS No. 130, “Reporting Comprehensive Income.”Comprehensive income is defined as changes in shareholders’ equity exclusive oftransactions with owners, such as capital contributions and dividends.Unrealized holding gains and losses on our available-for-sale marketablesecurities are included as a separate component of shareholders’ equity untilrealized. The differences between net income (loss) and comprehensive income(loss) for the periods presented are not material.

 

***Reclassifications***

Certain reclassificationshave been made in the 2003 and 2002 consolidated financial statements toconform to the 2004 presentation, including the reclassification of certain investmentsfrom cash and cash equivalents to available-for-sale short-term marketablesecurities.

 

***Certain Risks and Uncertainties***

Our future operatingresults and financial condition are subject to influences driven by rapidtechnological changes, a highly competitive industry, a lengthy sales cycle,and the cyclical nature of general economic conditions. Future operatingresults will depend on many factors, including demand for our products, theintroduction and industry acceptance of new products and the level and timingof available shippable orders and backlog.

 

In addition, we rely onseveral suppliers to provide certain key components used in our products. Someof these items are available from only one supplier or a limited group ofsuppliers. Any disruption in the availability and delivery of these items couldmaterially adversely affect our revenues.

 

# ***SegmentReporting***

We comply with SFASNo. 131, “Disclosures about Segments of an Enterprise and RelatedInformation*.*” Based upon therequirements of SFAS No. 131, we have determined that we operate in twobusiness segments: the Engineering Products Division (“EPD”) and the PyramidProbe Division (“PPD”). Our engineering probe stations, analytical probes,probing accessories and application software are sold through EPD. Ourproduction probe cards are sold through PPD.

 

F-12

----

 

***NOTE 2.  NEW ACCOUNTING PRONOUNCEMENTS***

 

***SFAS No. 151***

In November 2004, the FASB issued SFAS No. 151, “InventoryCosts: an amendment of ARB No. 43, Chapter 4,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial.  SFAS No. 151 is effective forinventory costs incurred during fiscal years beginning after June 15,2005.  While we have not completed ouranalysis of the impact of SFAS No. 151, we do not currently believe theprovisions of SFAS No. 151, when applied, will have a material impact on ourfinancial position, results of operations or cash flows.

 

***SFAS No. 153***

In December 2004, the FASB issued SFAS No. 153, “Exchangesof Nonmonetary Assets.” SFAS No. 153 amends APB Opinion No. 29, “Accountingfor Nonmonetary Transactions,” by replacing the exception for exchanges ofsimilar productive assets with an exception for exchanges that do not havecommercial substance.  A transaction has commercial substance if thefuture cash flows of the entity are expected to change significantly as aresult of the exchange.  SFAS No. 153 is effective for fiscal periodsbeginning after June 15, 2005.  We do not expect the adoption of SFASNo. 153 to have any effect on our financial position, results of operations orcash flow.

 

***FSP No. 109-2***

In December, 2004, the FASB issued FASB Staff Position(“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provisions within the American Jobs Creation Act of 2004” (theJobs Act). FSP No. 109-2 provides guidance with respect to reporting thepotential impact of the repatriation provisions of the Jobs Act on anenterprise’s income tax expense and deferred tax liability. The Jobs Act wasenacted on October 22, 2004, and provides for a temporary 85% dividendsreceived deduction on certain foreign earnings repatriated during a one-yearperiod. The deduction would result in an approximate 5.25% federal tax rate onthe repatriated earnings. To qualify for the deduction, the earnings must bereinvested in the United States pursuant to a domestic reinvestment planestablished by a company’s chief executive officer and approved by a company’sboard of directors. Certain other criteria in the Jobs Act must be satisfied aswell. FSP No. 109-2 states that an enterprise is allowed time beyond thefinancial reporting period to evaluate the effect of the Jobs Act on its planfor reinvestment or repatriation of foreign earnings. Although we have not yetcompleted our evaluation of the impact of the repatriation provisions of theJobs Act, we do not expect that these provisions will have a material impact onour financial position, results of operations or cash flow. Accordingly, asprovided for in FSP No. 109-2, we have not adjusted our tax expense or deferredtax liability to reflect the repatriation provisions of the Jobs Act.

 

F-13

----

 

**NOTE 3. MARKETABLE SECURITIES**

 

We account for ourmarketable securities in accordance with SFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities.” Accordingly, we haveclassified our marketable securities as available for sale securities and haverecorded them at fair value with unrealized gains and losses reported as aseparate component of shareholders’ equity. Certain information regarding ourmarketable securities is as follows (in thousands):

 
| **December 31,**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Fair market value:                        |       |     |       |     |       |
| Municipal  obligations                    |       | $        | 38,325     |     | $          | 4,765 |   |
| Agency  discount notes                    |       | 4,960    |       | 1,495    |       |
| Government  securities                    |       | 1,208    |       | —   |       |
| Corporate  obligations                    |       | —   |       | 996      |       |
|                                      |       | $        | 44,493     |     | $          | 7,256 |   |
| Cost:                                     |       |     |       |     |       |
| Municipal  obligations                    |       | $        | 38,327     |     | $          | 4,761 |   |
| Agency  discount notes                    |       | 4,967    |       | 1,495    |       |
| Government  securities                    |       | 1,216    |       | —   |       |
| Corporate  obligations                    |       | —   |       | 994      |       |
|                                      |       | $        | 44,510     |     | $          | 7,250 |   |
|                                      |       |     |       |     |       |
| Fair  market value by maturity:           |       |     |       |     |       |
| Within  one year                          |       | $        | 41,714     |     | $          | 7,256 |   |
| One  to two years                         |       | 2,779    |       | —   |       |
|                                      |       | $        | 44,493     |     | $          | 7,256 |   |
|                                      |       |     |       |     |       |
| Gross  unrealized holding gains (losses): |       |     |       |     |       |
| Municipal  obligations                    |       | $        | (2         | )        | $          | 4 |   |
| Agency  discount notes                    |       | (7       | )          | —   |       |
| Government  securities                    |       | (8       | )          | —   |       |
| Corporate  obligations                    |       | —   |       | 2        |       |
|                                      |       | $        | (17        | )        | $          | 6 |   |

 
| **Year Ended December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Proceeds  from sales             |       | $        | 9,379      |     | $          | 9,513    |       | $ | 11,795 |   |
| Gross  realized gains on sales   |       | $        | —     |     | $          | 3        |       | $ | 32 |   |
| Gross  realized losses on sales  |       | $        | —     |     | $          | —   |       | $ | 3 |   |

 

We use the specificidentification method for determining gains and losses on our marketablesecurities.

 

**NOTE 4. INVENTORIES**

 

Inventoriesconsist of the following (in thousands):

 
| **December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| Raw  materials        |       | $        | 4,665      |     | $          | 3,384 |   |
| Work-in-process       |       | 1,548    |       | 660      |       |
| Finished  goods       |       | 3,967    |       | 4,021    |       |
|                  |       | $        | 10,180     |     | $          | 8,065 |   |

 

F-14

----

 

**NOTE5.  FIXED ASSETS**

 

Fixedassets consist of the following (in thousands):

 
| **December 31,**          | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Equipment                      |       | $        | 12,342     |     | $          | 12,118 |   |
| Leasehold  improvements        |       | 2,833    |       | 2,622    |       |
|                           |       | 15,175   |       | 14,740   |       |
| Less  accumulated depreciation |       | (11,167  | )          | (9,874   | )          |
|                           |       | $        | 4,008      |     | $          | 4,866 |   |

 

Depreciation expense was$1.8 million, $1.9 million and $1.9 million, respectively, in 2004, 2003 and2002.

 

**NOTE6.  OTHER ASSETS**

 

Includedin other long-term assets on our balance sheet are patents. The grossamount of patents and the related accumulated amortization were as follows (inthousands):

 
| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Patents                   |       | $                     | 3,435      |   | $ | 3,033 |   |
| Accumulated  amortization |       | (2,251                | )          | (2,023 | ) |
|                      |       | $                     | 1,184      |   | $ | 1,010 |   |

 

Amortizationexpense totaled $255,000, $341,000 and $260,000, respectively, in 2004, 2003and 2002.

 

Amortizationof the patents is as follows over the next five years (in thousands):

 
| 2005       |   | $   | 210    |   |
|------------|--------|-----|--------|--------|
| 2006       |   | 168 |   |
| 2007       |   | 145 |   |
| 2008       |   | 95  |   |
| 2009       |   | 50  |   |
| Thereafter |   | 516 |   |

 

 

**NOTE 7.  ACCRUEDLIABILITIES**

 

Accruedliabilities consist of the following (in thousands):

 
| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Accrued  compensation and benefits |       | $                     | 1,527      |   | $ | 1,068 |   |
| Income  taxes payable              |       | 152                   |       | 352 |   |
| Accrued  warranty                  |       | 365                   |       | 178 |   |
| Other                              |       | 565                   |       | 449 |   |
|                               |       | $                     | 2,609      |   | $ | 2,047 |   |

 

F-15

----

 

**NOTE 8. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS**

 

In December 2003, inconjunction with the redemption of our Series C convertible preferredstock (“Series C”) (see Note 12), we issued a $7.0 million seniorunsecured note payable to Teachers Insurance and Annuity Association—CollegeRetirement Equity Fund (the “Note”). The Note was scheduled to accrue interestat 6.0% per annum through December 31, 2004, 8.0% per annum during 2005and 10% per annum during 2006, with interest payable quarterly. Principalpayments were due quarterly, with $500,000 due each quarter of 2004 and$625,000 due each quarter thereafter through December 2006. However, weprepaid the Note in full, without penalty, in December 2004.

 

Long-termdebt and capital lease obligations consist of the following (dollars inthousands):

 
| ** **                                                                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Obligations  under capital leases at interest rates ranging from 1.375% to 1.70%, due in  monthly installments of $2 including interest through November 2006 |       | $                     | 35         |   | $ | 81 |   |
| Senior  Unsecured Note                                                                                                                                             |       | —                |       | 7,000 |   |
|                                                                                                                                                               |       | 35                    |       | 7,081 |   |
| Current  portion of long-term debt and capital lease obligations                                                                                                   |       | (21                   | )          | (2,043 | ) |
|                                                                                                                                                               |       | $                     | 14         |   | $ | 5,038 |   |

 

Futurematurities of the capital leases are as follows (in thousands):

 
| **Year ending December 31,** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2005                              |       | $          | 21         |   |
| 2006                              |       | 14         |       |
|                              |       | $          | 35         |   |

 

**NOTE 9. INCOME TAXES**

 

Domesticand foreign pre-tax income (loss) is as follows (in thousands):

 
| ** ** | ** ** | **Year ended December 31,** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Domestic   |       | $                                | 6,161      |   | $ | (1,126 | ) | $ | (4,236 | ) |
| Foreign    |       | (67                              | )          | 925 |   | (66 | ) |
|       |       | $                                | 6,094      |   | $ | (201 | ) | $ | (4,302 | ) |

 

Theprovision (benefit) for income taxes consists of the following (in thousands):

 
| **Year ended December 31,**      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                              |       |     |       |     |       |     |       |
| Federal                               |       | $        | 1,318      |     | $          | 147      |       | $ | (1,671 | ) |
| State                                 |       | 90       |       | 11       |       | (406     | )          |
| Foreign                               |       | 139      |       | 385      |       | 38       |       |
| Total  current                        |       | 1,547    |       | 543      |       | (2,039   | )          |
|                                  |       |     |       |     |       |     |       |
| Deferred:                             |       |     |       |     |       |     |       |
| Federal                               |       | (188     | )          | (463     | )          | 150      |       |
| State                                 |       | 17       |       | 291      |       | (315     | )          |
| Foreign                               |       | 11       |       | (123     | )          | (40      | )          |
| Total  deferred                       |       | (160     | )          | (295     | )          | (205     | )          |
| Provision  (benefit) for income taxes |       | $        | 1,387      |     | $          | 248      |       | $ | (2,244 | ) |

 

F-16

----

 

Theprovision (benefit) for income taxes varies from the amounts computed byapplying the Federal statutory rate to income (loss) before income taxes asfollows (in thousands):

 
| **Year ended December 31,**                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal  income tax (benefit) computed at statutory rates |       | $        | 2,072      |     | $          | (68      | )          | $ | (1,463 | ) |
| Extraterritorial  income exclusion tax benefit            |       | (340     | )          | (95      | )          | (273     | )          |
| Difference  in foreign tax rate                           |       | 34       |       | (40      | )          | 48       |       |
| State  income taxes, net of federal benefit               |       | 172      |       | (48      | )          | (423     | )          |
| Deferred  stock-based compensation                        |       | 92       |       | 46       |       | (3       | )          |
| Tax  credits (R&D and foreign tax credit)             |       | (848     | )          | (467     | )          | (741     | )          |
| Changes  in valuation allowance                           |       | 35       |       | 781      |       | 978      |       |
| Other                                                     |       | 170      |       | 139      |       | (367     | )          |
| Provision  (benefit) for income taxes                     |       | $        | 1,387      |     | $          | 248      |       | $ | (2,244 | ) |

 

Significantcomponents of deferred income tax assets and liabilities were as follows (inthousands):

 
| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Current  deferred tax assets:           |       |                  |       |   |   |
| Reserves  and allowances                |       | $                     | 314        |   | $ | 215 |   |
| Inventory  reserves                     |       | 651                   |       | 610 |   |
| Accrued  vacation                       |       | 252                   |       | 174 |   |
| Deferred  intercompany profit           |       | 159                   |       | 221 |   |
| Other  current deferred tax assets      |       | 177                   |       | 233 |   |
| Total  current deferred tax assets      |       | 1,553                 |       | 1,453 |   |
|                                    |       |                  |       |   |   |
| Non-current  deferred tax assets:       |       |                  |       |   |   |
| Retirement  allowance                   |       | 211                   |       | 204 |   |
| State  net operating loss carryforwards |       | 139                   |       | 255 |   |
| State  research tax credits             |       | 1,274                 |       | 1,501 |   |
| Foreign  tax credits                    |       | 377                   |       | — |   |
| Other  non-current deferred tax assets  |       | 335                   |       | 201 |   |
| Valuation  allowance                    |       | (1,794                | )          | (1,759 | ) |
| Total  non-current deferred tax assets  |       | 542                   |       | 402 |   |
|                                    |       |                  |       |   |   |
| Non-current  deferred tax liabilities:  |       |                  |       |   |   |
| Patents                                 |       | 478                   |       | 398 |   |
| Net  deferred tax assets                |       | $                     | 1,617      |   | $ | 1,457 |   |

 

During 2004, we reversed$726,000 of a previously recorded valuation allowance against our deferred taxassets based on our 2004 performance. The reversal primarily relates toresearch and experimentation credits and state net operating loss carryforwardsthat we now expect to be able to utilize based on 2004 income. In 2004, weincreased our valuation allowance to $1.8 million for foreign tax creditsand state research and experimentation credits. The net increase in the totalvaluation allowance was $35,000, $781,000 and $978,000, respectively, in 2004,2003 and 2002. We determined that the valuation allowance was necessary asestimated future taxable income to be generated for tax purposes may not beenough to realize the remaining credit carryforwards prior to their expirationdate. Although realization of the remaining net deferred tax assets is notassured, we believe that it is more likely than not that net deferred taxassets without a valuation allowance will be realized.  We consider projected future taxable income,the scheduled reversal of deferred tax liabilities and tax planning strategieswhen making this assessment.

 

F-17

----

 

We have state and foreignnet operating loss carryforwards, foreign tax credits and state research andexperimentation credit carryforwards of approximately $768,000, $377,000 and$1.3 million, respectively, at December 31, 2004 to offset against futuretaxable income. These carryforwards expire beginning 2006 through 2024.

 

Tax expense, net ofassociated tax credits for taxes paid in Japan of $41,000, was recognized onthe declaration of a $1.5 million dividend from our Japanese subsidiary and isreflected in the tax provision for 2004. We have not provided for U.S. income taxes on the remainingundistributed earnings of foreign subsidiaries because they are consideredpermanently invested outside of the U.S. Upon repatriation, some of these earnings would generate foreign taxcredits, which may reduce the U.S. tax liability associated with any futureforeign dividend. At December 31, 2004, the cumulative amount of earningsupon which U.S. income taxes have not been provided is approximately $2.0million.

 

A provision of theInternal Revenue Code requires the utilization of net operating losses andresearch and experimentation credits be limited when we have a change inownership of more than 50%.  We believethat such a change occurred with the issuance of common stock in our initialpublic offering (“IPO”) in December 2004. Accordingly, the utilization ofthe net operating loss and credit carryforwards generated from periods prior toDecember 2004 may be limited in the timing of their utilization.

 

**NOTE10. RESEARCH AND DEVELOMENT AGREEMENT WITH KEY CUSTOMER**

 

In 2002, we entered intoa cooperative research and development agreement with a key customer. Pursuantto the terms of the agreement, this customer was to reimburse us for certainresearch and development work performed in relation to the development ofcertain probes. Accordingly, in 2004, 2003 and 2002, we received $94,000$248,000 and $90,000, which is netted with research and development expense onour consolidated statements of operations.

 

**NOTE11. OTHER INCOME (EXPENSE), NET**

 

Other income (expense),net consists of the following (in thousands):

 
| **Year ended December 31,**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gain  on investments, net                          |       | $        | —     |     | $          | 3        |       | $ | 29 |   |
| Gains  (losses) related to foreign currency hedges |       | 74       |       | 49       |       | (324     | )          |
| Translation  related foreign currency gains        |       | 132      |       | 318      |       | 304      |       |
| Other                                              |       | 9        |       | 20       |       | 29       |       |
|                                               |       | $        | 215        |     | $          | 390      |       | $ | 38 |   |

 

**NOTE12. CONVERSION OF REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

In 1999, we designated1.5 million shares of authorized preferred stock as Series Credeemable convertible preferred stock (Series C). In December 2003,all of the Series C was redeemed at a price of $8.00 per share in exchangefor a $7.0 million note and $3.0 million of cash. Upon redemption ofthe Series C, the related unaccreted costs of $219,000 were recorded as aloss on redemption. See also Note 8.

 

F-18

----

 

**NOTE 13. SHAREHOLDERS’ EQUITY**

 

***Public Sale of Common Stock***

We completed our IPO of3.3 million shares of our common stock in December 2004 for net proceedsof $41.7 million. Offering costs of $4.6 million were offset against theproceeds. Upon completion of the IPO, all of the then outstanding shares ofSeries A and Series B automatically converted to a total of 2,346,486shares of our common stock, and the common stock put agreement with one of ourfounders expired. Accordingly, the remaining $547,000 related to the putagreement was reclassified to common stock. In addition, our authorized commonstock increased from 12 million shares to 100 million shares.

 

***Registration Rights***

Upon completion of ourIPO, certain holders of shares of common stock have registration rights,including the right to require us to register the sale of their shares and theright to include their shares in public offerings we undertake in the future.We registered all shares of common stock that are issuable under our stockoption plans and employee stock purchase plan, and they may be freely sold inthe public market, subject to certain lock-up restrictions.

 

***Repurchase Option***

We or our designee hadthe option to repurchase all shares held by any shareholder that suchshareholder proposed to sell, assign, pledge, encumber, transfer, or otherwise disposeof for value to a competitor. Such repurchases were at the same terms andconditions specified in a bona fide third party offer for any or all of suchsecurities. The repurchase option lapsed upon our IPO. We repurchased thefollowing shares pursuant to this repurchase option during the periodsindicated (including shares repurchased pursuant to the Stock Put Agreementdescribed below):

 
| **Year Ended December 31,**           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Number  of shares repurchased              |       | 23,562   |       | 61,776   |       | 56,940   |       |
| Weighted  average per share purchase price |       | $        | 8.40       |     | $          | 5.00     |       | $ | 6.84 |   |
|                                            |            |          |            |          |            |          |            |  |  |  |

 

***Stock PutAgreement***

We had a common stock putagreement with one of our original founders. As part of the agreement, at thefounder’s annual option on or before July 1, we were required to purchasecommon shares valued at up to $150,000 based on our last annual valuation.Additional common shares could be purchased at our discretion if so agreed toby the founder.  In 2004, we purchased15,790 shares at $9.50 per share.  In2003, we repurchased 30,000 shares at $5.00 per share and in 2002, we purchased21,428 shares at $7.00 per share.  Thisagreement terminated upon our IPO in December 2004.

 

***Common StockWarrant***

In 1998, we issued awarrant for the purchase of 15,000 shares of our common stock at $3.80 pershare. The warrant entitled the holder to additional shares upon thesatisfaction of certain conditions, as defined in the agreement. During 1999,one such condition was satisfied, increasing the number of shares eligible forpurchase under the warrant to 25,000. In December 2003, we issued 18,091shares of our common stock upon the exercise of a portion of the warrants inexchange for $57,000 of cash and the surrender of the remaining warrants topurchase 6,909 shares of our common stock. The fair value of the initial 15,000shares and the additional 10,000 shares under the warrant was determined usingthe Black-Scholes valuation model with the following assumptions: no dividendyield; risk-free interest rates of 4.45% and 6.19%, respectively; expectedvolatility of 81%; and contractual lives of 5.0 and 4.5 years,respectively. The fair value of these warrants is not material to the financialstatements.

 

F-19

----

 

***Notes Receivablefor Common Stock***

We have sold shares ofcommon stock for notes receivable. The notes were due and payable at variousdates and bore interest at various rates. The notes were full recourse notesand were partially secured by the shares of common stock issued thereunder.  During 2002, the notes were paid in full.

 

***Stock Option Plans***

Our stock incentive plansinclude our 1993 Stock Incentive Plan (the “1993 Plan”) and our 2000 StockIncentive Plan (the “2000 Plan”) (together, the “Plans”) and provide for thegranting to employees of either incentive stock options or nonqualified stockoptions. Incentive stock options must be granted at an exercise price not lessthan 100% of the fair market value per share at the grant date. Nonqualifiedstock options granted or shares sold under the Plans cannot be granted or soldat a price less than 85% of the fair market value per share at the date ofgrant or sale. The terms of options granted under the Plans is 10 years, andthe right to exercise options granted generally vests 20% each year, withvarying initial holding periods. The 1993 Plan expired during 2003 and anyremaining unissued options were canceled. The 2000 Plan expires October 15,2010. In addition, options currently outstanding under the 1993 Plan will notbe available for reissuance upon cancellation. We have authorized a total of1.8 million shares of common stock for issuance under the 2000 Plan.

 

At December 31,2004, 611,417 shares were available for future grants, and we had 2,549,505shares of our common stock reserved for future issuance under the Plans. Stockoption activity for each of the years in the three-year period ended December 31,2004 is as follows:

 
| ** **                                | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| **Outstanding at December 31, 2001** |       | 1,857,097                |       | $                                     | 3.94       |   |
| Granted                                   |       | 227,200                  |       | 5.55                                  |       |
| Exercised                                 |       | (33,367                  | )          | (0.92                                 | )          |
| Forfeited                                 |       | (225,265                 | )          | (5.63                                 | )          |
| **Outstanding at December 31, 2002** |       | 1,825,665                |       | 3.98                                  |       |
| Granted                                   |       | 380,450                  |       | 5.26                                  |       |
| Exercised                                 |       | (130,397                 | )          | (0.81                                 | )          |
| Forfeited                                 |       | (302,223                 | )          | (3.82                                 | )          |
| **Outstanding at December 31, 2003** |       | 1,773,495                |       | 4.52                                  |       |
| Granted                                   |       | 496,250                  |       | 11.71                                 |       |
| Exercised                                 |       | (145,668                 | )          | (1.38                                 | )          |
| Forfeited                                 |       | (185,989                 | )          | (3.82                                 | )          |
| **Outstanding at December 31, 2004** |       | 1,938,088                |       | $                                     | 6.65       |   |

 

During 2003, we issuedoptions to purchase 380,450 shares of common stock to our employees andnon-employee directors. Due to the difference between the exercise price andthe estimated fair value of common stock, approximately $1.0 million ofcompensation expense is to be amortized over the vesting period of five years.During 2004, we granted options to purchase 496,250 shares of common stock toemployees and non-employee directors at fair market value and, therefore, didnot record any compensation expense related to these grants.

 

F-20

----

 

Stock options granted byquarter were as follows:

 
| **Grants made during quarter  ended (unaudited)** | ** ** | **Number of  options  granted** | ** ** | **Exercise  price per  share** | ** ** | **Fair market  value per  share** | ** ** | **Intrinsic  value per  share** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| March 31, 2003                               |       | —                          |       | $                              | —     |                              | $          | —                          |       | $ | — |   |
| June 30, 2003                                |       | —                          |       | —                         |       | —                            |       | —                          |       |
| September 30, 2003                           |       | 181,000                         |       | 5.00                           |       | 8.00                              |       | 3.00                            |       |
| December 31, 2003                            |       | 199,450                         |       | 5.50                           |       | 8.00                              |       | 2.50                            |       |
| March 31, 2004                               |       | 11,500                          |       | 9.50                           |       | 9.50                              |       | —                          |       |
| June 30, 2004                                |       | 38,500                          |       | 9.50                           |       | 9.50                              |       | —                          |       |
| September 30, 2004                           |       | 173,000                         |       | 9.50                           |       | 9.50                              |       | —                          |       |
| December 31, 2004                            |       | 273,250                         |       | 13.52                          |       | 13.52                             |       | —                          |       |
|                                                   |            |                                 |            |                                |            |                                   |            |                                 |            |  |  |  |

 

The fair market value foroptions granted during 2003 was determined retrospectively based primarily on anegotiated transaction in December 2003. The fair market value for optionsgranted during 2004 was determined contemporaneously by our Board of Directorsutilizing an analysis that considers factors such as recent arms-lengthtransactions, our financial condition and recent operating results, ourcompetitive position and future prospects, the value of comparable publiccompanies, the lack of an active public market for our common stock and thelikelihood of an initial public offering.

 

Thefollowing information relates to options outstanding and exercisable under thePlans at December 31, 2004:

 
| **Options Outstanding**              | ** ** | ** **             | ** ** | ** **                                        | ** ** |
|--------------------------------------|------------|------------------------|------------|---------------------------------------------------|------------|
| ** **                           | ** ** | ** **             | ** ** | **Weighted**                                      | ** ** | ** ** | ** ** | **Options Exercisable** | ** ** |
| **Range  of  exercise  price**       | ** ** | **Number of  options** | ** ** | **average  remaining  contractual  life (years)** | ** ** | **Weighted  average  exercise  price** | ** ** | **Number of  options** | ** ** | **Weighted  average  exercise  price** | ** ** |
| $   1.80 – 2.50  |       |                   | 101,500    |                                              | 0.62       |   | $ | 2.18 |   | 101,500 |   | $ | 2.18 |   |
| 3.10                                 |       |                   | 305,580    |                                              | 2.33       |   | 3.10 |   | 305,580 |   | 3.10 |   |
| 3.80                                 |       |                   | 160,513    |                                              | 4.32       |   | 3.80 |   | 160,513 |   | 3.80 |   |
| 5.00 – 7.00                     |       |                   | 874,245    |                                              | 7.41       |   | 6.07 |   | 485,959 |   | 6.20 |   |
| 9.50                                 |       |                   | 223,000    |                                              | 9.55       |   | 9.50 |   | — |   | — |   |
| 13.52                                |       |                   | 273,250    |                                              | 8.64       |   | 13.52 |   | 60,010 |   | 13.52 |   |
| $   1.50 – 13.52 |       |                   | 1,938,088  |                                              | 6.42       |   | $ | 6.65 |   | 1,113,562 |   | $ | 5.03 |   |

 

At December 31, 2003and 2002, 1,028,825 and 1,170,814 options, respectively, were exercisable atweighted average exercise prices of $3.65 per share and $2.87 per share,respectively.

 

***Deferred Stock-Based Compensation***

During 2003, we issued380,450 options to employees and non-employee directors. Due to the differencebetween the exercise price and the estimated fair value of common stock,approximately $1.0 million of compensation expense is to be amortized overthe vesting period of five years. We recognized compensation expense of$326,000 in 2004 and $139,000 in 2003 related to these options. Additionally,in 2003, we recognized the remaining $38,000 in deferred stock-basedcompensation related to options issued to employees and non-employee directorsprior to our attempted public offering in 2000.

 

Previously recognizedcompensation expense related to unvested options that are forfeited is reversedin the quarter that the options are forfeited and no future amortizationrelated to the forfeited options is recognized. Reversals of compensation expense totaled $117,000, $32,000 and $88,000in 2004, 2003 and 2002, respectively.

 

F-21

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***Employee Stock Purchase Plan***

In February 2004,our board of directors approved the 2004 Employee Share Purchase Plan (the “2004ESPP”) and the reservation of 400,000 shares of our common stockthereunder.  The 2004 ESPP consists ofconsecutive, overlapping offering periods with a new offering period commencingon the first trading day on or after February 1 and August 1 eachyear (the “Enrollment Date”).  Based onthe effective date of our IPO, the first offering period will commence with thefirst trading day on or after February 1, 2005.  Any eligible employee may participate in the2004 ESPP by completing a subscription agreement which will allow participantsto purchase up to 5,000 shares, per offering period, at a purchase price of 85%of the fair market value of a share, of Common Stock on the enrollment date oron the exercise date, whichever is lower. The exercise date is the last trading day of each offering period.

 

**NOTE 14. RELATED PARTY TRANSACTIONS**

 

***AgilentTechnologies***

Prior to our IPO, AgilentTechnologies held all of the outstanding shares of Series A and 87,500shares of the Series B.  Upon ourIPO, the Series A and Series B were converted into a total of 1,424,819 sharesof our common stock and, as of December 31, 2004, Agilent held 798,957shares of our common stock, which represented approximately 7.4% of ouroutstanding common stock. Sales to Agilent in 2004, 2003 and 2002 were$2.0 million, $1.3 million and $1.5 million, respectively.  At December 31, 2004 and 2003, $328,000and $154,000, respectively, was receivable from Agilent and $79,000 and$34,000, respectively, was payable to Agilent. Purchases from Agilent were$327,000, $268,000 and $576,000 in 2004, 2003, and 2002, respectively. Inaddition, we have obtained a non-exclusive license to use certain patentedtechnology of Agilent (formerly Hewlett-Packard) relating to electricalmeasurement apparatuses. We paid royalties of $9,000, $22,000 and $24,000 in2004, 2003 and 2002, respectively, pursuant to this license.

 

***Electroglas,Inc.***

Pursuant to a July 1999license agreement, in 2001, we received $400,000 from Electroglas, Inc., aholder of 505,000 shares of our Series B prior to our IPO. Upon our IPO,the Series B converted into a total of 505,000 shares of our common stock andwere sold.  As of December 31, 2004,Electroglas held no shares of our common stock. The July 1999 agreementprovided Electroglas an exclusive right to incorporate certain of ourtechnologies into certain products they manufacture in exchange for a royalty.As a result of this license agreement no longer being exclusive, no futureroyalty payments are expected. In addition, we purchase certain probingequipment from Electroglas, which totaled $2,000, $355,000 and $731,000, respectively,in 2004, 2003, and 2002. Product sales to Electroglas were $38,000, $63,000 and$109,000, respectively, in 2004, 2003 and 2002. At December 31, 2004 and 2003, $18,000 and zero, respectively, wasreceivable from Electroglas.  No amountswere payable to Electroglas at either December 31, 2004 or 2003.

 

**NOTE 15. EMPLOYEE BENEFIT PLAN**

 

We sponsor a 401(k)savings plan which allows eligible employees to contribute a certain percentageof their salary. We match 40% of eligible employees’ contributions, up to amaximum of 2% of the employees’ earnings. Our matching contribution for thesavings plan was $194,000, $180,000 and $183,000, respectively, in 2004, 2003and 2002.

 

F-22

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**NOTE 16. COMMITMENTS AND CONTINGENCIES**

 

***Operating Leases and Subleases***

We lease office andmanufacturing space under operating leases that expire at various dates through2009. In addition to lease expense, we pay real property taxes, insurance andrepair and maintenance expenses for our corporate office and manufacturingfacility. Future minimum lease payments under noncancelable operating leaseswith initial or remaining terms in excess of one year are as follows (inthousands):

 
| **Year Ending December 31,** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2005                              |       | $          | 2,271      |   |
| 2006                              |       | 2,292      |       |
| 2007                              |       | 2,113      |       |
| 2008                              |       | 1,512      |       |
| 2009                              |       | 590        |       |
| Thereafter                        |       | —     |       |
|                              |       | $          | 8,778      |   |

 

Lease expense was $2.5million, $2.4 million and $3.1 million, respectively, in 2004, 2003 and 2002.

 

We plan to subleasecertain office space to a third party. During May 2002, we expensed therental payments for the period of time the building would remain unoccupied andthe difference between the expected rental sublease payments and our obligationunder the lease. The total amount expensed was $628,000 and is not included inthe total lease expense, but is included in the five-year payout table. Thebalance of the accrual at December 31, 2004 and 2003 was $102,000 and$174,000, respectively, and is included in other long-term liabilities on ourconsolidated balance sheets.

 

***Legal Proceedings***

We are involved invarious claims and legal actions arising in the ordinary course of business. Inthe opinion of management, the ultimate disposition of these matters will nothave a material adverse effect on our financial position, results of operationsor liquidity.

 

***NOTE 17.  SEGMENT REPORTING AND ENTERPRISE-WIDEDISCLOSURES***

 

The segment data below ispresented in the same manner that management organizes the segments forassessing certain performance trends. Management evaluates segment performanceprimarily based on revenue. A limited amount of financial information isprepared for each segment. This information is not prepared in accordance with U.S.generally accepted accounting principles and does not represent the stand-aloneperformance, revenue, cost of sales, gross profit (loss) or operating resultsof each segment. In preparing this financial information, certain operatingexpenses are allocated to the segments based on management estimates, whileothers are based on specific factors such as headcount. Some operating expensesare not allocated because it is impracticable to do so. For example, certainindirect costs related to the manufacture of key components by PPD on behalf ofEPD, have been fully allocated to PPD in the data below. In addition, noadjustments have been made to reflect the sale of these components by PPD toEPD. These factors have a significant impact on the amount of gross profit(loss) and operating income (loss) for each segment.

 

F-23

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Assignment of otherreasonable allocations to each segment would result in much different segmentoperating results. We believe that it would not be cost-effective to produceadditional timely financial information that would attempt to more closelyreflect the economic performance of each segment.

 

The following tablessummarize various financial amounts for each of our business segments from thelimited financial information prepared. We do not track our assets on a segmentlevel, and accordingly, that information is not provided. (in thousands):

 
| ** **                                | ** ** | **EPD** | ** ** | **PPD** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|---------|------------|---------|------------|-----------|------------|
| **Year Ended December 31, 2004**     |       |    |       |    |       |      |       |
| Revenue  from sales to external customers |       | $       | 58,467     |    | $          | 5,948     |       | $ | 64,415 |   |
| Gross  profit                             |       | 27,775  |       | 948     |       | 28,723    |       |
| Operating  income (loss)                  |       | 10,202  |       | (3,991  | )          | 6,211     |       |
|                                      |       |    |       |    |       |      |       |
| **Year Ended December 31, 2003**     |       |    |       |    |       |      |       |
| Revenue  from sales to external customers |       | $       | 47,345     |    | $          | 3,211     |       | $ | 50,556 |   |
| Gross  profit (loss)                      |       | 20,469  |       | (365    | )          | 20,104    |       |
| Operating  income (loss)                  |       | 3,953   |       | (4,707  | )          | (754      | )          |
|                                      |       |    |       |    |       |      |       |
| **Year Ended December 31, 2002**     |       |    |       |    |       |      |       |
| Revenue  from sales to external customers |       | $       | 48,270     |    | $          | 2,837     |       | $ | 51,107 |   |
| Gross  profit (loss)                      |       | 19,786  |       | (2,042  | )          | 17,744    |       |
| Operating  income (loss)                  |       | 2,316   |       | (7,003  | )          | (4,687    | )          |

 

As of January 2005,we primarily collect revenue information for each division as the ChiefOperating Decision Maker has determined that the additional information previouslyprepared does not provide useful information upon which to base operatingdecisions. Accordingly, beginning in the first quarter of 2005, the financialstatements may only present revenue data for each segment.

 

We are not able toprovide revenue by product line or group of similar products as it would beimpracticable to do so.

 

Ourrevenues by geographic area are as follows (in thousands):

 
| ** **            | ** ** | **Year ended December 31,** | ** ** |
|-----------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Geographic  revenues: |       |                             |       |   |   |   |   |
| United  States        |       | $                                | 24,762     |   | $ | 24,708 |   | $ | 22,060 |   |
| Japan                 |       | 14,909                           |       | 11,838 |   | 11,861 |   |
| Taiwan                |       | 6,853                            |       | 3,631 |   | 6,290 |   |
| Other                 |       | 17,891                           |       | 10,379 |   | 10,896 |   |
|                  |       | $                                | 64,415     |   | $ | 50,556 |   | $ | 51,107 |   |

 

Long-lived assets,exclusive of long-term investments and deferred income taxes, by geographicarea are as follows (in thousands):

 
| ** **          | ** ** | **December 31,** | ** ** |
|---------------------|------------|-----------------------|------------|
| ** **          | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Long-lived  assets: |       |                  |       |   |   |
| United  States      |       | $                     | 5,230      |   | $ | 5,809 |   |
| Japan               |       | 225                   |       | 330 |   |
| Other               |       | 19                    |       | 20 |   |
|                |       | $                     | 5,474      |   | $ | 6,159 |   |

 

F-24

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**Report ofIndependent Registered Public Accounting Firm**

 

TheBoard of Directors

CascadeMicrotech, Inc.:

 

Underdate of February 11, 2005, we reported on the consolidated balance sheetsof Cascade Microtech, Inc. and subsidiaries as of December 31, 2004 and2003, and the related consolidated statements of operations, redeemable stockand shareholders’ equity, and cash flows for each of the years in thethree-year period ended December 31, 2004, which are included in this Form10-K for the year ended December 31, 2004. In connection with our auditsof the aforementioned consolidated financial statements, we also audited therelated consolidated financial statement schedule in this Form 10-K forthe years ended December 31, 2004, 2003 and 2002. This financial statementschedule is the responsibility of the Company’s management.  Our responsibility is to express an opinion onthis financial statement schedule based on our audits.

 

In ouropinion, such financial statement schedule, when considered in relation to thebasic consolidated financial statements taken as a whole, presents fairly, inall material respects, the information set forth therein.

 
| /s/ KPMG LLP           |   |
|------------------------|--------|
| Portland, Oregon       |
| February 11, 2005 |

 

F-25

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**SCHEDULE II**

 

**CascadeMicrotech, Inc.**

**Valuationand Qualifying Accounts**

**YearsEnded December 31, 2004, 2003 and 2002**

**(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, 2002:** |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| Allowance  for uncollectible accounts  |       | $                                    | 95         |                                | $          | 152                                            |       | $                              | 6          |   | $ | (154 | ) | $ | 99 |   |
| Inventory  reserves                    |       | $                                    | 1,318      |                                | $          | 672                                            |       | $                              | —     |   | $ | (216 | ) | $ | 1,774 |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| **Year Ended December 31, 2003:** |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| Allowance  for uncollectible accounts  |       | $                                    | 99         |                                | $          | 6                                              |       | $                              | 5          |   | $ | (9 | ) | $ | 101 |   |
| Inventory  reserves                    |       | $                                    | 1,774      |                                | $          | 377                                            |       | $                              | —     |   | $ | (412 | ) | $ | 1,739 |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| **Year Ended December 31, 2004:** |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| Allowance  for uncollectible accounts  |       | $                                    | 101        |                                | $          | 15                                             |       | $                              | 3          |   | $ | (33 | ) | $ | 86 |   |
| Inventory  reserves                    |       | $                                    | 1,739      |                                | $          | 159                                            |       | $                              | —     |   | $ | (96 | ) | $ | 1,802 |   |

 

----

(a) Charges to thisaccount relate to changes in foreign currency exchange rates.

(b) Charges to theaccounts included in this column are for the purposes for which the reserveswere created.

 

F-26

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