**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON, D. C. 20549**

 

#### **FORM10-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, 2005** |
|                                             |       |                                                          |
| **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 its charter)

 

| **Oregon**                                                     | ** ** | **93-0856709**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

| **2430 N.W. 206th Avenue**               | ** ** | ** ** |
|------------------------------------------|------------|------------|
| **Beaverton, Oregon**                    |       | **97006**  |
| (Address of principal executive offices) |       | (Zip Code) |

 

Registrant’s telephone number, including area code:  **(503) 601-1000**

 

Securities 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 if the Registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes  o     No  ý

 

Indicateby check mark if the Registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes  o     No  ý

 

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 during thepreceding 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. ý

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. Largeaccelerated filer oAccelerated filer ý   Non-accelerated filer o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-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 $77,669,883, computed by reference to thelast sales price ($14.60) as reported by the Nasdaq SmallCap System, as of thelast business day of the Registrant’s most recently completed second fiscalquarter (June 30, 2005).

 

Thenumber of shares outstanding of the registrant’s common stock as of March 9, 2006was 11,406,549 shares.

 

**Documents Incorporated by Reference**

Portionsof the registrant’s definitive Proxy Statement for the 2006 Annual Shareholders’Meeting are incorporated by reference into Part III.

 

 

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**CASCADEMICROTECH, INC.**

**2005 FORM10-K ANNUAL REPORT**

**TABLE OFCONTENTS**

** **
| **PART I**   |
|--------------|
|         |   |   |   |
| Item 1.      |   | Business |   |
|         |   |   |   |
| Item 1A.     |   | Risk Factors |   |
|         |   |   |   |
| Item 1B.     |   | Unresolved  Staff Comments |   |
|         |   |   |   |
| Item 2.      |   | Properties |   |
|         |   |   |   |
| Item 3.      |   | Legal Proceedings |   |
|         |   |   |   |
| Item 4.      |   | Submission  of Matters to a Vote of Security Holders |   |
|         |   |   |   |
| **PART II**  |
|         |   |   |   |
| Item 5.      |   | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities |   |
|         |   |   |   |
| Item 6.      |   | Selected  Consolidated Financial Data |   |
|         |   |   |   |
| Item 7.      |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|         |   |   |   |
| Item 7A.     |   | Quantitative  and Qualitative Disclosures About Market Risk |   |
|         |   |   |   |
| Item 8.      |   | 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**

 

**Forward-Looking Statements**

 

This Annual Report onForm 10-K and the documents incorporated herein by reference containforward-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-looking,including, 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 financial performance.In some cases, you can identify forward-looking statements by terminology,including “intend,” “could,” “may,” “will,” “should,” “expect,” “plan,” “anticipate,”“believe,” “estimate” “predict,” “potential,” “future,” or “continue,” thenegative of these terms or other comparable terminology. These statements areonly predictions. Actual events or results may differ materially from thoseexpressed or implied in such forward-looking statements. In evaluating thesestatements, you should specifically consider various factors, including therisks listed in Item 1A below.

 

We do not guaranteefuture results, levels of activity, performance or achievements. We do notintend to update any of the forward-looking statements after the date of thisdocument to conform them to actual results or to changes in our expectations.

 

**Overview**

 

We design, develop andmanufacture advanced wafer probing solutions for the electrical measurement ofhigh performance chips. We design, manufacture and assemble our products inBeaverton, Oregon, with global sales, service and support centers in NorthAmerica, Europe, Japan and Singapore. We were incorporated and introduced ourfirst commercial products in 1984.

 

Our products includeengineering probe stations, analytical probes, production probe cards,application software and services. Engineering probe stations address the needfor precise and accurate measurement of semiconductor electricalcharacteristics during chip design or when optimizing the chip fabricationprocess. Our engineering probe stations are highly configurable and aretypically sold with various accessories, including our analytical probes andapplication software, as well as accessories from third parties. In addition,we design and build custom engineering probe stations to address the specificrequirements of our customers. Analytical probes are used as consumablecomponents of our engineering probe stations. Our production probe cards aredesigned and sold for production test applications, ranging from very lowcurrent parametric testing to sophisticated, high speed radio frequencytesting. We refer to analytical probes and production probe cards asconsumables, as they are routinely replaced during the testing process. We alsogenerate revenue through the sale of service contracts to our customers.

 

To date, we have derivedthe majority of our revenue from the sale of our engineering probe stations,and we expect to continue to do so for the next few years. Our production probecard revenue, however, has increased as a percentage of total revenues in 2005and we expect that trend to continue in 2006.

 

**Where You Can Find More Information**

 

Wefile annual, quarterly and current 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

 

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maintainsan Internet Web site at http://www.sec.gov/ where you can obtain some of ourSEC filings. In addition, you can inspect our reports, proxy materials andother information at the offices of the Nasdaq Stock Market at 1735 K StreetNW, Washington D.C. 20006. We also make available free of charge on our websiteat www.cascademicrotech.com our annual report on Form 10-K, quarterly reportson Form 10-Q, current reports on Form 8-K, and amendments to those reportsfiled or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act assoon as reasonably practicable after they are filed electronically with the SEC. Youcan also obtain copies of these reports by contacting Investor Relations at503-601-1000.

 

**IndustryBackground**

 

During the last decade,growth in the computer, telecommunications, consumer and industrial electronicsmarkets has increased demand for chips. The Semiconductor Industry Associationestimates that worldwide semiconductor sales totaled $227 billion in 2005and are expected to grow to $309 billion in 2008. To reduce the cost andincrease the performance of electronic products, chips have become smaller andfaster and incorporate greater levels of functionality at a lower price.Advancements in manufacturing technologies, such as smaller chip elements, newmaterials, and larger wafer sizes have permitted manufacturers to meet theserequirements. However, these advancements in chip manufacturing technologieshave led to increasing challenges in the design, manufacturing and testing ofchips.

 

Chips are measured andtested multiple times throughout the design and manufacturing process to ensurethe integrity of the chip design and the quality of the manufacturing process.Chip testing that occurs during design or in support of production is referredto as engineering test. Chip testing that occurs during manufacturing isreferred to as production test. Engineering test involves performing a widevariety of highly precise measurements during chip research and developmentactivities on a low volume of chips. Production test, in contrast, involvesperforming a targeted set of tests at a rapid rate on a high volume of chips.

 

Our engineering products businessand operating results depend in significant part on the level of capitalexpenditures related to semiconductor research and development, which, in turn,depends upon current and anticipated market demand for chips. Historically, thesemiconductor industry has been highly cyclical with recurring periods ofover-supply, which has often resulted in a reduction in demand for ourproducts. While our financial results are impacted by cycles within the semiconductorindustry, we believe our business cycles are typically less pronounced thanthose of other semiconductor equipment companies. We believe this is due to ourgreater reliance on our customers’ research and development capital spendingand usage of test consumables rather than on our customers’ spending toincrease production capacity. Capital spending aimed at increasing productioncapacity is one of the first areas in which most semiconductor manufacturersreduce spending in an industry downturn.

 

**Products**

 

We design, manufactureand sell multiple product lines, including engineering probe stations,analytical probes, production probe cards, application software, and variousservices. An engineering probe station is used in conjunction with our applicationsoftware and analytical probes to test chips in wafer form, together forming anengineering probing system. Analytical probes electrically connect testequipment to the chips under test and are sold as consumable components of, andare mounted into, engineering probe stations.

 

Engineering probingsystems are required in the development of new generations of chip processesand designs, and we expect that the demand for engineering probing systems willcontinue to grow approximately at the rate of worldwide semiconductor revenues.The process development complexities and costs have continually increased aseach generation of semiconductor process has required the integration of morelayers of smaller chip elements incorporating a longer list of new materials.Engineering probing systems are a basic tool for characterizing and verifyingthe electrical performance, reliability, and repeatability of the new chipelements.

 

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*Engineering Probe Stations.*  We offer engineering probe stations for300mm, 200mm and 150mm or smaller wafer sizes. Engineering probe stations arehighly configurable depending upon the size and type of wafer, the particularcharacteristics of the chip that the customer is testing, the requiredmeasurements, the temperatures at which the chip is tested and the testequipment that the customer is using. Our engineering probe stations areavailable in either manual or semiautomatic versions. We also offer many probestation accessories, including thermal control systems, special cables andconnectors, microscopes, lasers, cameras and other items.

 

300mm wafer technologymore than doubles the available area on a wafer, increasing the number of chipsper wafer and reducing per unit manufacturing costs compared to 200mm wafers. Whilemany industry players continue to ramp up 300mm wafer volumes, high conversioncosts combined with continued process developments on 200mm wafers continue tomake sales of our non-300mm probing systems an important component of ourrevenue stream for the foreseeable future.

 

In early 2005 weintroduced the Pureline option for our 200mm and 300mm probe stations. Purelineextends the low-current and low-voltage measurement capabilities of thesestations, thus extending our performance and technology lead vs. competitivestations.

 

In mid-2005 we introduceda new microscope product for our 300mm and 200mm probe station families we callthe eVue microscope. This is a high-performance digital microscope withadvanced and unique navigation and probing-specific features. eVue enables usto address and differentiate our offerings in new application segments withinengineering wafer probing. One of our stated growth strategies is to work withstrategic partners to deliver new solutions, and the eVue microscope is theresult of one such relationship.

 

Another of our statedgrowth strategies is to expand our end-market opportunities. In mid-2005 weannounced the L-Series platform, our first standard products for life sciencesapplications. For several years biological researchers have been one of theniche groups using our engineering probe stations. These customers requiresophisticated microscopy, sample environment control, electrical probing andmechanical manipulators. The L-Series adds to these capabilities microfluidicports for delivery of precise quantities of liquids for microfluidics research.

 

*Analytical Probes.*  We offer over 50 different analyticalprobe models primarily for engineering test. The newer Infinity series probesare designed with unique probe tips derived from our proprietary lithographicmanufacturing technology, and offer exceptional electrical contact on aluminumand copper pads. While our analytical probes are used primarily for engineeringtest, several of our analytical probes are also used in production testing ofsome high-frequency devices. In 2005 we continued to add new models ofanalytical probes that address higher frequency and higher complexitymeasurements.

 

*Application Software.*  Our proprietary WinCal software isspecifically designed to facilitate and improve the user’s productivity duringset-up, calibration and data-logging to perform sophisticated high frequencymeasurements accurately and reliably. During 2005 we introduced and began shippingour new platform, WinCal2006, which significantly enhances WinCal’s measurementcapabilities and improves user productivity in making complex measurements.

 

*Services.*  In addition to routine installationservices at the time of sale, we offer services to enable our customers tomaintain and more effectively utilize our equipment, probes and software and toenhance our customer relationships.

 

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

 

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One of our stated growthstrategies is to grow the sales of consumables. In 2005, our probe cardrevenues were up 69% over 2004, comprising approximately 14% of total 2005revenue. We achieved growth in demand from our customers in all geographicalregions and expect the growth in production cards to continue during 2006.

 

As chip makers continueto decrease the cost of fabricating chip elements by about 25-30% per year,production test departments must similarly reduce chip test costs. A commonstrategy today is to increase the number of chips tested simultaneously, orparallel test. At the production wafer probe stage memory chips are typicallytested 64 to 200 at a time. Comparatively, logic and mixed-signal chips aretypically tested 2 to 8 at a time due to the higher number of connections perchip, increased test complexities, and in many cases, lower unit volumes. Wefocus our production probe card applications exclusively on logic andmixed-signal chip testing.

 

The value propositionsdriving our Pyramid Probe growth are several unique advantages that reduce thecost of production testing. First, Pyramid Probes provide a solid solution fordecreased test costs through increased parallelism in logic test, anapplication that has become increasingly problematic for conventionalcantilever probe cards on wirebonded chips. Second, for smaller and thinnerchip pads Pyramid provides consistent electrical contact with less pad damage,especially for chips with low-k dielectrics or requiring higher reliability. Third,the cost of ownership of Pyramid cards is often lower than for conventionalcards. Fourth, for RF or wireless chip applications Pyramid technology allowstest speeds ranging to well above 20 GHz, which is many times the electricalperformance of any other production probe card. Other benefits include superiorelectrical contact, less probe card maintenance, and less tester downtime forprobe cleaning or repair.

 

The chips tested byPyramid Probe cards were originally limited to mostly high-speed communicationschips and wireless chips, where testing benefited from the unique electricalperformance. Pyramid sales for chips used in wireless and RF applications, suchas cellular phones, wireless LAN, or Bluetooth products, continue to increasestrongly due to the growth of those end applications as well as the trend tomore thoroughly test these chips at the wafer level before assembling them intomore expensive modules. The other major Pyramid application today is paralleltest of wirebonded logic chips for a wide range of end applications. Such chipsinclude various microcontrollers, digital signal processors, data converters,power management chips, application-specific standard products (“ASSPs”) andothers.

 

**Customersand Geographic Revenue**

 

Our products are used bysemiconductor manufacturers, test subcontractors, research organizations anddesigners. Fabless semiconductor suppliers do not manufacture their ownsemiconductors but they purchase our analytical probes and engineering probestations for research and development and purchase, or direct their foundriesto purchase, our Pyramid Probe cards to test chips manufactured for them. Wehave built strong relationships with our customers through frequentinteractions over the past 20 years. To foster stronger customerrelationships, we conduct analyses for the needs of our customers’ new labs orproducts, seminars on topics such as measurement techniques, and proactiveservice calls. This close interaction has helped us build a consistently loyalcustomer base. More than 800 customers purchased our products in 2005. Our top20 end-user customers during 2005 were: Agilent, Broadcom, CharteredSemiconductor, Freescale, Fujitsu, Hitachi, Hynix Semiconductor, IBM, Infineon,Intel, Micron Technology, NEC, Raytheon, RF Micro Devices, Samsung, Sony, Spansion,ST Microelectronics, Taiwan Semiconductor Manufacturing Company and TexasInstruments.

 

We believe our customersconsider timely customer service and support to be an important aspect of ourrelationship. Our engineering probe stations are installed at customer sites eitherby us, our manufacturers’ representatives or our distributors, depending on thecomplexity of the installation and the customer’s geographic location. Weassist our customers in the selection, integration and use of our products byproviding engineering application support. We also provide worldwide on-sitetraining, seminars and telephone support. Our manufacturers’ representativesand distributors provide additional service and support.

 

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In 2005 and 2004, nosingle customer accounted for 10% or more of our total revenues. In 2003, salesof our products to IBM represented 11% of our total revenue. Our top 10customers accounted for approximately 33%, 34%, and 34% of our total revenue ineach of 2005, 2004 and 2003, respectively.

 

International salesaccounted for more than 50% of our total revenue in each of 2005, 2004 and 2003.Two foreign countries, Japan and Taiwan, had revenues that totaled 10% or moreof our total revenues in 2005, 2004 or 2003. Geographic revenue was as follows(in thousands):

 
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States |       | $                                          | 23,877     |   | $ | 24,762 |   | $ | 24,708 |   |
| Japan         |       | 15,085                                     |       | 14,909 |   | 11,838 |   |
| Taiwan        |       | 7,612                                      |       | 6,853 |   | 3,631 |   |
| Other         |       | 27,063                                     |       | 17,891 |   | 10,379 |   |
|          |       | $                                          | 73,637     |   | $ | 64,415 |   | $ | 50,556 |   |

 

**Segments**

 

The segment data below ispresented in the same manner that management organizes the segments forassessing certain performance trends. Our Chief Operating Decision Makermonitors the revenue streams of engineering products and Pyramid probe products.

 

The following tablesummarizes revenue for each of our business segments. We do not track ouroperating income or assets on a segment level, and, accordingly, thatinformation is not provided (in thousands):

 
| ** **                                                            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **Revenue from sales to external customers** | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| EPD (Engineering  Products Division)                                  |       | $                                          | 63,566     |   | $ | 58,467 |   | $ | 47,345 |   |
| PPD (Pyramid  Probe Division)                                         |       | 10,071                                     |       | 5,948 |   | 3,211 |   |
|                                                                  |       | $                                          | 73,637     |   | $ | 64,415 |   | $ | 50,556 |   |

 

We are not able toprovide revenue by product line or group of similar products within a divisionas it would be impracticable to do so.

 

**Technology**

 

We are a leadinginnovator in developing electrical measurement, or metrology, and productiontest tools. One of our stated growth strategies is to continue to developnext-generation technologies. We have focused our research and developmentefforts on enabling our customers to take more precise electrical measurementsin less time, on smaller and more dense devices, and with more robustness. Ourcore technologies include:

 

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

 

•                  *Precise Low-Level Measurements.*  In 1993, we were first tocommercialize a shielded probe station utilizing our patented MicroChambertechnology that increased thermal measurement productivity by 10 times andcurrent measurement resolutions by 1,000 times. Many of our engineering probestations feature MicroChambers, which ensure a dark, electrically noise-freemeasurement environment to enable low-current measurements over a wide thermalrange. Our engineering probe stations also incorporate our proprietarylow-noise thermal

 

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chuck technologies that increase measurement integrityand reduce the time required to take precise measurements. These features, inturn, increase the number of chips that can be tested or measured in a givenamount of time. During 2005 we introduced our Pureline option, which implementsour latest probe station technologies for improved low-current and low-voltagemeasurements.

 

•                  *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. Ourproprietary Pyramid technology has been under development since 1992 andcontinues to evolve and improve. At the center of a Pyramid probe card, testerconnections converge on the chips under test through our unique,lithographically defined microscopic probe tips and electrical interconnectionwiring. We print the patented probe tips and interconnects on a flexiblesubstrate in much the same manner as chips or circuit boards are printed, butwith our unique materials and probe designs. Our processing continues to matureand evolve, enabling faster delivery times, larger probe areas, smaller tipdimensions and interconnects, and wider test temperature ranges. As chipelements continue to shrink, we expect to be able to scale and evolve ourlithographic processes to continue to meet our customers’ requirements.

 

**Salesand Marketing**

 

We sell our engineeringprobe stations, analytical probes and production probe cards through acombination of manufacturers’ representatives, distributors and direct salespeople. Manufacturers’ representatives are independent third parties that agreeto sell our products at our prices and on terms set by us, in return for acommission based on sales. We typically use manufacturers’ representatives inareas that we believe require greater levels of customer support than we candeliver 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.

 

In North America andAsia, excluding Japan, Singapore and Malaysia, we sell our products throughmanufacturers’ representatives and a direct sales force. In Japan, we sellthrough Cascade Microtech Japan, K.K., our direct sales and service subsidiary.In Singapore and Malaysia, we sell through our branch office, Cascade MicrotechSingapore. We are currently in the process of establishing a distribution salesoffice in China and a direct sales office in Taiwan. In Europe, we primarilysell through distributors and manufacturers’ representatives managed by CascadeMicrotech Europe, Ltd., our direct sales and service subsidiary in theUnited Kingdom. We also sell certain products directly in Germany, Austria,Switzerland France, the Benelux countries, Italy and Spain. In other countries,we typically sell through manufacturers representatives or distributors. Oursales managers oversee and manage these worldwide sales activities.

 

We work closely with ourcustomers to select the most appropriate product or to configure a customsolution to best fit their applications. Sales of our engineering testsolutions require significant interaction with our customers’ engineering labsand knowledge of their product development schedules and systems, as well ason-site demonstration capability. We also may assist our customers in thedesign requirements for their products to enhance testability. 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. Our sales managers are experienced sales professionals within-depth technical training, customer knowledge and industry expertise. Thetechnical sophistication of our products requires substantial training for ourmanufacturers’ representatives, distributors and sales staff. We devoteconsiderable effort and resources to developing a highly trained sales forcethat is responsive to our customers’ changing needs.

 

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We focus our marketingefforts on building awareness of our products among designers and manufacturersof complex semiconductors. We market our products and capabilities byparticipating in trade shows, providing product and technical information inprint and on our website, hosting technical and product seminars, advertisingin trade publications and using direct mailings. In addition, our marketingstaff performs market research and product planning. We also participate injoint sales and marketing activities with complementary equipment and softwarevendors to offer our customers complete test solutions. These relationshipsbenefit us because they can lead to broader awareness and increased sales ofour products.

 

**Researchand Development**

 

Our industry is subjectto rapid technological change and new product introductions and improvements.Our continued investment in research and development and timely introduction ofnew products and services is critical to maintaining and improving ourcompetitive position. Our growth depends upon our ability to rapidly developnew products that enable customers to improve their electrical, optical andmechanical measurements and increase their productivity. As a result, we expectto continue to devote substantial resources to research and development. Ourresearch and development expenses were $7.0 million in 2005, $5.7 millionin 2004 and $5.4 million in 2003. These amounts are net of customerreimbursements of $0, $94,000 and $248,000, respectively, in 2005, 2004 and 2003for work on a joint project. We did not expend material amounts oncustomer-sponsored research and development in 2005, 2004 or 2003. In addition,we do not currently have any agreements with third parties for joint researchand development projects. We are currently devoting substantial resources toprojects such as releasing new Pyramid Probe products and manufacturingprocesses, developing faster, higher accuracy analytical probes and enhancingthe functionality of our 300mm engineering probe stations. At December 31, 2005,we employed 45 research and development engineers. We conduct research anddevelopment for all of our product lines at our Beaverton, Oregon facilities.

 

**Manufacturingand Assembly**

 

Our manufacturing andassembly operations consist of the production of highly complex andsophisticated components and assemblies, some of which are customized to meetcustomers’ needs and specifications. We perform nearly all of our manufacturingand assembly in Beaverton, Oregon at our manufacturing facility within ourheadquarters building, at our Pyramid Probe microfabrication and assemblyfacility and at our machine shop. Our microfabrication facility includes a10,000 square foot clean room. Our manufacturing strategy is to purchasecomponents from vendors to the extent possible. However, we manufacture keycomponents that we deem to be proprietary or that provide us with a competitiveadvantage. We depend on limited source suppliers for some materials, componentsand subassemblies used in our products.

 

Our product design andmanufacturing process activities emphasize accurate electrical measurements,precise and reliable mechanical components and assemblies, and compliance withindustry and governmental safety requirements. We prototype and test our newstandard product designs and components to ensure high electrical signalintegrity, mechanical accuracy and safety. In our manufacturing operations, weperform electrical, mechanical and chemical tests and use statistical processcontrol methods, internally developed manufacturing information systems andinspections of purchased components and products to monitor our product qualitythroughout the various stages of our manufacturing process.

 

Whenfully equipped and staffed, the capacity of our probe cardmicrofabrication facility is estimated to be about $40 millionannually with our current probe card product mix. We are currentlyusing less than one third of the facility’s capacity. In the near term, ourprobe card growth rate, therefore, relies on our ability to recruit and trainenough top-quality people for product fulfillment and field support. We have steppedup our recruiting efforts and we expect to make further investments inequipment to expand production run rates during 2006.

 

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**Competition**

 

The markets forengineering probe stations, analytical probes and production probe cards arehighly competitive. We anticipate that the markets for our products willcontinually evolve and be subject to rapid technological change.

 

*Engineering Probe Stations.*  Our primary competitor in the engineeringprobe station market is Suss MicroTec AG (Karl Suss), but we also compete withBekutasemikon K.K., Lucas/Signatone Corporation, The Micromanipulator CompanyInc. and Wentworth Laboratories Inc., among others. We believe that the primarycompetitive factors in the engineering probe station market are measurementaccuracy and versatility, measurement speed, automation features, completenessof the measurement solutions, applications support, delivery time and price. Wecompete favorably with respect to these factors, except in small niche marketswhere customers seek solutions that provide highly specialized testingenvironments.

 

*Analytical Probes.*  Our primary competitor in the analyticalprobe market is GGB Industries. We believe that the primary competitive factorsin this market are breadth of probe types, probe frequency and electricalsignal integrity, contact integrity and the related cleaning required,calibration support, applications support, delivery time and price. We competefavorably with respect to these factors, except in small niche markets wherecustomers seek solutions that provide highly specialized testing environments.

 

*Production Probe Cards.*  Competition in the production probe cardmarket is fragmented and characterized by many suppliers offering productsbased on differing technologies. Our Pyramid Probe cards compete with productofferings of other probe card vendors including Feinmetall GmbH, FormFactorInc., GGB Industries Inc., Japan Electronic Materials Corporation, MesatronicsS.A., Micronics Japan Company, Ltd., MicroProbe Inc., Micro Square TechnologyInc., PHICOM Corporation, SV Probe Inc., Technoprobe S.r.l., Tokyo CathodeLaboratory Company Ltd., Wentworth Laboratories Inc. and others. At least threeprobe card vendors, FormFactor Inc., Mesatronics S.A. and PHICOMCorporation, are also offering probe cards built using types of lithographicpatterning. The high capital investment and other costs associated with thedevelopment of lithographically defined probe cards and the time and high costof customer evaluation, represent a significant barrier to entry for this typeof technology. We believe that the primary competitive factors in theproduction probe market depend upon the type of chip being tested, but includecustomer service, delivery time, price, probe card lifetime, chip damage,application support, probe tip touch-down accuracy, speed and frequency of theprobe card, number of chips contacted in parallel, number of probe tips andtheir layout, signal integrity, and frequency and effectiveness of cleaningrequired. We believe that we generally compete favorably in probe cards forhigh frequencies and high-speed signals, and in probe cards for paralleltesting of chips with densely-packed bond pads. We generally do not compete inapplications that require very large probe areas, such as memory test, or thatrequire delivery times of less than two weeks, or that require very highcurrents, such as some microprocessors.

 

**IntellectualProperty**

 

Our success in large partdepends on our proprietary technology. We do not depend on any one individualpatent, instead relying on intellectual property, including patents and tradesecrets, covering electrical measurement reliability and integrity, electricalshielding and the Pyramid Probe contact structure and production process. As ofDecember 31, 2005, we had 88 issued patents and 50 pending patent applicationsin the U.S. and 55 issued foreign patents and 74 pending foreign patentapplications. In addition, we regard certain of our processes, information andknow-how that we have developed and used to design and manufacture our productsas proprietary trade secrets.

 

One important group ofour patents claims technology relating to electrical shielding and otherinventions required to measure extremely small signals on wafers. Most of theseU.S. patents will expire between 2012 and 2015. Another important group of ourpatents claims designs and construction methods for probe tips on Pyramidprobes. These patents will expire beginning in 2016.

 

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Our policy is to seekpatents where appropriate on inventions involving new products and improvementsto existing products as part of our ongoing engineering and research anddevelopment activities. We cannot assure you that any of our pending patentapplications will be approved, that we will develop additional proprietarytechnology that is patentable, that any patents owned by or issued to us willprovide us with competitive advantages or that these patents will not bechallenged by third parties. Furthermore, there can be no assurance that thirdparties will not design around our patents.

 

We also use certainpatented technology of third parties in the manufacture of our productspursuant to license agreements. Pursuant to an agreement with Micronics JapanCompany Ltd. and Hewlett-Packard Japan Ltd. (now Agilent Technologies),our subsidiary, Cascade Microtech Japan, Inc. and its affiliates, havebeen granted a non-exclusive worldwide license to make, have made, use, lease,sell, or otherwise transfer certain products that make use of patentedtechnology relating to electric circuit measurement apparatuses. In exchangefor the rights granted under the license, we pay royalties to Micronics JapanCompany Ltd. and Agilent Technologies based on the number of products soldor leased. Our license will expire upon the expiration of the patent coveringthe licensed technology, which will occur in June 2013.

 

**Seasonality**

 

In the past, our businesshas experienced seasonality. Typically, our revenue has been lower in ourfiscal first quarter than in our fiscal fourth quarter preceding it. However,revenue in the first quarter of 2005 was greater than the revenue in the fourthquarter of 2004 as strength in the Asian market outweighed the seasonalityfactors. We also expect our revenue in the first quarter of 2006 to be greaterthan our revenue in the fourth quarter of 2005 due to delays in closing certainorders in the fourth quarter of 2005. In addition, as is typical in ourindustry, we recognize a large percentage of our quarterly revenue in the lastmonth of the quarter.

 

**Employees**

 

As of December 31, 2005,we had a total of 287 employees: 45 in engineering and research anddevelopment; 159 in manufacturing; and 83 in selling, general andadministrative functions. Of these employees, 252 were located in the U.S., 17were in Japan, 8 were in Great Britain, 7 were in Singapore, 1 was in Canadaand 2 were in Taiwan. Many of our employees are highly skilled and our futureperformance depends largely on our ability to continue to attract, train andretain qualified technical, sales, service, marketing and managerial personnel.None of our employees is subject to a collective bargaining agreement. We havenot experienced any work stoppages and consider our relations with ouremployees to be good.

 

**EnvironmentalMatters**

 

As part of ourmanufacturing operations, we have handled and continue to handle materials thatare considered hazardous or toxic under federal, state and local laws andregulations, and we are subject to environmental laws and regulations relatedto the use, storage, discharge, disposal and human exposure to such materials.We believe we are in material compliance with the environmental laws andregulations applicable to the conduct of our business and operations. However,there can be no assurance that violations of environmental laws or regulationswill not occur in the future as a result of human error, equipment failure orother causes. The risk of a release of hazardous or toxic materials cannot becompletely 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.

 

In addition, 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 lead,which 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. This mayrequire us to make additional capital expenditures. In addition the costsassociated with compliance may negatively impact our earning and competitiveposition. We are also working with our suppliers to redesign or reformulatetheir components containing lead to reduce or eliminate lead in our products.

 

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Further, we are workingwith selected customers who specify and/or provide specific components used insome of our products to choose components that comply with the RoHS Directive. Basedupon current information available to us, we believe that we will be able tocomply with RoHS Directive within the applicable time period. However, if we donot comply with this Directive, we may suffer a loss of revenue, be unable tosell in certain markets or countries and suffer competitive disadvantage.

 

The European Parliamenthas also recently finalized the Waste Electrical and Electronic EquipmentDirective, 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. Our products have been labeled in accordancewith the WEEE Directive since before August 13, 2005, the WEEE implementationdate. We determined the products we presently produce are exempt because theyeither meet the definition of “Large Scale Industrial Equipment,” or arepassive or non-electrical accessories that do not function on their own. Wehave not incurred any costs or fees or penalties associated with non-compliancethrough March 3, 2006. Therefore, we have some confidence that we areinterpreting the rules correctly. However, 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 still unknownat this time. Costs to comply with the WEEE Directive and similar futurelegislation, if applicable, may also include legal and regulatory costs andinsurance costs. We may also be required to take reserves for costs associatedwith compliance with these regulations.

 

We are subject topotentially conflicting and changing regulatory agendas of political, businessand environmental groups and governmental priorities concerning environmentallaws and regulations. We may be required to incur substantial costs to complywith current or future environmental laws or regulations, and our operations,business or financial condition could be adversely affected by suchrequirements.

 

**Backlog**

 

Our backlog consists ofpurchase orders we have received for products and services with scheduleddelivery dates that we expect to ship and deliver or perform within the next12 months. At December 31, 2005 our backlog was $10.7 millioncompared with $12.1 million at December 31, 2004. 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, 2005backlog in 2006. 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.

 

**ITEM 1A. RISK FACTORS**

 

**Ouroperating results have fluctuated in the past and are likely to fluctuate inthe future, which could cause us to miss analyst expectations about theseresults and cause the trading price of our common stock to decline.**

 

Our operating resultshave fluctuated in the past and are likely to continue to fluctuate. As aresult, we believe that you should not rely on period-to-period comparisons ofour financial results as an indication of our future performance. Factors thatare likely to cause our revenue and operating results to fluctuate include:

 

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

 

•                  timing, cancellation or delay of customer orders;

 

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

 

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

 

•                  fluctuations in foreign currency exchange rates;

 

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

 

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

 

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

 

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

 

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

 

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

 

For example, a largemajority of our revenue in the last five years was derived from theresearch and development equipment spending of companies in the semiconductorindustry or, to a much lesser extent, various research organizations, includinguniversities, that conduct research that benefits the semiconductor industry.Our customers’ spending on research and development is roughly proportional tothe customers’ overall revenues. Historically, semiconductor industry revenueshave been highly cyclical. According to industry data, the semiconductorindustry has experienced four significant cyclical downturns in the22 years from 1983 through 2005. For example, our revenue increasedapproximately 37% from 1999 to 2000. In contrast our revenue decreasedapproximately 29% from 2001 to 2002 and increased approximately 27% and 14%from 2003 to 2004 and 2004 to 2005, respectively. Given this history, there is noreason to expect that our customers’ business and, therefore, their demand forour products, will be less cyclical in the future.

 

If our revenue oroperating results fall below the expectations of analysts or investors, themarket price of our common stock could decline substantially.

 

**Thecyclicality of the semiconductor industry affects our financial results, and,as a result, we may experience reduced sales or operating losses in asemiconductor industry downturn.**

 

The semiconductorindustry is highly cyclical with recurring periods of wide fluctuations inproduct supply and demand. From time to time, this industry has experiencedsignificant downturns, often in connection with, or in anticipation of, periodsof oversupply, maturing product and technology cycles, excess inventories anddeclines in general economic conditions. Our customers’ purchase behavior inresponse to these cycles has been generally unpredictable. In the past, ouroperating results have been adversely affected by the cyclical downturns in thesemiconductor industry.

 

Our business is heavilydependent on the level of research and development spending of our customers,the volume of semiconductor production by semiconductor manufacturers, thedevelopment of new semiconductors and semiconductor designs and the overallfinancial strength of our customers, which, in turn, depend upon the currentand anticipated market demand for semiconductors and the products incorporatingthem. Semiconductor manufacturers in particular are known to sharply curtailtheir capital expenditures when confronted with an industry downturn, such asthe downturns experienced from 1996 through 1998 and from 2001 through thefirst six months of 2003. We expect that the markets for future generations ofsemiconductors will also be subject to similar fluctuations. Furthermore, somesegments of the semiconductor industry may experience greater fluctuations thanothers. We may not achieve or maintain our current or prior levels of revenuegrowth. Any factor adversely affecting the semiconductor industry in general,or the particular

 

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segments, regions ormajor customers of the industry that our products target, will adversely affectour ability to generate revenue and could cause us to experience operatinglosses.

 

**Asis the case with other companies in our industry, many of our customers deferpurchasing decisions until late each quarter. As a result, we are significantlydependent upon the sale of our products in the third month of each quarter,and, if we do not generate enough revenue in the third month of each quarter tomeet the earnings expectations of analysts or investors, the price of ourcommon stock could decline.**

 

As is the case with othercompanies in our industry, we have historically recognized a substantialportion of our revenue in the last month of each quarter because many of ourcustomers defer purchasing decisions until late each quarter. Historically, wehave often recognized more than 50% of our quarterly revenue in the third monthof the quarter. We expect this trend to continue for the foreseeable future. Asa result, our ability to meet the earnings expectations of analysts depends onour ability to not only generate customer orders in the third month of eachquarter but also satisfy each of the various accounting requirements forrecognizing the revenue generated by such sales prior to the end of thequarter. Moreover, our engineering probe stations typically range in price from$30,000 to $350,000 for a single unit, so a delay in the shipment of even oneengineering probe station and the corresponding delay in recognition of revenuefor the sale of probe stations, can have a very large impact on our quarterlyresults. If we are unable to generate a sufficient amount of sales during thelast month of the quarter or if we are unable to recognize the revenuegenerated 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.

 

**Becausewe generally do not have a sufficient backlog of unfilled orders to meet ourquarterly revenue targets, revenue in any quarter is substantially dependentupon customer orders received and fulfilled in that quarter.**

 

Our revenue is difficultto forecast because we generally do not have a sufficient backlog of unfilledorders for our engineering probe stations, analytical probes and productionprobe cards to meet our quarterly revenue targets at the beginning of aquarter. Historically, a significant portion of our revenue in any quarterdepends upon customer orders that we receive and fulfill in that quarter.Furthermore, because our expense levels are based in part on our expectationsas to future revenue and, to a large extent, are fixed in the short term, wemight be unable to adjust spending in time to compensate for any unexpectedshortfall in revenue. Accordingly, any significant shortfall in revenue inrelation to our expectations and the expectations of analysts or investorscould hurt our operating results and result in a decline in the price of ourcommon stock. For example, in the fourth quarter of 2005, several large ordersrelated to sales of our S300 systems were delayed, which resulted in a declinein our fourth quarter 2005 revenue below our expectations and a consequentdecline in our operating profit for the quarter.

 

**Wecontinue to devote significant effort and resources to the growth anddevelopment of our Pyramid Probe products, which has had, and could continue tohave, an adverse effect on our operating margins.**

 

Our future growthdepends, in part, on continued market adoption of, and growing demand for, ourproduction probe cards. Large-scale market adoption of these products willdepend on our ability to demonstrate the superior reliability and costeffectiveness of these products to potential customers and on the continuedgrowth of the market for high-speed or complex chips. Production customers aregenerally very risk-averse when adopting new technologies that could affecttheir production output, especially a sole source supplier such as we are inthe case of Pyramid Probes. We have devoted significant resources to thedevelopment and growth of these products in the past, and expect to devotesignificantly more investment in the form of people and equipment during 2006.If our production probe cards are not adopted in the market at a rate that issufficient to offset the costs and resources that we devote to the developmentand promotion of these products, the future growth of our overall business andour operating margins would be adversely affected.

 

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**Ifwe do not keep pace with technological developments in the semiconductorindustry, especially the trend toward faster, smaller and lower cost chips, ourrevenue and operating results could suffer as potential customers decide toadopt our competitors’ products.**

 

We must continue toinvest in research and development and certain manufacturing capabilities toimprove our competitive position and to meet the testing needs of ourcustomers. Our future growth depends, in significant part, on our ability towork effectively with and anticipate the testing needs of our customers and onour ability to develop and support new products and product enhancements tomeet these needs on a timely and cost-effective basis. Our customers’ testingneeds are becoming more challenging as the semiconductor industry continues toexperience rapid technological change driven by the demand for complex chipsthat have smaller element sizes and at the same time are increasing in speedand functionality and becoming less expensive to produce. Our customers expectthat they will be able to integrate our wafer probing products into theirdesign and production processes as soon as they are deployed. Therefore, tomeet these expectations and remain competitive, we must continually design,develop and introduce on a timely basis new products and product enhancementswith improved features. Successful product development and introduction on atimely basis require that we:

 

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

 

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

 

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

 

•                  adjust to changing market conditions quickly andcost-effectively.

 

If we are unable totimely predict industry changes, or if we are unable to modify our products ona timely basis, we might lose customers or market share, and our operatingresults could suffer. We cannot assure you that we will successfully developand bring new products to market in a timely and cost-effective manner, thatany product enhancement or new product developed by us will gain marketacceptance or that products or technologies developed by others will not renderour products or technologies obsolete or uncompetitive.

 

**Thereis no assurance that products recently introduced for micro-fluidics researchfor the life sciences industry will generate revenues and profits.**

 

Wehave recently introduced new products for micro-fluidics research for the lifesciences industry. To date there has been no significant revenue from theseproducts and there can be no assurance that significant revenues will beachieved by this product line in the future. In addition, we cannot assure youthat we shall bring new products for this industry to market in a timely andcost-effective manner and that any new product will gain market acceptance.

 

**Intensecompetition in the semiconductor wafer probing business may reduce demand forour products and reduce our sales.**

 

The markets for ourproducts are highly competitive, and we expect competition to continue in thefuture. We believe that our principal competitors are the major providers ofprobe stations, production probe cards and analytical probes. Our primarycompetitor in the probe station market is Suss MicroTec AG (Karl Suss), but wealso compete with Bekutasemikon, K.K., Lucas/Signatone Corporation, TheMicromanipulator Company Inc., and Wentworth Laboratories Inc., among others. OurPyramid Probe cards compete with product offerings of other probe card vendorsincluding Feinmetall GmbH, FormFactor Inc., GGB Industries Inc., JapanElectronic Materials Corporation, Mesatronics S.A., Micronics JapanCompany, Ltd., MicroProbe, Inc., Micro Square Technology Inc., PHICOMCorporation, SV Probe, Technoprobe S.r.l., Tokyo Cathode Laboratory Company, Ltd.,Wentworth Laboratories Inc. and others. At least three probe card vendors,FormFactor Inc., Mesatronics S.A. and PHICOM Corporation, are also offeringprobe cards built using types of lithographic patterning. Our primarycompetitor in the analytical probe market is GGB Industries. These competitorsor other potential competitors may have developed or may be developing

 

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technology of which weare unaware that may render our products uncompetitive. Some of our competitorshave significantly greater financial, technical and marketing resources than wedo. As a result, these competitors may be able to respond more quickly to newor emerging technologies and changes in customer requirements, to devotegreater resources to the development, promotion and sale of their products orto deliver competitive products at lower prices. We cannot assure you that wewill maintain our current competitive position or that our production probecards will achieve widespread acceptance in the market. Finally, increasedcompetition could result in pricing pressures, reduced sales, reduced marginsor failure to achieve or maintain widespread market acceptance for ourproducts, any of which could prevent us from growing our business.

 

**Weobtain some of the materials, components and subassemblies used in our productsfrom a single source or a limited group of suppliers. If these suppliers areunable to provide us with these materials, components or subassemblies inadequate quantities and on a timely basis, we may be unable to manufacture ourproducts or meet our customers’ needs.**

 

We obtain some of thematerials, components and subassemblies used in our products from a singlesource or a limited group of suppliers. Certain of our product purchases for2005 were from sole source suppliers. Although we were not forced to delayshipment of any product due to delays in 2005 related to such suppliers, fromtime to time, we may experience difficulties in obtaining these materials,components and subassemblies from some suppliers, especially during periods ofhigh demand for semiconductor capital equipment. The manufacture of some of thematerials, components and subassemblies that we use in our products, such asthermal chucks and microscopes, is a complex process, and in the event that wecannot obtain 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.

 

The delay in shipmentsfrom, or complete loss of, any one of these suppliers could prevent us fromproducing and shipping our products, resulting in delayed or lost orders forour products and damage to our customer relationships, which would harm ourresults of operations. Furthermore, a significant increase in the price of oneor more of these materials, components or subassemblies could materiallyadversely affect our results of operations.

 

**Wedepend upon the sale of our engineering probe stations for a significant portionof our revenue, and a decline in demand for our engineering probe stationswould have a more significant impact on our revenue than a downturn in demandfor our analytical probes or production probe cards.**

 

Historically, we havederived a large majority of our revenue from the sale of our engineering probestations. We anticipate that sales of our engineering probe stations willcontinue to represent a large majority of our revenue for the next few years.Our business depends in large part upon continued demand in current marketsfor, and adoption in new markets of, current and future generations of ourengineering probe stations. In addition, while our analytical probes aresometimes sold to serve as components of test equipment manufactured by third parties,they are most often sold for use with our engineering probe stations. Continuedmarket adoption depends upon our ability to increase customer awareness of thebenefits of our engineering probe stations and to prove their reliability andcost effectiveness.

 

We may be unable to sellour engineering probe stations to existing and potential customers if thosecustomers change their chip test strategies, change their capital equipmentbuying strategies or chose not to change or upgrade their existing testequipment. We might not be able to sustain or increase our revenue from salesof our engineering probe stations, particularly if conditions in thesemiconductor market deteriorate or if the market enters into another downturn.

 

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In addition, sales of ourengineering probe stations depend in part upon the level of research anddevelopment spending in the semiconductor industry. Historically, the level ofresearch and development spending in the semiconductor industry has followedthe overall cycles of the semiconductor industry but at a reduced rate ofgrowth or decline, as the case may be. If our customers reduce their researchand development spending or if the overall level of research and development spendingin the semiconductor industry does not continue to follow the growth rate ofthe overall semiconductor industry, consistent with historical patterns, ourrevenue would decline, which could result in a decline in the price of ourcommon stock.

 

We believe that wecurrently have a significant market share in the engineering probe stationmarket. As a result, it may be difficult for us to both maintain our currentlevel of market share and capture opportunities for growing our market share,especially if the market for engineering probe stations does not continue togrow as we expect. If the market for engineering probe stations does notcontinue to grow, our business may not expand, even if we are successful inincreasing our market share.

 

**Wemay make future acquisitions, which may be costly, difficult to integrate withour operations, divert management resources and dilute shareholder value.**

 

As part of our businessstrategy, we may make acquisitions of, or investments in, companies, productsor technologies that complement our current product offerings, enhance ourtechnical capabilities, expand our operations into new markets or offer othergrowth opportunities. If we fail to successfully integrate any acquiredbusinesses, products or technologies, we would not achieve anticipated revenueand cost benefits. We may acquire companies, products or technologies in thefuture, which could pose risks to our operations including:

 

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

 

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

 

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

 

**Weface economic, political and other risks associated with our internationalsales and operations, which could materially harm our operating results.**

 

Since 1997, we havederived more than 50% of our annual revenue from sales outside North America,primarily in Japan, other Asian countries and Europe. No individual countrywithin Asia, except Japan and Taiwan, and no individual country within Europerepresented 10% or more of total revenue in 2005, 2004 or 2003. Geographicrevenue was as follows (in thousands):

 
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States |       | $                                          | 23,877     |   | $ | 24,762 |   | $ | 24,708 |   |
| Japan         |       | 15,085                                     |       | 14,909 |   | 11,838 |   |
| Taiwan        |       | 7,612                                      |       | 6,853 |   | 3,631 |   |
| Other         |       | 27,063                                     |       | 17,891 |   | 10,379 |   |
|          |       | $                                          | 73,637     |   | $ | 64,415 |   | $ | 50,556 |   |

 

We expect internationalsales to continue to represent a substantial portion of our revenue for theforeseeable future. In the past, the economic climate in some foreign markets,particularly in Asia, has quickly and dramatically changed, resulting in anegative effect on our operating results. For example, during the Asian economiccrisis that began in 1998, we saw a 34% decline in revenue in 1998 compared to1997 from Asia not including Japan. We saw a 41% decrease in revenue from thesame region in 2003 compared to 2001.

 

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

 

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

 

•                  the possible lack of financial and political stabilityin foreign countries, preventing overseas sales growth;

 

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

 

•                  longer payment cycles;

 

•                  differing and more burdensome labor regulations andpractices in Europe;

 

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

 

•                  the effects of sudden outbreaks of epidemics in Asiaand other parts of the world; and

 

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

 

The different cultures incountries where we do business often challenge us to meet or manage localexpectations about how employees are hired, managed, compensated, orterminated. For example, most employees in Japan expect an organization whereina manager’s direct reports are younger than the manager. In Europe, governmentsforce the severance costs of a reduction in force action to be generally muchhigher than in the U.S.

 

Finally, there have beensignificant fluctuations in the exchange rates between the dollar and thecurrencies of countries in which we do business. While most of our internationalsales have been denominated in U.S. dollars, our international operatingexpenses have been denominated in foreign currencies. As a result, a decreasein the value of the U.S. dollar relative to the foreign currencies couldincrease the relative costs of our overseas operations, which could reduce ouroperating margins. Significant unfavorable fluctuations in the exchange ratesbetween the U.S. dollar and foreign currencies could cause us to lower ourprices and thus reduce our profitability. In addition, fluctuations in exchangerates could cause customers to delay or cancel orders because of the increasedcost of our products relative to those of our competitors who manufacture inother countries. Other income (expense), net in 2005, 2004 and 2003 includesthe following currency related gains and losses (in thousands):

 
| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Gains related to  foreign currency hedges              |       | $                                          | 151,000    |   | $ | 74,000 |   | $ | 49,000 |   |
| Remeasurement  related foreign currency gains (losses) |       | (34,000                                    | )          | 132,000 |   | 318,000 |   |
|                                                   |       | $                                          | 117,000    |   | $ | 206,000 |   | $ | 367,000 |   |

 

**Werely on independent manufacturers’ representatives and distributors for asignificant portion of our revenue, and a disruption in our relationship withour manufacturers’ representatives or distributors would have a materialadverse effect on our revenue.**

 

Approximately 72% of ourrevenue for 2005 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,

 

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and we do not effectivelyand efficiently manage such a change, we could lose sales to existing customersand fail to obtain new customers. Establishing alternative sales channels wouldconsume substantial time and resources, decrease our revenue and increase ourexpenses.

 

**Ifsemiconductor manufacturers do not convert to 300mm wafers, or do not convertat the rate we anticipate, our growth and profitability could be harmed.**

 

The 2001 to 2003 downturnin the semiconductor industry caused various chip manufacturers to readdresstheir respective strategies for converting existing 200mm wafer fabricationfacilities to 300mm wafer fabrication or for building new 300mm waferfabrication facilities. Some manufacturers, including some of our customerssuch as Texas Instruments, Motorola and ST Microelectronics delayed, cancelledor postponed previously announced plans to convert to 300mm wafer fabrication. Whilewe have since then seen an increase in these conversion efforts, these delayshave impacted demand for our 300mm probe stations. We believe that the decisionto convert to a 300mm wafer fabrication facility is made by each manufacturerbased upon both internal and external factors, such as:

 

•                  current and projected prices for semiconductors;

 

•                  projected price erosion for the manufacturer’sparticular semiconductors;

 

•                  supply and demand levels for semiconductors;

 

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

 

•                  the availability of funds to the manufacturer;

 

•                  the technology roadmap of the manufacturer; and

 

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

 

One or more of these internaland external factors, as well as other factors, including factors that amanufacturer may choose not to disclose publicly, could impact the decision tomaintain a 300mm conversion schedule, to delay the conversion schedule for aperiod of time or to cancel the conversion. We have invested significantresources to develop technology that addresses the market for 300mm wafers. Beginningin 2003 and continuing into early 2005, we saw an acceleration in thetransition from 200mm to 300mm technology but since then the rate ofacceleration has declined. If manufacturers delay or discontinue the transitionto 300mm wafers, or make the transition more slowly than we currently expect,our growth and profitability could be affected.

 

**Failureto retain key managerial, technical, and sales and marketing personnel or toattract new key personnel could harm our business.**

 

Our success depends onthe continued services of our executive officers and other key management,technical, and sales and marketing personnel and on our ability to continue toattract, retain and motivate qualified personnel. Currently, our key personnelinclude Eric Strid, our Chairman, President and Chief Executive Officer, BruceMcFadden, our Vice President and General Manager, Pyramid Probe Division,Steven Sipowicz, our Chief Financial Officer, John Pence, our Vice Presidentand General Manager, Engineering Products Division and K. Reed Gleason,our Vice President of Advanced Technology. Our executive officers and other keyemployees are able to exercise stock options and sell the underlying stock,which may reduce their incentive to continue their employment with us. The lossof key personnel could limit our ability to develop new products and adapt existingproducts to our customers’ evolving requirements and may result in lost salesand a diversion of management resources. Furthermore, much of our competitiveadvantage and intellectual property is based on the expertise, experience andknow-how of our key personnel. We do not have employment agreements ornon-competition agreements with any of our employees except for an employmentagreement with our Chief Financial Officer. To support our future growth, wewill need to attract and retain additional qualified management, technical, andsales and marketing employees. Competition for such personnel in our industryis intense, and we cannot assure you that we will be successful in attractingand retaining such personnel.

 

18

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**Ourcustomers’ evaluation processes can lead to lengthy sales cycles, during whichwe may incur significant costs that may not result in sales.**

 

Our customers typicallyexpend significant efforts in evaluating and qualifying our products prior toplacing an order, particularly for orders of engineering probe stations andproduction probe cards. This evaluation and qualification process frequentlyresults in a lengthy sales cycle, typically ranging from three to12 months and sometimes longer. During the period in which our customersare evaluating our products, we incur substantial sales, marketing, researchand development expenses and expend significant management efforts. Aftercompleting 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.

 

Additional factors, someof which are partially or completely outside our control, that affect thelength of time it takes us to complete a sale, include:

 

•                  the efforts of our sales force;

 

•                  the history of previous sales to the customer;

 

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

 

•                  the internal technical capabilities and sophisticationof the customer; and

 

•                  the capital expenditure budgets of the customer.

 

The lengthy andunpredictable nature of our sales cycle could result in fluctuations in our operatingresults, which could fall below the expectations of analysts and investors forany particular period of time, and result in a decline in the price of ourcommon stock.

 

**Ifour products contain defects, our reputation would be damaged, and we could losecustomers and revenue and incur warranty expenses.**

 

The complexity andongoing development of our products, as well as the inclusion in our productsof components purchased from third parties, could lead to design, manufacturingor performance problems. Our products may contain defects which could cause oursales to decline, our reputation to be significantly damaged and our customersto be reluctant to buy our products, any or all of which could result in adecline in revenue, an increase in product returns, higher field service costs,the loss of existing customers or the failure to attract new customers. Ourwarranty expense totaled $624,000, $639,000 and $679,000, for 2005, 2004 and2003, respectively. Although we are not currently seeking reimbursement fromany vendors related to our warranty expense, we have in the past, and may againin the future, seek reimbursement from certain vendors. To the extent that weexperience additional failures of purchased components that increase ourwarranty expenses that are not reimbursed by the vendor, our results ofoperations will be adversely affected.

 

**Ifwe fail to protect our proprietary technology and rights, competitors may beable to use our technologies, which would weaken our competitive position and couldreduce our sales.**

 

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

 

19

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Unauthorized parties mayattempt to copy aspects of our products or to obtain and use information thatwe regard as proprietary. Others may independently develop or otherwise acquiresimilar or competing technologies or methods or design around our patents.Additionally, some of our proprietary technology cannot be effectivelyprotected by patents. In these cases, we rely on trade secret laws andconfidentiality 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.

 

Since 1997, we have derivedmore than 50% of our annual revenue from products sold to customers outside ofNorth America. The laws of some foreign countries do not protect ourproprietary rights to the same extent as the laws of the United States, andmany companies have encountered substantial problems in protecting theirproprietary rights against infringement in such countries. The manner in whichwe 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.

 

**Intellectualproperty infringement claims by or against us may result in litigation, thecost of which could be substantial and could prevent us from selling ourproducts.**

 

The semiconductorindustry is characterized by uncertain and conflicting intellectual propertyclaims, frequent litigation regarding patent and other intellectual propertyrights and vigorous protection and pursuit of these rights. Questions ofinfringement in the semiconductor industry involve highly technical andsubjective analyses. Litigation may be necessary to determine the validity andscope of our proprietary rights or to defend against claims of infringement orinvalidity by third parties, and we may not prevail in any litigation. Any suchlitigation, whether or not determined in our favor or settled, might be costly,could harm our reputation, could cause product shipment delays and could divertthe efforts and attention of our management and technical personnel from ournormal business operations. We are not currently involved in any suchlitigation. However, an adverse outcome in any intellectual property litigationmight result in the loss of our proprietary rights, subject us to significantliabilities, require us to spend significant resources to developnon-infringing technology, require us to seek licenses from third parties,prevent us from manufacturing and selling our products or require us todiscontinue the use of certain technology in our products, any of which couldhave an adverse effect on our business, financial condition and results of operations.License agreements, if required, might not be available on terms acceptable tous or at all.

 

**Ourgrowth could strain our personnel and infrastructure resources, and, if we areunable to implement appropriate controls and procedures to manage our growth,we may not be able to successfully implement our business plan.**

 

Our growth has placed andwill continue to place significant demands on our management, operational,financial and technical resources and on our internal control, management informationand reporting systems. Our success will depend, in part, upon the ability ofour senior management to manage this growth effectively. To manage the expectedgrowth of our operations and personnel, we will need to:

 

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

 

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

 

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

 

20

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**Oursuccess depends on our continued investment in research and development, thelevel and effectiveness of which could reduce our profitability.**

 

We will continue to makeinvestments in research and development to sustain and improve our competitiveposition and meet our customers’ needs. These investments currently includerefining Pyramid Probe fabrication processes, developing higher performancePyramid Probe cards and enhancing engineering probe stations for both 300mm andsub-300mm wafers. To maintain our competitive position, we may need to increaseour research and development investment, which could reduce our profitability.In addition, we cannot assure you that we will achieve a return on theseinvestments, nor can we assure you that these investments will improve ourcompetitive position and meet our customers’ needs.

 

**Wemanufacture nearly all of our products at our Oregon facilities, and anydisruption in the operations of these facilities could harm our business.**

 

We manufacture almost allof our products in our facilities located in Beaverton, Oregon. Ourmanufacturing processes are complex and require sophisticated and costlyequipment 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.

 

**Adisruption in our strategic relationship with Agilent Technologies could have anegative effect on our ability to market our products and could result in adecline in the price of our common stock.**

 

We have a longstandingrelationship with Agilent Technologies in which we jointly market selectedprobing solutions, comprised of products from both companies. Consequently, ourrelationship with Agilent is an important factor in our ability to market ourproducts. Our joint marketing relationship with Agilent is not governed by acontract. Therefore, Agilent could terminate its relationship with us orannounce a strategic relationship with one of our competitors at any time.While we do not track the portion of our revenue that is attributable to ourjoint marketing relationship with Agilent, we believe that a termination of ourrelationship with Agilent could harm our ability to market our products andcould result in a decline in the price of our common stock.

 

Furthermore, in thosesituations in which a customer purchases our products alongside Agilent’sproducts, we depend on Agilent’s ability to timely deliver its products tocomplete the installation of our product. To the extent that there is a delayin the shipment of Agilent’s products, the timing of our revenue could beadversely affected, which could cause us to miss the earnings expectations ofanalysts and investors and result in a decline in the price of our commonstock.

 

**Wemay fail to comply with environmental regulations, which could result insignificant costs and harm our business.**

 

We are subject to avariety of federal, state and local laws, rules and regulations relating to thestorage, use, discharge, disposal and human exposure to hazardous and toxicmaterials used in our thin-film fabrication facility and other manufacturingoperations. The risk of a release of hazardous or toxic materials cannot becompletely 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. Our past, present orfuture failure to comply with environmental laws and regulations could resultin enforcement actions, substantial liabilities and suspension of production orcessation of operations in extreme situations. Compliance with current orfuture environmental laws and regulations could restrict our ability to expandour facilities or build new facilities or require us to acquire additionalexpensive equipment, modify our manufacturing processes, or incur othersubstantial expenses which could harm our business, financial condition andresults of operation. For example, the European

 

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Parliament has finalizedthe Restriction on Use of Hazardous Substances Directive, or RoHS Directive,which restricts the sale of new electrical and electronic equipment containingcertain hazardous substances, including lead, which is currently used in someof the products we manufacture. We are working to modify our manufacturingprocesses to eliminate lead from products we put on the market by July 1,2006 as required by the RoHS Directive. We are working with our suppliers toredesign or reformulate their components containing lead to reduce or eliminatelead in our products. Further, we are working with selected customers whospecify and/or provide specific components used in some of our products tochoose components that comply with the RoHS Directive. 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.

 

**Productliability claims may be asserted against us, resulting in costly litigation forwhich we may not have sufficient liability insurance.**

 

Our customers may use ourproducts in the testing of high reliability semiconductors for criticalapplications such as telecommunications infrastructure, military, medical andaerospace equipment. Defects or other problems with the performance of ourproducts could result in financial or other damages to our customers. Inaddition, some of our engineering probe stations that use high powered lasersor operate at high voltage or extreme temperatures may cause death or injury topersons utilizing such equipment due to undetected design or manufacturingdefects or due to improper use or maintenance by our customers. Although ourproduct invoices and sales contracts generally contain provisions designed tolimit our exposure to product liability claims, existing or future laws orunfavorable judicial decisions could negate these provisions. Product liabilitylitigation against us, even if it were unsuccessful, could be time consumingand costly to defend. Additionally, although we carry product liabilityinsurance, in some circumstances it may not cover certain claims or be adequateto cover all claims.

 

**Werely on a small number of customers for a significant portion of our revenue,and the termination of any of these relationships would adversely affect ourbusiness.**

 

Our top four customersaccounted for 16% and 18% of our revenue in 2005 and 2004, respectively. Ourcustomers are not obligated by long-term contracts to purchase our products andmay discontinue purchasing our products at any time. The semiconductor industryis highly concentrated and a small number of semiconductor manufacturersgenerally account for a substantial portion of the purchases of semiconductortest equipment, including our products. Consequently, our business andoperating results would be materially, adversely affected by the loss of any ofour significant customers.

 

In addition, our abilityto increase our revenue will depend in part upon our ability to obtain ordersfrom new customers, particularly customers of our production probe cards.Obtaining orders from new customers is difficult because semiconductormanufacturers typically select one vendor’s products for testing a particularnew generation of chips. Once a manufacturer has selected a vendor, thatmanufacturer is more likely to continue to purchase products from that vendorfor that generation of chips, as well as subsequent generations of chips. Wetherefore place great emphasis on relationships with our current customersbecause these customers are difficult to replace. In addition, we focus onleveraging our relationships with current customers to sell into additionalengineering labs

 

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and production lines inthe same company and similar groups in other companies. If we are unable tomaintain our relationships with our existing significant customers or to obtainnew customers that adopt and implement our products and technology, we will notbe able to meet our revenue and growth targets, which could result in a declinein the price of our common stock.

 

**Ouremployment costs in the short-term are, to a large extent, fixed, andtherefore, any shortfall in sales would harm our operating results.**

 

Our operating expenselevels are based, in significant part, on our headcount. For a variety ofreasons, particularly the high cost and disruption of layoffs, the costs ofrecruiting 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.

 

**Theadditional costs that we incur as a result of being a public company willaffect our operating results.**

 

We incurred incrementalcosts as a public company for additional expenses such as increased auditingand legal fees and director and officer liability insurance, which increasedour operating expenses and make it more difficult for us to offset any futurerevenue shortfalls by offsetting expense reductions in the short-term. Inaddition, the Sarbanes-Oxley Act of 2002, as well as new rules and regulationssubsequently enacted by the Securities and Exchange Commission, or the SEC, andthe Nasdaq National Market have imposed new corporate governance requirementsfor listed companies. We expect these rules to increase our legal and financialcompliance costs and to make some activities more difficult, time consuming andcostly. We also expect these new rules and regulations to make it moredifficult and more expensive for us to obtain director and officer liabilityinsurance, and we may be required to accept reduced coverage or incursubstantially higher costs to obtain coverage. These new rules and regulationscould also make it more difficult for us to attract and retain qualifiedmembers of our board of directors and qualified executive officers.

 

##### **Unanticipated changes in our tax rates orexposure to additional income tax liabilities could affect our profitability.**

##### ** **

##### **We are subject to income taxes in both the UnitedStates and various foreign jurisdictions, and our domestic and internationaltax liabilities are subject to the allocation of expenses in differentjurisdictions. Our effective tax rate could be adversely affected by changes inthe mix of earnings in countries with different statutory tax rates, changes inthe valuation of deferred tax assets and liabilities, changes in tax laws,including pending tax law changes, such as the benefit from export sales andthe research and development credit by material audit assessments. Inparticular, the carrying value of deferred tax assets, which are predominantlyin the United States, is dependent on our ability to generate future taxableincome in the United States. In addition, the amount of income taxes we paycould be subject to ongoing audits in various jurisdictions and a materialassessment by a governing tax authority could affect our profitability.**

##### ** **

**Ourofficers and directors and their affiliates will control the outcome of mattersrequiring shareholder approval.**

 

Our executive officersand directors and their affiliates beneficially own approximately 32% of ouroutstanding shares of common stock. Consequently, these shareholders will have substantialinfluence over the election of our directors and the outcome of corporateactions requiring shareholder approval, such as a merger or a sale of ourcompany or a sale of all or substantially all of our assets. This concentrationof voting power and control could have a significant effect in delaying,deferring or preventing an action that might otherwise be beneficial to ourother shareholders and be disadvantageous to our shareholders with interestsdifferent from those of our officers, directors and affiliates. Theseshareholders will also have significant control over our business, policies andaffairs.

 

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Additionally, thissignificant concentration of share ownership may adversely affect the tradingprice for our common stock because investors often perceive disadvantages inowning stock in companies with controlling shareholders.

 

**Theanti-takeover provisions of our charter documents and Oregon law may inhibit atakeover or change in our control that shareholders may consider beneficial.**

 

Provisions of ourarticles of incorporation and bylaws and provisions of Oregon law may have theeffect of delaying or preventing a merger or acquisition of us, making a mergeror acquisition of us less desirable to a potential acquirer or preventing achange in our management, even if the shareholders consider the merger oracquisition favorable or if doing so would benefit our shareholders. Inaddition, 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 willmake it more difficult for a group of shareholders to quickly change thecomposition of our board.

 

•                  Our board of directors is authorized, without priorshareholder approval, to create and issue preferred stock with voting or otherrights or preferences that could impede the success of any attempt to acquireus or change our control, commonly referred to as “blank check” preferredstock.

 

•                  Members of our board of directors can only be removedfor cause.

 

•                  The board of directors may alter our bylaws withoutobtaining shareholder approval.

 

•                  Shareholders are required to provide advance noticefor nominations for election to the board of directors or for proposing mattersto be acted upon at a shareholder meeting.

 

•                  Any action that is taken by written consent ofshareholders must be unanimous.

 

We are also subject tothe provisions of the Oregon Control Share Act and the Oregon BusinessCombination Act, each of which may have certain anti-takeover effects.

 

**Ifour stock price is volatile, securities class action litigation may be broughtagainst us, which could result in substantial costs.**

 

In the past, securitiesclass action litigation has often been brought against a company followingperiods of volatility in the market price of its securities, and newly publiccompanies tend to experience more volatility in their stock price. We may bethe target of such litigation in the future. Securities litigation may resultin substantial costs and divert management’s attention and resources, which mayseriously harm our business.

 

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

##### ** **

None.

 

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

##### ** **

We maintain our corporateheadquarters in Beaverton, Oregon. Our primary site contains corporateadministration, sales and marketing, design, test, light manufacturing andassembly and various support functions in leased space totaling 102,438 squarefeet in three adjacent buildings. The space we lease in an adjoining building,totaling 23,000 square feet, is available for sub-lease. This lease expires inJune 2008. The lease on the remaining space in a third building expires atthe end of January 2007. Under the terms of the lease, current rent on theprimary site is approximately $115,000 per month. Our Pyramid Probe manufacturingis conducted in a 10,000 square foot clean room within a 58,817 square footfacility that we lease at a separate site in Beaverton, Oregon. Our lease ofthis facility expires in August 2009 and current rent is approximately $67,500per month. Approximately 10,000 square feet of this facility is available forsub-lease. We lease small sales and service offices in Tokyo, Japan, Banbury,England and Singapore.

 

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

##### ** **

As of the date of filingthis Form 10-K, we are not a party to any material legal proceedings. However,the semiconductor test industry is characterized by vigorous protection andpursuit of intellectual property rights and positions. To protect ourintellectual property from infringement, we have from time to time initiatedlitigation against third parties and may be required to do so in the future. Wecannot assure you that we will be successful in future intellectual propertylitigation and this litigation often is protracted and expensive; however,until now we have successfully defended our intellectual property in threelawsuits and successfully defended ourselves in one case of allegedinfringement.

 

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

##### ** **

No matters were submittedto a vote of security holders during the fourth quarter of 2005.

 

#### **PARTII**

#### ** **

| **ITEM 5.** | **MARKET FOR THE  REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES  OF EQUITY SECURITIES** |
|-------------|-----------------------------------------------------------------------------------------------------------------------------|

** **

Our common stock began tradingon the Nasdaq National Market System under the symbol “CSCD” on December 15,2004. The high and low closing sale price of our common stock by quarter fromDecember 14, 2004 through December 31, 2005 was as follows:

 
| **2004**  | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------|------------|----------|------------|---------|------------|
| Quarter 4 |       | $        | 14.14      |    | $          | 13.29 |   |
|           |            |          |            |         |            |  |  |

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

 

As of March 9, 2006,there were 74 shareholders of record. Many shareholders hold their shares instreet name. We believe we currently have approximately 1,400 beneficialshareholders.

 

Wehave not declared or paid any cash dividends on our common stock in the pasttwo years. We currently expect to retain any future earnings to fund theoperation and expansion of our business, and therefore, we do not currentlyexpect to pay cash dividends in the foreseeable future.

 

Wefiled a registration statement on Form S-1, File No. 333-113256 for an initialpublic offering of common stock, which was declared effective by the Securitiesand 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 $41.6 million. As of December 31, 2005, we had used approximately $5.5million of those proceeds for the repayment of indebtedness. No payments weremade to our directors or officers or their associates, holders of 10% or moreof any class of our equity securities or to any affiliates.

 

SeeItem 12. for Equity Compensation Plan Information.

 

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

##### ** **

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

 
| ** **                                                             | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **IN THOUSANDS  (except per share amounts)**       | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statement  of Operations Data**                                      |       |                                                         |       |   |   |   |   |   |   |   |   |
| Revenue                                                                |       | $                                                            | 73,637     |   | $ | 64,415 |   | $ | 50,556 |   | $ | 51,107 |   | $ | 72,296 |   |
|                                                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
| Cost of sales                                                          |       | 39,351                                                       |       | 35,625 |   | 30,433 |   | 33,357 |   | 42,055 |   |
| Stock-based  compensation                                              |       | 39                                                           |       | 67 |   | 19 |   | 6 |   | 19 |   |
| Gross profit                                                           |       | 34,247                                                       |       | 28,723 |   | 20,104 |   | 17,744 |   | 30,222 |   |
| Operating  expenses:                                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
| Research and  development                                              |       | 6,951                                                        |       | 5,651 |   | 5,407 |   | 6,265 |   | 7,801 |   |
| Selling, general  and administrative                                   |       | 19,712                                                       |       | 16,602 |   | 15,293 |   | 16,180 |   | 17,894 |   |
| Stock-based  compensation                                              |       | 83                                                           |       | 259 |   | 158 |   | (14 | ) | 115 |   |
| Total operating  expenses                                              |       | 26,746                                                       |       | 22,512 |   | 20,858 |   | 22,431 |   | 25,810 |   |
| Income (loss)  from operations                                         |       | 7,501                                                        |       | 6,211 |   | (754 | ) | (4,687 | ) | 4,412 |   |
| Other income  (expense), net                                           |       | 1,991                                                        |       | (117 | ) | 553 |   | 385 |   | 429 |   |
| Income (loss)  before income taxes                                     |       | 9,492                                                        |       | 6,094 |   | (201 | ) | (4,302 | ) | 4,841 |   |
| Provision  (benefit) for income taxes                                  |       | 1,173                                                        |       | 1,387 |   | 248 |   | (2,244 | ) | 950 |   |
| Net income  (loss)                                                     |       | 8,319                                                        |       | 4,707 |   | (449 | ) | (2,058 | ) | 3,891 |   |
| Accretion of  redeemable stock and loss on redemption                  |       | —                                                       |       | 113 |   | 583 |   | 362 |   | 358 |   |
| Net income  (loss) attributed to common shareholders                   |       | $                                                            | 8,319      |   | $ | 4,594 |   | $ | (1,032 | ) | $ | (2,420 | ) | $ | 3,533 |   |
| Basic net income  (loss) per share attributed to common shareholders   |       | $                                                            | 0.75       |   | $ | 0.84 |   | $ | (0.20 | ) | $ | (0.48 | ) | $ | 0.70 |   |
| Diluted net  income (loss) per share attributed to common shareholders |       | $                                                            | 0.70       |   | $ | 0.56 |   | $ | (0.20 | ) | $ | (0.48 | ) | $ | 0.41 |   |
| Shares used in  basic per share calculations                           |       | 11,055                                                       |       | 5,439 |   | 5,089 |   | 5,015 |   | 5,015 |   |
| Shares used in  diluted per share calculations                         |       | 11,816                                                       |       | 8,452 |   | 5,089 |   | 5,015 |   | 9,482 |   |

 
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|
| **Balance Sheet Data**                                    | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash, cash  equivalents and short-term marketable securities        |       | $                     | 50,346     |   | $ | 43,747 |   | $ | 10,717 |   | $ | 8,632 |   | $ | 10,950 |   |
| Working capital                                                     |       | 74,601                |       | 63,333 |   | 24,228 |   | 25,573 |   | 26,846 |   |
| Total assets                                                        |       | 90,120                |       | 79,016 |   | 37,766 |   | 40,815 |   | 43,775 |   |
| Current portion  of long-term debt and capital lease obligations    |       | 8                     |       | 21 |   | 2,043 |   | 21 |   | 122 |   |
| Long-term debt  and capital lease obligations, less current portion |       | —                |       | 14 |   | 5,038 |   | 25 |   | 43 |   |
| Other long-term  liabilities                                        |       | 1,100                 |       | 1,449 |   | 1,398 |   | 1,622 |   | 1,045 |   |
| Redeemable stock                                                    |       | —                |       | — |   | 584 |   | 10,152 |   | 10,864 |   |
| Shareholders’  equity                                          |       | 81,505                |       | 70,188 |   | 22,960 |   | 23,848 |   | 25,432 |   |
|                                                                     |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| **ITEM 7.** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------|

** **

*Youshould read the following discussion in conjunction with our consolidatedfinancial statements and notes thereto appearing elsewhere in this Form 10-K.In addition to historical consolidated financial information, the followingdiscussion and analysis contains forward-looking statements that involve risks,uncertainties and assumptions. Our actual results could differ materially fromthose anticipated by these forward-looking statements as a result of manyfactors, including those discussed under Item 1A, Part I, “Risk Factors,” andelsewhere in this Form 10-K. We do not guarantee future results, levels ofactivity, 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 design, develop andmanufacture advanced wafer probing solutions for the electrical measurement ofhigh performance chips. We design, manufacture and assemble our products inBeaverton, Oregon, with global sales, service and support centers in NorthAmerica, Europe, Japan and Singapore. We were incorporated and introduced ourfirst commercial products in 1984.

 

Our products includeengineering probe stations, analytical probes, production probe cards,application software and services. Engineering probe stations address the needfor precise and accurate measurement of semiconductor electricalcharacteristics during chip design or when optimizing the chip fabricationprocess. Our engineering probe stations are highly configurable and aretypically sold with various accessories, including our analytical probes andapplication software, as well as accessories from third parties. In addition,we design and build custom engineering probe stations to address the specificrequirements of our customers. Analytical probes are sold to serve ascomponents of our engineering probe stations, or less often, to serve ascomponents of test equipment manufactured by third parties. Our productionprobe cards are designed and sold for production test applications, rangingfrom very low current parametric testing to sophisticated, high speed radiofrequency testing. We refer to analytical probes and production probe cards asconsumables, as they are routinely replaced during the testing process. We alsogenerate revenue through the sale of service contracts to our customers.

 

To date, we have derivedthe majority of our revenue from the sale of our engineering probe stations,and we expect to continue to do so for the next few years. Our production probecard revenue, however, has increased as a percentage of total revenues in 2005and we expect that trend to continue in 2006.

 

Our engineering probestations, analytical probes, probing accessories and application software aresold through our Engineering Products Division. Our production probe cards aresold through our Pyramid Probe Division. As of January 2005, we collect onlyrevenue information for each division because we believe that the segment datapreviously collected was not useful for understanding our business and was notuseful information on which to base operating decisions. Accordingly, beginningin the first quarter of 2005, the segment reporting financial statementfootnote only presents revenue data for each segment.

 

Our engineering products businessand operating results depend in significant part on the level of capitalexpenditures related to semiconductor research and development, which, in turn,depends upon current and anticipated market demand for chips. Historically, thesemiconductor industry has been highly cyclical with recurring periods ofover-supply, which has often resulted in a reduction in demand for ourproducts. While our financial results are impacted by cycles within thesemiconductor industry, we believe our business cycles are typically lesspronounced than those of other semiconductor equipment companies. We believethis is due to our greater reliance on our customers’ research and developmentcapital spending and usage of test consumables rather than on our customers’spending to increase production capacity. Capital spending aimed at increasing

 

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production capacity isone of the first areas in which most semiconductor manufacturers reducespending in an industry downturn.

 

While the conversion to300mm technology continues, high conversion costs combined with continuedprocess developments on 200mm wafers continue to make sales of our sub-300mmprobing systems an important component of our revenue stream for the foreseeablefuture. 300mm technology more than doubles the available area on a wafer,significantly increasing the number of chips per wafer and reducing per unitmanufacturing costs.

 

Revenue from our 300mmengineering probe stations, including all probes, accessories and other itemssold therewith, represented 33.0%, 32.2% and 26.1% of our total EngineeringProducts Division revenue in 2005, 2004 and 2003, respectively.

 

We sell our products bothdirectly through our own sales force and indirectly through a combination ofmanufacturers’ representatives and distributors. In North America and Asia,excluding Japan, Singapore and Malaysia, we sell most of our products throughmanufacturers’ representatives. We sell certain products in these regionsdirectly. In Japan, Singapore and Malaysia, we sell through Cascade MicrotechJapan, 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. We are currently in the processof establishing a distribution sales office in China and a direct sales officein Taiwan. Our distributors normally place orders with us once they havereceived an order from an end-user customer, and, therefore, the total amountof inventory held by our distributors at any given date is not material.

 

In the past, our businesshas experienced seasonality. Typically, our revenue has been lower in ourfiscal first quarter than in our fiscal fourth quarter preceding it. However,revenue in the first quarter of 2005 was greater than the revenue in the fourthquarter of 2004 as strength in the Asian market outweighed the seasonalityfactors. Also, we expect our revenue in the first quarter of 2006 to be greaterthan our revenue in the fourth quarter of 2005 due to delays in closing certainorders in the fourth quarter of 2005. In addition, as is typical in ourindustry, we recognize a large percentage of our quarterly revenue in the lastmonth of the quarter.

 

We sell our solutions tomost segments of the semiconductor industry, including manufacturers ofcommunications, wireless, microprocessors and other logic and memory chips. Asubstantial portion of our revenue is generated from sales of our engineeringprobe stations and analytical probes to research and development laboratoriesof semiconductor manufacturers as well as to fabless semiconductor companiesand academic institutions. As a result, we sell to a geographically diversifiedcustomer base, with more than 50% of our revenue in 2005, 2004 and 2003generated outside of North America, primarily in Japan, other Asian countriesand, to a lesser extent, Europe.

 

Cost of sales includespurchased materials, fabrication, assembly, test and installation labor andoverhead, customer-specific engineering costs, warranty costs, royalties andprovision for inventory valuation reserves.

 

Fluctuations in grossprofit as a percentage of revenue, or gross margin, primarily result fromchanges in geographic mix, product mix, general pricing dynamics and yields insome of our production lines. Sales in Europe typically have a lower marginthan sales in North America and Japan due to our use of third-partydistributors in Europe. We typically achieve higher margins on our consumablesthan on our engineering probe stations. Gross margin will also vary dependingon our revenue levels, the level of overhead absorption, and, to a lesserextent, the success of our ongoing productivity improvements and componentprices. In addition, as we add production related personnel and equipment andthird-party costs to improve lead times, this will cause gross margins todecline if this does not result in additional revenue in the same quarter.

 

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Research and developmentcosts are expensed as incurred and include compensation and related expensesfor personnel, materials, consultants and overhead. From time to time, we enterinto arrangements that provide for the reimbursement of research anddevelopment expenses. Such reimbursements are netted against gross research anddevelopment expenses. In addition, our research and development expensesfluctuate from quarter to quarter depending on the usage level of ourproduction probe fab for research and development activity. Research anddevelopment expenses do not include costs to obtain patents or defend ourintellectual property rights, consisting of patents and trademarks, oramortization of capitalized patents and trademarks. Such expenses are includedwith selling, general and administrative. Research and development expensesalso do not include expenses for design work on custom orders that do notresult in reusable technology. Such expenses are included as a component ofcost of sales.

 

Selling, general andadministrative, or SG&A, expenses include compensation and related expensesfor personnel, travel, outside services, manufacturers’ representativecommissions, patent and trademark amortization and overhead incurred in oursales, marketing, customer support, management, legal and other professionaland administrative support functions, as well as costs to operate as a publiccompany.

 

Stock-based compensationincludes the amortization of value attributed to stock options granted duringthe one-year period prior to filing our registration statement for our initialpublic offering in 2004, as well as amortization of deferred stock-basedcompensation related to option grants at the time we filed a registrationstatement for our planned initial public offering in 2000. The stock optionsgranted during these periods were granted at the fair market value of ourcommon stock on the date of grant, as determined by our Board of Directors, andare accounted for using the intrinsic value method as prescribed by AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued toEmployees.” Given the lack of an active public market for our outstandingcommon stock at the time, our Board of Directors established estimates of fairvalue for our common stock, as well as for options to purchase our commonstock, based on factors such as recent negotiated transactions, our financialcondition and recent operating results, our competitive position and futureprospects and analysis of financial data of comparable public companies.

 

Although we believed thatthe exercise price of the options granted prior to our 2004 initial publicoffering reflected the fair market value of our common stock on each grantdate, in anticipation of our initial public offering in 2004, we re-evaluatedthe fair market value of our common stock for the three-year period immediatelypreceding the filing of the registration statement. Based on such re-evaluationwe determined that the fair market value of our common stock during theone-year period prior to the filing of the registration statement exceeded theexercise price of options granted during such period. We therefore recordeddeferred compensation totaling the amount by which the re-assessed fair marketvalue of our common stock exceeded the exercise price of the options grantedduring the period. The balance of the deferred stock-based compensation was$142,000 as of December 31, 2005.

 

Other income (expense)typically includes interest income, interest expense, gains and losses on salesof investments and transaction and remeasurement related foreign currency gainsand losses. Other income (expense) can also include other miscellaneousnon-operating gains and losses. Transaction related foreign currency gains andlosses result from gains and losses recognized on foreign exchange forwardcontracts and on certain of our accounts receivable that are denominated inJapanese yen. Remeasurement related foreign currency gains result from theremeasurement of foreign currency denominated accounting records into U.S.dollars.

 

Accretion of redeemablestock and loss on redemption includes the accretion of certain costs related tothe issuance of our Series C convertible preferred stock and the cost ofredeeming certain shares of our common stock. In December 2003, weredeemed our Series C convertible preferred stock for cash and athree-year note and, accordingly, we recognized the remaining unaccreted costsof $219,000 as a loss upon the redemption.

 

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**Resultsof Operations**

 

The following table setsforth our consolidated statement of operations data for the periods indicatedas a percentage of revenue.(1)

 
| ** **                                                           | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| **IN THOUSANDS (except per share amounts)** | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Statement  of Operations Data**                                    |       |                                                         |       |   |   |   |   |
| Revenue                                                              |       | 100.0                                                        | %          | 100.0 | % | 100.0 | % |
| Cost of sales  and stock-based compensation                          |       | 53.5                                                         |       | 55.4 |   | 60.2 |   |
| Gross profit                                                         |       | 46.5                                                         |       | 44.6 |   | 39.8 |   |
| Operating  expenses:                                                 |       |                                                         |       |   |   |   |   |
| Research and  development                                            |       | 9.4                                                          |       | 8.8 |   | 10.7 |   |
| Selling, general  and administrative                                 |       | 26.8                                                         |       | 25.8 |   | 30.2 |   |
| Stock-based  compensation                                            |       | 0.1                                                          |       | 0.4 |   | 0.3 |   |
| Total operating  expenses                                            |       | 36.3                                                         |       | 34.9 |   | 41.3 |   |
| Income (loss)  from operations                                       |       | 10.2                                                         |       | 9.6 |   | (1.5 | ) |
| Other income  (expense), net                                         |       | 2.7                                                          |       | (0.2 | ) | 1.1 |   |
| Income (loss)  before income taxes                                   |       | 12.9                                                         |       | 9.5 |   | (0.4 | ) |
| Provision for  income taxes                                          |       | 1.6                                                          |       | 2.2 |   | 0.5 |   |
| Net income  (loss)                                                   |       | 11.3                                                         |       | 7.3 |   | (0.9 | ) |
| Accretion of  redeemable stock and loss on redemption                |       | —                                                       |       | 0.2 |   | 1.1 |   |
| Net income  (loss) attributed to common shareholders                 |       | 11.3                                                         | %          | 7.1 | % | (2.0 | )% |

 

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

##### ** **

***Revenue***

 

Revenue increased $9.2million, or 14.3%, to $73.6 million in 2005 compared to $64.4 millionin 2004 and increased $13.9 million, or 27.4%, in 2004 compared to$50.6 million in 2003.

 

Revenue in theEngineering Products Division increased $5.1 million, or 8.7%, to $63.5 millionin 2005 compared to $58.5 million in 2004 and increased$11.2 million, or 23.5%, in 2004 compared to $47.3 million in 2003.

 

The increase inEngineering Products revenue in 2005 compared to 2004 was primarily due to a 31.6%increase in unit sales of our engineering probe stations in 2005 compared to2004. The increase related to improved unit sales was partially offset by an overalldecrease in average order total of 14.9% in 2005 compared to 2004. Averageorder total includes the sales price of all analytical probes, probe cards andother accessories purchased with an engineering probe station.

 

The decrease in theoverall average order total included decreases for both 300mm and non-300mmstations in 2005 compared to 2004. The 300mm station average order totaldecreased 1.9% in 2005 compared to 2004, while the non-300mm station averageorder total decreased 18.4% in the same time period. The decrease in averageorder total for our 300mm stations was primarily due to a high average ordertotal comparison from the second half of 2004 due to the sale of units withadditional accessories in that period. The decrease in the non-300mm stationaverage order total was due primarily to the sale of a new, lower cost versionof one of our preexisting 200mm stations. While we currently sell a largernumber of non-300mm engineering probe stations than 300mm engineering probestations, we expect the trend of increased unit sales of 300mm probe stationsto continue into 2006 as the industry continues to shift to 300mm fabricationfacilities and as chip structures continually become increasingly complex.

 

The increase in revenuein the Engineering Products Division in 2004 compared to 2003 was primarily dueto an increase in the average order total, as well an overall increase in unitvolume. Average order total in the Engineering Products Division increased26.9% in 2004 compared to 2003, primarily due to

 

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a 40.4% increase in theunit volume of sales of our 300mm engineering probe stations, which have ahigher average selling price than our 200mm engineering probe stations.Offsetting the increase in 300mm unit volume, was a 4.2% decrease in unitvolume sales of our 200mm engineering probe stations in 2004 compared to 2003,for an overall increase in total unit volume sales of 4.6%. The increase inaverage order total was also attributable to an increase in sales ofaccessories and options ordered by customers with their engineering probestations in 2004 compared to 2003.

 

Revenue in the PyramidProbe Division increased $4.2 million, or 69.3%, to $10.1 million in2005 compared to $5.9 million in 2004 and increased $2.7 million, or85.2%, in 2004 compared to $3.2 million in 2003.

 

The increases in revenuein the Pyramid Probe Division in 2005 compared to 2004 and in 2004 compared to2003 were due to increases in the number of production probe cards sold. Whileour Pyramid probes still represent a small portion of our customers’ totalprobe card purchases, many of our large customers are now ordering our Pyramidprobes for numerous, mainstream, high-volume logic test applications,displacing their historical purchases of cantilever and vertical probe cards.We continue to have a significant share of the market in probe cards forwireless devices. We also expect to continue to increase our non-wirelessproduction probe card applications for a variety of wirebonded chip types. Wehave been adding probe card capabilities in the form of headcount and equipmentover the past several quarters. However, the strong demand has caused our leadtimes to increase. We expect to continue to add headcount and equipment in thecoming quarters in order to shorten the lead times.

 

Whenfully utilized, the capacity of our probe card microfabricationfacility is about $40 million annually with our current product mix.We are currently using less than one third of the facility’s capacity. Ourgrowth rate, therefore, relies on our ability to recruit and train enoughtop-quality people for product fulfillment and field support.

 

***Cost of Sales***

 

Cost of sales increased $3.8million, or 10.5%, to $39.4 million in 2005 compared to $35.6 millionin 2004 and increased $5.2 million, or 17.1%, in 2004 compared to$30.4 million in 2003.

 

The increase in cost ofsales in 2005 compared to 2004 was primarily due to the increase in revenuediscussed above, partially offset by an improvement in gross profit as a percentageof revenue discussed below.

 

The increase in cost ofsales in 2004 compared to 2003 was primarily due to the increase in unit volumesales of our engineering probe stations discussed above, partially offset byproduction improvements made during 2003 primarily related to our probe stationproduct platforms.

 

***Gross Profit***

 

Ourgross profit increased $5.5 million, or 19.2%, to $34.2 million in 2005compared to $28.7 million in 2004 and increased $8.6 million, or 42.9%, in2004 compared to $20.1 million in 2003.

 

The increase in our grossprofit in 2005 compared to 2004 was primarily attributable to the increaseddemand and production volumes of our products, as well as an improved productmix for a higher gross profit as a percentage of revenue in 2005 compared to2004. In 2005, the product mix included more Pyramid probe revenue, and,since the fixed costs of the Pyramid microfabrication facility are relativelyhigh, this revenue increase resulted in margin leverage for those products.

 

The increase in our grossprofit in 2004 compared to 2003 was primarily due to production improvements,efficiencies gained as production volumes increased, approximately $166,000 ofsavings due to improved component pricing with certain vendors, a $172,000decrease in inventory write-downs and a $40,000 decrease in warranty expense.The decrease in inventory write-downs was due to $180,000 of write-downs in2003 related to the poor adoption of one of our product lines that wasdiscontinued compared to only $9,000 of such write-downs in 2004.

 

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Gross profit as apercentage of revenue increased to 46.5% in 2005 compared to 44.6% in 2004 and39.8% in 2003.

 

The increase in our grossprofit as a percentage of revenue in 2005 compared to 2004 was primarily due toabsorption of fixed costs as sales volumes increased, particularly in thePyramid microfabrication facility, partially offset by a shift in mix to morenon-300mm systems as compared to 300mm systems in 2005 compared to 2004. Weachieve lower gross profit as a percentage of revenue on our non-300mm systemsthan we do on our 300mm systems.

 

The increase in our grossprofit as a percentage of revenue in 2004 compared to 2003 was due toproduction improvements, efficiencies gained as a result of an increase inproduction volumes, improved component pricing and decreases in inventorywrite-downs.

 

***Research andDevelopment***

 

Research and developmentexpenses increased $1.3 million, or 23.0%, to $7.0 million in 2005compared to $5.7 million in 2004 and increased $244,000, or 4.5%, in 2004compared to $5.4 million in 2003.

 

The increase in researchand development expenses in 2005 compared to 2004 was primarily due to a $329,000increase in contractor fees for new product development efforts, a $587,000increase in employee wages and related costs due to headcount increases andsalary adjustments in the latter half of 2004 and a $207,000 increase inproject supplies.

 

The increase in researchand development expenses in 2004 compared to 2003 was due primarily to only$94,000 of reimbursement of our research and development expenses on a jointproject in 2004 compared to $248,000 of such reimbursements in 2003. Theremainder of the increase resulted from contract labor related to developmentof reusable technology from customer specific orders.

 

***Selling,General and Administrative***

 

SG&A expenseincreased $3.1 million, or 18.7%, to $19.7 million in 2005 compared to $16.6 millionin 2004 and increased $1.3 million, or 8.6%, in 2004 compared to$15.3 million in 2003.

 

The increase in SG&Ain 2005 compared to 2004 was primarily due to an increase in representativecommissions, due to both the increase in revenues as well as an increase in thecommission rate in 2005 compared to 2004, an increase in employee wages andrelated costs due to headcount increases and salary adjustments in the latterhalf of 2004 and 2005, an increase in media advertising, an increase in legaland patent costs and an increase in other costs related to being a publiccompany, including director and officer insurance, accounting fees andSarbanes-Oxley Act compliance consultants as detailed below:

 
| **Amount of increase due to:** |   |      |    |
|----------------------------------------------------|--------|-----------|---------|
| Representative  commissions                        |   | $         | 610,000 |   |
| Employee wages  and related costs                  |   | 650,000   |    |
| Media  Advertising                                 |   | 188,000   |    |
| Legal and patent  costs                            |   | 287,000   |    |
| Public company  costs                              |   | 1,296,000 |    |
|                                                    |        |           |         |  |

 

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

 

The increase in SG&Ain 2004 compared to 2003 was primarily due to $180,000 of severance related tothe termination of our former Chief Financial Officer in the second quarter of2004 compared to $98,000 of severance in 2003. Representative commissions andemployee commissions increased $661,000, which was 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 andheadcount increases. Unfavorable changes in the exchange rate between the U.S.dollar and the Japanese yen in 2004 compared to 2003 contributed $236,000 tothe increase in 2004.

 

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***Stock-BasedCompensation***

 

Total stock-basedcompensation was $122,000 in 2005 compared to $326,000 in 2004 and $177,000 in2003.

 

Thedecrease in 2005 compared to 2004 was due to our accelerated amortizationmethod, wherein more expense is amortized in the early periods. In addition,the reversal of $265,000 of stock-based compensation in 2004, which included areversal of $117,000 related to the termination of our former Chief FinancialOfficer in the second quarter of 2004, lowered our future amortization.

 

In addition to normalamortization, stock-based compensation in 2004 included $86,000 due toaccelerated vesting of stock options related to the termination of our formerChief Financial Officer and is net of reversals for employee terminations of $265,000and $32,000 in 2004 and 2003, respectively. Stock-based compensation in 2004 includedthe amortization of value attributed to stock options issued in the one-yearperiod prior to filing the registration statement related to our 2004 initialpublic offering, whereas deferred stock compensation in 2003 included amortizationof deferred costs related to the grant of stock options at the time we filed aregistration statement for our planned initial public offering in 2000.

 

***Other Income(Expense)***

 

Interest incomerepresents interest earned on cash and cash equivalents and investments inmarketable securities and totaled $1.1 million, $133,000 and $164,000,respectively, in 2005, 2004 and 2003. The increase in 2005 compared to 2004 wasprimarily due to the increase in our invested balances as a result of proceedsreceived from our initial public offering in December 2004. The decrease in2004 compared to 2003 was primarily due to lower interest rates in 2004compared to 2003 and lower invested cash balances due to the payment of$3.0 million in the fourth quarter of 2003 for the conversion of ourSeries C preferred stock and the repayment of $7.0 million of a notepayable in 2004.

 

Interest expense was $18,000in 2005, of which $16,000 was related to interest on our $7.0 million notepayable for the portion of the 30-day prepayment notice period that occurred inJanuary 2005. We gave notice of prepayment and prepaid the remainder of our$7.0 million note payable and related interest in late December 2004. Interestexpense of $465,000 in 2004 represented interest on the $7.0 million notepayable, which resulted from the conversion of our Series C preferredstock in the fourth quarter of 2003.

 

Other, net totaled $948,000in 2005 compared to $215,000 in 2004 and $390,000 in 2003. Other, net wascomprised of the following (in thousands):

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Foreign currency  remeasurement gain (loss) |       | $                                          | (34        | ) | $ | 132 |   | $ | 318 |   |
| Foreign currency  transaction gain          |       | 151                                        |       | 74 |   | 49 |   |
| Settlement  income from a service provider  |       | 700                                        |       | — |   | — |   |
| Other                                       |       | 131                                        |       | 9 |   | 23 |   |
|                                        |       | $                                          | 948        |   | $ | 215 |   | $ | 390 |   |

 

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

 

***Income Taxes***

 

Our provision for incometaxes totaled $1.2 million, or 12.4%, of income before income taxes, in 2005compared to $1.4 million, or 22.8% of income before income taxes, in 2004 and$248,000, or 123.4%, of loss before income taxes in 2003.

 

Our 2005 tax rate differedfrom federal statutory tax rates primarily due to higher non-taxable income forboth federal and state income tax purposes, utilization of tax credits and therelease of prior year

 

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valuation allowancessince management believes the benefit of these credits is more likely than notto be utilized in future years.

 

Deferred tax assets arisefrom the tax benefit of amounts expensed for financial reporting purposesbut not yet realized for tax purposes and from unutilized tax credits and netoperating loss carry forwards. We evaluate our deferred tax assets on a regularbasis to determine if a valuation allowance is required. To the extent it isdetermined that it is more likely than not that we will not realize the benefitof our deferred tax assets, we record a valuation allowance against deferredtax assets. In 2005, we released $28,000 of valuation allowance related to thefuture realization of foreign tax credits and foreign net operating losses. Wenow believe it is more likely than not that the benefit of these credits andlosses will be realized in future periods based on anticipated future profits.The valuation allowance was $1.8 million as of both December 31, 2005 and 2004.

 

Our 2004 tax provisionincluded the reversal of $726,000 of previously recorded valuation allowancebased on our 2004 performance. The reversal primarily related to U.S. researchand engineering credits and state net operating loss carryforwards, which wereutilized during 2004. In addition, in 2004, we increased the valuationallowance by $761,000 for excess foreign tax credits and State of Oregonresearch and engineering credits, which we believe are more likely than not tonot be utilized in the future. The net result was an increase in valuationallowance in 2004 of $35,000. Tax expense, net of associated tax credits fortaxes paid in Japan, of $41,000 was recognized on the declaration of a $1.5million dividend from our Japanese subsidiary and is reflected in the taxprovision for 2004. We have not provided for United States income taxes on theremaining undistributed earnings of foreign subsidiaries because they areconsidered permanently invested outside of the United States. Uponrepatriation, some of these earnings would generate foreign tax credits whichmay reduce the United States tax liability associated with any future foreigndividend.

 

At December 31, 2005, wehad net deferred tax assets on our balance sheet totaling $2.0 million,primarily related to timing differences in the recognition of certain reservesand accruals.

 

***Accretion ofRedeemable Stock***

 

Accretion of redeemablestock totaled $113,000 in 2004 compared to $583,000 in 2003. Upon completion ofour initial public offering in December 2004, all outstanding redeemable stockconverted to common stock and, therefore, we did not have any accretion ofredeemable stock in 2005.

 

The decrease in accretionof redeemable stock in 2004 compared to 2003 was due to the conversion of ourSeries C convertible preferred stock in the fourth quarter of 2003.Accordingly, the 2004 amount only included accretion of the redeemable commonstock, whereas the 2003 amount included accretion of both the redeemable commonand preferred stock. In addition, the 2003 amount included the remaining$219,000 of unaccreted costs related to the Series C convertible preferredstock as a loss on redemption, which occurred in the fourth quarter of 2003.

 

**Liquidityand Capital Resources**

 

We anticipate meeting ourcash requirements for the next 12 months and for the foreseeable futurefrom existing cash and short-term marketable securities, which totaled $50.3 millionat December 31, 2005, as well as from cash expected to be generated fromoperations.

 

Net cash provided byoperating activities in 2005 was $5.9 million and consisted of net income of $8.3 millionand non-cash expenses of $2.0 million, offset by net changes in our operatingassets and liabilities. These changes are described below.

 

Accounts receivable, netincreased to $16.2 million at December 31, 2005 compared to $13.6 millionat December 31, 2004, primarily due to increased sales, as well as alarger dollar amount of sales in the last month of the fourth quarter of 2005compared to the last month of the fourth quarter of 2004. Our days salesoutstanding was approximately 83 days at December 31, 2005 compared to 68 daysat December 31, 2004.

 

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Inventories increased to$10.9 million at December 31, 2005 compared to $10.2 million atDecember 31, 2004, primarily due to an increase in our demonstrationinventory as we sold off some of our demonstration inventory in the fourthquarter of 2004 and replaced it in 2005. This increase was partially offset bydecreases in our work-in-process and finished goods inventories. We believethat our inventory levels at December 31, 2005 are adequate given our revenueprojections for the first quarter of 2006.

 

Prepaid expenses andother current assets increased to $3.0 million at December 31, 2005 comparedto $1.6 million at December 31, 2004 primarily due to increases ininvestment interest receivable and the value of foreign exchange contractsrelated to Japanese yen receivables.

 

Accrued liabilitiesincreased to $3.1 million at December 31, 2005 compared to $2.8 million atDecember 31, 2004, primarily due to increased employees stock purchasewithholdings.

 

Net cash used ininvesting activities of $7.8 million in 2005 resulted from $5.2 millionused for the net purchase of marketable securities, $2.0 million used for thepurchase of fixed assets and $0.5 million used for investment in patents andother assets.

 

Net cash provided byfinancing activities of $2.1 million in 2005 resulted from $2.2 million ofproceeds from the exercise of employee stock options, partially being offset by$99,000 of additional costs related to our December 2004 initial publicoffering and $27,000 used for payments on capital lease obligations.

 

At December 31, 2005, wehad an unused $150,000 standby letter of credit to be utilized in the event acustomer requires certain guarantees. This letter of credit is collateralizedby $150,000 of our cash and cash equivalents and expires August 14, 2006.

 

**ContractualCommitments**

 

The following is asummary of our contractual commitments and obligations as of December 31,2005 (in thousands):

 
| ** **                  | ** ** | **Payments Due By Period** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| **Contractual  Obligation** | ** ** | **Total**                                 | ** ** | **2006** | ** ** | **2007 and  2008** | ** ** | **2009 and  2010** | ** ** | **2011 and  beyond** | ** ** |
| Capital Leases              |       | $                                         | 8          |   | $ | 8 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating Leases            |       | 6,645                                     |       | 2,410 |   | 3,645 |   | 590 |   | — |   |
| Purchase Order Commitments  |       | 9,066                                     |       | 9,066 |   | — |   | — |   | — |   |
|                        |       | $                                         | 15,719     |   | $ | 11,484 |   | $ | 3,645 |   | $ | 590 |   | $ | — |   |

 

Purchaseorder commitments primarily represent open orders for inventory.

 

**CriticalAccounting Policies and the Use of Estimates**

 

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions. Theseestimates and assumptions affect the reported amounts of assets and liabilitiesand disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amount of revenue and expenses during thereporting period. It is possible that the estimates we make may change in thefuture.

 

***Revenue Recognition***

 

Revenue from productsales to customers that do not have acceptance criteria, including productsales to distributors, is recognized when a written purchase order has beenobtained, the product is shipped, title has transferred, no obligations remainand collectibility is reasonably assured. Generally,

 

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we ship our products FOBshipping point. For any shipments with FOB destination terms, we defer revenueuntil delivery to the customer. Revenue from customers who have acceptancecriteria beyond our standard terms and conditions is deferred until allacceptance criteria are satisfied. Revenue for installation services,consisting of assembly and testing, and for systems shipped to integrators isalso deferred. Deferred revenue related to service contracts is recognized overthe life of the contract, typically one to two years. Deferred revenue forsystems shipped to integrators is recognized upon shipment to the finalcustomer.

 

Our transactions mayinvolve the sale of systems and services under multiple element arrangements.Revenue under multiple element arrangements is allocated based on the fairvalue of each element. A typical multiple element arrangement may include someor all of the following components: product shipments, accessories,installation services and extended warranty contracts. The total sales price isallocated based on the relative fair value of each component when soldseparately.

 

***Allowance for Doubtful Accounts***

 

The allowance fordoubtful accounts is estimated based on past collection history and knowntrends with current customers. Our estimates for allowance for doubtfulaccounts are reviewed and updated on a quarterly basis. Changes to the reserveoccur based upon changes in revenue levels, associated balances in accountsreceivable and estimated changes in credit quality. Our allowance for doubtfulaccounts totaled $97,000 and $86,000, respectively, at December 31, 2005and 2004 and our bad debt expense totaled $15,000, $15,000 and $6,000,respectively, in 2005, 2004 and 2003.

 

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

 

We regularly analyze thevalue of our inventory based on a combination of factors including, but notlimited to, the following: forecasted sales or usage, historical usage rates,estimated service period, product end-of-life dates, estimated current andfuture market values, service inventory requirements and new productintroductions. Inventories are stated at the lower of standard cost, whichapproximates cost computed on a first-in, first-out basis, or market andinclude materials, labor and manufacturing overhead. Inventory is reviewed forobsolescence and excess quantities on a quarterly basis, based on estimatedfuture use of quantities on hand, which is determined based on past usage,planned changes to products and known trends in markets and technology. Becauseof the long-lived nature of many of our products, we maintain a supply of partsfor possible use in future repairs and customer field service. As these serviceparts become older, we apply a higher write-down against the recorded balance,recognizing that the older the part, the less likely it will be used. Ifcircumstances related to our inventories change, our estimates of the value ofinventory could materially change. Inventory write-downs are recorded quarterlyas a component of cost of sales. Total write-downs to inventory were $125,000, $159,000and $377,000, respectively, in 2005, 2004 and 2003. The write-downs include $73,000,$9,000 and $180,000, respectively, related to inventory write-downs due to pooradoption of one of our product lines, which was discontinued. The inventoryrelated to the discontinued product line was either transferred to serviceinventory, discarded or donated to universities or other organizations.

 

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

 

We evaluate the remaininglives and recoverability of equipment and other assets, including intangibleassets, whenever events or changes in circumstances indicate that the carryingamount of the asset may not be recoverable in accordance with SFAS No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets.” If there isan indication of impairment, we prepare an estimate of future, undiscountedcash flows expected to result from the use of the asset and its eventualdisposition. If these cash flows are less than the carrying value of the asset,we adjust the carrying amount of the asset to its estimated fair value. We havenot recorded any impairment charges for long-lived assets during the yearsended 2005, 2004 or 2003.

 

***Warranty Liabilities***

 

Warranty costs includelabor to repair the system and replacement parts for defective items, as wellas other costs incidental to warranty repairs. Any cost recoveries fromwarranties offered to us by our suppliers covering defective components arealso netted against the warranty expense. We estimate

 

36

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a liability for costs torepair or replace products under warranties ranging from 90 days toone-year and technical support costs when the related product revenue isrecognized. The products are sold without a right of return or price protectionrights. The liability for product warranties is calculated as a percentage ofsales. The percentage is based on historical actual product repair costs. Ourestimated warranty costs are reviewed and updated on a quarterly basis. Weanticipate our future warranty reserve accrual rate to be approximately 1% ofrevenue. Changes to the reserve occur as volume, product mix and actual warrantycosts fluctuate. Our warranty reserve totaled $488,000 and $365,000,respectively, at December 31, 2005 and 2004. These amounts are estimatesof warranty costs for our installed base during the 12-month period. Warrantyexpense totaled $624,000, $639,000 and $679,000, respectively, during 2005, 2004and 2003.

 

***Deferred Tax Asset Valuation Allowance***

 

We record deferred taxassets for the estimated future benefit of research and development taxcredits, foreign tax credits, net operating loss carryforwards and othertemporary differences to the extent management believes these assets will berealized. A valuation allowance is recorded when management can not reach theconclusion that it is more likely than not that the deferred tax assets will berealized. During 2005 and 2004, we reversed $28,000 and $726,000, respectively,of a previously recorded valuation allowance against our deferred tax assetsbased on our 2005 and 2004 performance. The reversal in 2005 related primarilyto foreign tax credits and foreign net operating losses. The reversal in 2004primarily related to research and engineering credits and state net operatingloss carryforwards that were utilized based on 2004 income. During 2004, werecorded a valuation allowance against our deferred tax assets totaling $761,000as a result of management’s conclusion that certain of our foreign tax creditsand state research and development credits may expire before we are able torecognize them. At December 31, 2005, we had a net deferred tax asset onour balance sheet totaling $2.0 million, primarily related to timingdifferences in the recognition of certain reserves and accruals, as well asstate research tax credits which can be carried forward. We believe it is morelikely than not that the benefits of these assets will be realized. We mayrecord additional valuation allowances in the future.

 

**NewAccounting Pronouncements**

 

***SFAS No. 123R***

 

In December 2004, theFinancial Accounting Standards Board (“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.” We adopted SFAS No. 123R effective January 1,2006. SFAS No. 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values. We are currently evaluating the provisions of SFAS No. 123Rand expect that the adoption will have a material impact on our consolidatedresults of operations and earnings per share, as the stock-based compensationexpense will be charged directly against our reported earnings. The adoption ofSFAS No. 123R will not have any effect on our cash flows or liquidity asequity-based compensation is a non-cash expense. The pro forma disclosurespreviously permitted under SFAS No. 123 are no longer an alternative tofinancial statement recognition. See Note 1 of Notes to Consolidated FinancialStatements, *Summary of Significant Accounting Policies –Stock-Based Compensation*, for the pro forma effects of applying SFASNo. 123 in 2005, 2004 and 2003.

 

***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 inventorycosts incurred during fiscal years beginning after June 15, 2005.Accordingly, we adopted SFAS No. 151 effective January 1, 2006. Whilewe have not completed our analysis of the impact of SFAS No. 151, we donot currently believe the provisions of SFAS No. 151, when applied, willhave a material impact on our financial position, results of operations or cashflows.

 

***SFASNo. 154***

 

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections: a replacementof APB Opinion No. 20 and FASB Statement No. 3,” which requires companies toapply most voluntary accounting changes retrospectively to prior financialstatements. We adopted SFAS No. 154 effective January 1, 2006 and, accordingly,any future voluntary accounting changes made by us will be accounted for underSFAS No. 154.

 

**Off-BalanceSheet Arrangements**

 

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have amaterial current or future effect on our financial condition, changes infinancial condition, revenue or expenses, results of operations, liquidity,capital expenditures or capital resources.

 

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##### **ITEM7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

##### ** **

***Foreign Currency Exchange Risk***

 

We sometimes attempt tomitigate our currency exposures for recorded transactions by using forwardexchange contracts. The purpose of these activities is to reduce the risk thatfuture cash flows of the underlying assets and liabilities will be adverselyaffected by changes in exchange rates. In some cases, we enter into forwardsale or purchase contracts for foreign currencies, primarily the Japanese yen,to hedge specific receivables and bookings positions. As of December 31, 2005,we had contracts outstanding for the purchase of Japanese yen totalingapproximately $2.2 million, which mature through March 2006.

 

Historically, we have notattempted to mitigate the impact of foreign currency fluctuations on the remeasurementof our subsidiaries’ net assets and results of operations, nor do we enter intoderivative financial instruments for speculative purposes.

 

Our forward exchangecontracts do not qualify for hedge accounting treatment in accordance with SFASNo. 138, “Accounting for Certain Derivative Instruments and CertainHedging Activities – an amendment of FASB Statement No. 133,” and, accordingly,gains and losses on our forward exchange contracts are recognized currently asa component of other income (expense).

 

***Interest Rate Risk***

 

Our exposure to marketrisk from changes in interest rates relates primarily to our investments.Because we have no variable interest rate debt outstanding at December 31,2005, we would not experience a material impact on our results of operations,financial position or cash flows as the result of a one percent increase ininterest rates. The primary objective of our investment activities is topreserve principal while maximizing yields without significantly increasingrisk. This is accomplished by investing in diversified investments, consistingonly of investment grade securities.

 

As of December 31, 2005,we held cash, cash equivalents and short-term marketable securities of $50.3 million.Declines of interest rates over time would reduce our interest income from ourhighly liquid short-term investments. A decrease in interest rates of onepercent would cause a corresponding decrease in our annual interest incomerelated to our cash, cash equivalents and marketable securities ofapproximately $503,000, assuming our December 31, 2005 balances remainedconstant. Due to the nature of our highly liquid cash equivalents, a change ininterest rates would not materially affect the fair market value of our cashand cash equivalents.

 

As of December 31, 2005,we held long-term fixed rate investments of $1.5 million that consisted ofmunicipal and corporate notes. An increase or decrease in interest rates wouldnot have a material impact on our results of operations, financial position orcash flows, as we have classified our securities as available-for-sale and,therefore, may choose to sell or hold them as changes in the market occur.Declines in interest rates over time would reduce our interest income from ourlong-term investments, as funds are re-invested at current market interestrates.

 

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###### **ITEM8.**                             CONSOLIDATEDFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

###### ** **

The financial statementsand notes thereto required by this item begin on page F-1 of this document, aslisted in Item 15 of Part IV. Unaudited quarterly financial data**for each of the eight quarters in the two-year period endedDecember 31, 2005 is as follows (unaudited):

 
| **In thousands, except per share data** | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **2004**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Revenue                                                          |       | $                    | 13,834     |                 | $          | 15,120               |       | $                    | 17,059     |   | $ | 18,402 |   |
| Gross profit                                                     |       | 5,880                |       | 6,547                |       | 7,640                |       | 8,656                |       |
| Net income                                                       |       | 373                  |       | 1,239                |       | 1,428                |       | 1,667                |       |
| Accretion of  redeemable stock                                   |       | 38                   |       | 37                   |       | 38                   |       | -                    |       |
| Net income  attributed to common shareholders                    |       | 335                  |       | 1,202                |       | 1,390                |       | 1,667                |       |
| Basic net income  per share                                      |       | 0.07                 |       | 0.23                 |       | 0.27                 |       | 0.27                 |       |
| Diluted net income  per share                                    |       | 0.05                 |       | 0.15                 |       | 0.17                 |       | 0.19                 |       |
|                                                             |       |                 |       |                 |       |                 |       |                 |       |
| **2005**                                                         |       |                 |       |                 |       |                 |       |                 |       |
| Revenue                                                          |       | $                    | 18,661     |                 | $          | 18,311               |       | $                    | 18,987     |   | $ | 17,678 |   |
| Gross profit                                                     |       | 9,159                |       | 8,650                |       | 8,866                |       | 7,572                |       |
| Net income  attributed to common shareholders                    |       | 2,495                |       | 2,231                |       | 2,148                |       | 1,445                |       |
| Basic net income  per share                                      |       | 0.23                 |       | 0.20                 |       | 0.19                 |       | 0.13                 |       |
| Diluted net  income per share                                    |       | 0.21                 |       | 0.19                 |       | 0.18                 |       | 0.12                 |       |

 
| **ITEM 9.** | **CHANGES IN AND DISAGREEMENTS  WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

 

None.

 

**ITEM9A. CONTROLS AND PROCEDURES**

 

**Management’s Report on Internal Control OverFinancial Reporting**

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules 13a –15(f).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting based on the framework in *InternalControl – Integrated Framework**issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO).* Based onour evaluation under the framework in *InternalControl – Integrated Framework**issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO)*, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2005.

 

Management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2005 has been audited by KPMG LLP, an independentregistered public accounting firm, as stated in their report, which is includedbelow.

 

**Changes in Internal Controls**

 

There has been no changein our internal control over financial reporting that occurred during our lastfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**DisclosureControls and Procedures**

 

Our management hasevaluated, under the supervision and with the participation of our ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934(the “Exchange Act”). Based on that evaluation, our Chief Executive

 

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Officer and Chief Financial Officer have concluded that, as of the endof the period covered by this report, our disclosure controls and proceduresare effective in ensuring that information required to be disclosed in ourExchange Act reports is (1) recorded, processed, summarized and reportedin a timely manner, and (2) accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosure.

 

**Limitation on Effectiveness of Controls**

 

Our management, including our Chief Executive Officer and ChiefFinancial Officer, do not expect that our disclosure controls and procedures orour internal control over financial reporting will prevent or detect all errorsand all occurrences of fraud. A control system, no matter how well designed andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control systems are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of all controls must be considered relative to their costs. Controlsystems can be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the control. Inaddition, over time, controls may become inadequate because of changes inconditions, or the degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in all control systems, no evaluation ofcontrols can provide absolute assurance that the control systems will detectall control issues, including instances of fraud, if any.

 

**Report of Independent Registered Public AccountingFirm**

 

The Board of Directorsand ShareholdersCascade Microtech, Inc.:

 

We have audited management’s assessment, included in the accompanying Management’sReport on Internal Control Over Financial Reporting, that Cascade Microtech, Inc.maintained effective internal control over financial reporting as of December 31,2005 based on criteria established in *InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO)*. Cascade MicrotechInc’s management is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. Our audit included obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made

 

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only in accordance with authorizations of management and directors ofthe company; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections ofany evaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Cascade Microtech, Inc.maintained effective internal control over financial reporting as of December 31,2005 is fairly stated, in all material respects, based on criteria establishedin *Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO)*.Also, in our opinion, Cascade Microtech, Inc. maintained, in all materialrespects, effective internal control over financial reporting as of December 31,2005, based on criteria established in *Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO)*.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofCascade Microtech, Inc. and subsidiaries as of December 31, 2005 and2004 and the related consolidated statements of operations, redeemable stock, shareholders’equity and comprehensive income (loss), and cash flows for each of the years inthe three-year period ended December 31, 2005, and our report dated March 15,2006 expressed an unqualified opinion on those consolidated financialstatements.

 
| /s/ KPMG LLP        |   |
|---------------------|--------|
| Portland, Oregon    |
| March 15, 2006 |

 

**ITEM9B. OTHER INFORMATION**

 

None.

 

**PART III**

 

We have omitted from Part III the information that will appear inour definitive proxy statement for our 2006 Annual Meeting of Shareholders (the“Proxy Statement”), which will be filed within 120 days after the end of ouryear ended December 31, 2005 pursuant to Regulation 14A.

 

**ITEM10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information with respect to directors and executive officers isincluded under “Election of Directors,” “Executive Officers,” “Section 16(a) BeneficialOwnership Reporting Compliance,” “Audit Committee Financial Expert,” “AuditCommittee Report” and “Code of Ethics” in our definitive proxy statement forour 2006 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” in our definitive proxy statement for our2006 Annual Meeting of Shareholders and is incorporated herein by reference.

 

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##### **ITEM12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL 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 2006 Annual Meetingof Shareholders and is incorporated herein by reference.

 

##### **ITEM13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by this item is included under “CertainRelationships and Related Transactions” in our definitive proxy statement forour 2006 Annual Meeting of Shareholders and is incorporated herein byreference.

 

##### **ITEM14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information required by this item is included under “Ratificationof Appointment of Independent Auditors” in our Proxy Statement for our 2006 AnnualMeeting of Shareholders and is incorporated herein by reference.

 

##### **PART IV**

 

##### **ITEM15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

**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,  2005 and 2004                                                                                                 |   |   |
|                                                                                                                                                               |   |   |
| Consolidated Statements of  Operations for the years ended December 31, 2005, 2004 and 2003                                                                   |   |   |
|                                                                                                                                                               |   |   |
| Consolidated Statements of  Redeemable Stock, Shareholders’ Equity and Comprehensive Income (Loss) for  the years ended December 31, 2005, 2004 and 2003 |   |   |
|                                                                                                                                                               |   |   |
| Consolidated Statements of  Cash Flows for the years ended December 31, 2005, 2004 and 2003                                                                   |   |   |
|                                                                                                                                                               |   |   |
| Notes to Consolidated  Financial Statements                                                                                                                        |   |   |
|                                                                                                                                                               |   |   |
| Schedule II – Valuation and  Qualifying Accounts                                                                                                         |   |   |

 

**Exhibits**

** **

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

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                  |       | Third Amended and Restated Articles of Incorporation of Cascade  Microtech, Inc. Incorporated by reference to Exhibit 3.1 to our Form 8-K  filed December 23, 2004.                                                 |
| 3.2                  |       | 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                                                                                                                                                                                                   |
| 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.                                           |

 

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| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                             |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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 Steven Sipowicz. Incorporated by reference to Exhibit 10.12  to our Registration Statement on Form S-1, File No. 333-113256.                                                                                                                                                                                                                                         |
| 10.6*                |       | First Amendment to Executive Employment Agreement of Steven Sipowicz  dated October 27, 2005. Incorporated by reference to Exhibit 10.2  to our Form 10-Q for the quarterly period ended September 30, 2005  and filed November 14, 2005.                                                                                                                                          |
| 10.7                 |       | Lease Agreements I and II between Amberjack, Ltd. And Cascade  Microtech, Inc. dated August 20, 1997, and Amendment No. 2 to  Lease Agreement I dated July 23, 1998, and Amendment No. 2 to  Lease Agreement II dated April 12, 1999. Incorporated by reference  to Exhibit 10.9 to our Registration Statement on Form S-1, File No. 333-47100. |
| 10.8                 |       | Lease Agreement between Bermuda Trust (Singapore) Limited and Cascade  Microtech, Inc. commencing December 12, 2003. Incorporated by  reference to Exhibit 10.6 to our Registration Statement on Form S-1,  File No. 333-113256.                                                                                                                                                   |
| 10.9                 |       | 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                |       | 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.                                                                                                                                                                                                                               |
| 10.11                |       | 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.                                                                                                                                                                       |
| 10.12*               |       | Cascade Microtech, Inc. 2005 Executive Compensation Plan for the  Six-Month Period Ending December 31, 2005. Incorporated by reference to Exhibit 10.2  to our Form 10-Q for the quarterly period ended September 30, 2005  and filed November 14, 2005.                                                                                                                      |
| 10.13*               |       | Cascade Microtech, Inc. 2006 Executive Compensation Plan for the  Six-Month Period Ending June 30, 2006. Incorporated by reference to Item  1.01 to our Form 8-K filed February 14, 2006.                                                                                                                                                                                               |
| 10.14                |       | Summary of Non-Employee Director Compensation. Incorporated by  reference to Exhibit 10.1 to Form 8-K filed December 13, 2005.                                                                                                                                                                                                                                                               |
| 14                   |       | Code of Ethics. Incorporated by reference to Exhibit 14 to our Form 10-K  for the year ended December 31, 2004 and filed March 29, 2005.                                                                                                                                                                                                                                                |
| 21                   |       | List of Subsidiaries. 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.                                                                                                                                                                                                                         |

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, Cascade Microtech, Inc. has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized on March 15, 2006:

 
|   | 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 15, 2006.

 
| **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            |                                          |
|                            |                                               |                                            |  |  |  |  |  |

 

44

----

 

**Report of Independent Registered Public Accounting Firm**

 

TheBoard of Directors and ShareholdersCascade Microtech, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Cascade MicrotechInc., and subsidiaries as of December 31, 2005 and 2004, and the relatedconsolidated statements of operations, redeemable stock, shareholders’ equityand comprehensive income (loss), and cash flows for each of the years in thethree-year period ended December 31, 2005. In connection with our auditsof the consolidated financial statements, we also have audited the accompanyingfinancial statement schedule. These consolidated financial statements andfinancial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements and financial statement schedule based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Cascade Microtech, Inc.and subsidiaries as of December 31, 2005 and 2004 and the results of theiroperations and their**cash flowsfor each of the years in the three-year period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic consolidated financial statements taken as a whole, presentfairly, in all material respects, the information set forth therein.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of CascadeMicrotech Inc.’s internal control over financial reporting as of December 31,2005 based on criteria established in *InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO)*, and our reportdated March 15, 2006 expressed an unqualified opinion on management’sassessment of, and the effective operation of, internal control over financialreporting.

 

KPMG LLP

Portland,OregonMarch 15, 2006

 

F-1

----

 

**CascadeMicrotech, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                                                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Assets**                                                                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Assets:                                                                                       |       |                  |       |   |   |
| Cash and  cash equivalents                                                                            |       | $                     | 2,224      |   | $ | 2,033 |   |
| Short-term  marketable securities                                                                     |       | 48,122                |       | 41,714 |   |
| Accounts  receivable, net of allowances of $97 and $86                                                |       | 16,182                |       | 13,640 |   |
| Inventories,  net                                                                                     |       | 10,889                |       | 10,180 |   |
| Prepaid  expenses and other                                                                           |       | 3,000                 |       | 1,579 |   |
| Deferred  income taxes                                                                                |       | 1,699                 |       | 1,552 |   |
| Total  Current Assets                                                                                 |       | 82,116                |       | 70,698 |   |
|                                                                                                  |       |                  |       |   |   |
| Long-term marketable securities                                                                       |       | 1,549                 |       | 2,779 |   |
| Fixed assets, net                                                                                     |       | 4,422                 |       | 4,008 |   |
| Deferred income taxes                                                                                 |       | 336                   |       | 65 |   |
| Other assets, net                                                                                     |       | 1,697                 |       | 1,466 |   |
| Total Assets                                                                                          |       | $                     | 90,120     |   | $ | 79,016 |   |
|                                                                                                  |       |                  |       |   |   |
| **Liabilities and Shareholders’ Equity**                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current Liabilities:                                                                                  |       |                  |       |   |   |
| Current  portion of capital leases                                                                    |       | $                     | 8          |   | $ | 21 |   |
| Accounts  payable                                                                                     |       | 3,904                 |       | 3,951 |   |
| Deferred  revenue                                                                                     |       | 516                   |       | 579 |   |
| Accrued  liabilities                                                                                  |       | 3,087                 |       | 2,814 |   |
| Total  Current Liabilities                                                                            |       | 7,515                 |       | 7,365 |   |
|                                                                                                  |       |                  |       |   |   |
| Capital leases                                                                                        |       | —                |       | 14 |   |
| Deferred revenue                                                                                      |       | 255                   |       | 282 |   |
| Other long-term liabilities                                                                           |       | 845                   |       | 1,167 |   |
| Total  Liabilities                                                                                    |       | 8,615                 |       | 8,828 |   |
|                                                                                                  |       |                  |       |   |   |
| Commitments and Contingencies (Note 15)                                                               |       |                  |       |   |   |
|                                                                                                  |       |                  |       |   |   |
| Shareholders’ Equity:                                                                            |       |                  |       |   |   |
| Common  stock, $0.01 par value. Authorized 100,000 shares; issued and outstanding:  11,328 and 10,864 |       | 113                   |       | 109 |   |
| Additional  paid-in capital                                                                           |       | 58,287                |       | 55,402 |   |
| Deferred  stock-based compensation                                                                    |       | (142                  | )          | (310 | ) |
| Accumulated  other comprehensive loss - unrealized holding losses on investments                      |       | (76                   | )          | (17 | ) |
| Retained  earnings                                                                                    |       | 23,323                |       | 15,004 |   |
| Total  Shareholders’ Equity                                                                      |       | 81,505                |       | 70,188 |   |
| Total  Liabilities and Shareholders’ Equity                                                      |       | $                     | 90,120     |   | $ | 79,016 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-2

----

 

**CascadeMicrotech, Inc.**

**Consolidated Statements of Operations**

**(Inthousands, except per share amounts)**

 
| ** **                                                                                                                     | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                     | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                     | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                                                                        |       | $                                        | 73,637     |   | $ | 64,415 |   | $ | 50,556 |   |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Cost of sales                                                                                                                  |       | 39,351                                   |       | 35,625 |   | 30,433 |   |
| Stock-based compensation                                                                                                       |       | 39                                       |       | 67 |   | 19 |   |
| Gross profit                                                                                                                   |       | 34,247                                   |       | 28,723 |   | 20,104 |   |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Operating expenses:                                                                                                            |       |                                     |       |   |   |   |   |
| Research and  development (excludes $17, $30 and $15, respectively, of amortization of  stock- based compensation)             |       | 6,951                                    |       | 5,651 |   | 5,407 |   |
| Selling,  general and administrative (excludes $66, $229 and $143, respectively, of  amortization of stock-based compensation) |       | 19,712                                   |       | 16,602 |   | 15,293 |   |
| Stock-based  compensation                                                                                                      |       | 83                                       |       | 259 |   | 158 |   |
|                                                                                                                           |       | 26,746                                   |       | 22,512 |   | 20,858 |   |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Income (loss) from operations                                                                                                  |       | 7,501                                    |       | 6,211 |   | (754 | ) |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Other income (expense):                                                                                                        |       |                                     |       |   |   |   |   |
| Interest  income                                                                                                               |       | 1,061                                    |       | 133 |   | 164 |   |
| Interest  expense                                                                                                              |       | (18                                      | )          | (465 | ) | (1 | ) |
| Other, net                                                                                                                     |       | 948                                      |       | 215 |   | 390 |   |
|                                                                                                                           |       | 1,991                                    |       | (117 | ) | 553 |   |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Income (loss) before income taxes                                                                                              |       | 9,492                                    |       | 6,094 |   | (201 | ) |
| Provision for income taxes                                                                                                     |       | 1,173                                    |       | 1,387 |   | 248 |   |
| Net income (loss)                                                                                                              |       | 8,319                                    |       | 4,707 |   | (449 | ) |
| Accretion of redeemable stock and loss on  redemption                                                                          |       | —                                   |       | 113 |   | 583 |   |
| Net income (loss) attributed to common  shareholders                                                                           |       | $                                        | 8,319      |   | $ | 4,594 |   | $ | (1,032 | ) |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Basic net income (loss) per share  attributed to common shareholders                                                           |       | $                                        | 0.75       |   | $ | 0.84 |   | $ | (0.20 | ) |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Diluted net income (loss) per share  attributed to common shareholders                                                         |       | $                                        | 0.70       |   | $ | 0.56 |   | $ | (0.20 | ) |
|                                                                                                                           |       |                                     |       |   |   |   |   |
| Shares used in per share calculations:                                                                                         |       |                                     |       |   |   |   |   |
| Basic                                                                                                                          |       | 11,055                                   |       | 5,439 |   | 5,089 |   |
| Diluted                                                                                                                        |       | 11,816                                   |       | 8,452 |   | 5,089 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-3

----

 

**CascadeMicrotech, Inc.**

**Consolidated Statements of Redeemable Stock, Shareholders’ Equity andComprehensive Income (Loss)**

**For TheYears Ended December 31, 2005, 2004 and 2003**

**(Inthousands)**

 
| ** **                                                                                 | ** ** | **Redeemable Stock**      | ** ** | ** **       | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **  | ** ** | ** ** | ** ** | **Deferred**      | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------|------------|------------------|------------|---------------------------------|------------|------------------|------------|-------------|------------|------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                 | ** ** | **Convertible Preferred** | ** ** | ** **       | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **  | ** ** | ** ** | ** ** | ** **        | ** ** | **Additional**  | ** ** | **Stock-**             | ** ** | **Other**  | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                                                                 | ** ** | **Stock and Warrant**     | ** ** | **Common Stock** | ** ** | **Convertible Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Based**  | ** ** | **Comprehensive** | ** ** | **Retained**    | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                 | ** ** | **Shares**                | ** ** | **Amount**       | ** ** | **Shares**                      | ** ** | **Amount**       | ** ** | **Shares**  | ** ** | **Amount** | ** ** | **Shares**        | ** ** | **Amount**      | ** ** | **Capital**            | ** ** | **Comp.**  | ** ** | **Income(Loss)** | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2002**                                                      |       | 1,250                     |       | $                | 9,568      |                            | 472        |             | $          | 584         |       | 2,346      |       | $                 | 23         |            | 4,537      |                   | $          | 45         |       | $ | 12,246 |   | $ | (59 | ) | $ | 43 |   | $ | 11,550 |   | $ | 23,848 |   |
|                                                                                       |       |                      |       |             |       |                            |       |             |       |        |       |       |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | 148               |       | 2               |       | 161                    |       | —     |       | — |   | — |   | 163 |   |
| Common stock repurchased                                                                   |       | —                    |       | —           |       | (30                             | )          | (150             | )          | —      |       | —     |       | (32               | )          | —          |       | (92                    | )          | —     |       | — |   | (67 | ) | (159 | ) |
| Accretion of common stock redemption                                                       |       | —                    |       | —           |       | —                          |       | 150              |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | (150 | ) | (150 | ) |
| Accretion of preferred stock redemption                                                    |       | —                    |       | 214              |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | (214 | ) | (214 | ) |
| Conversion of preferred stock to debt and loss on  redemption                              |       | (1,250                    | )          | (9,782           | )          | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | (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**                                                      | ** ** | **—**                |       | —           |       | 442                             |       | 584              |       | 2,346       |       | 23         |       | 4,653             |       | 47              |       | 13,335                 |       | (902       | )          | 6 |   | 10,451 |   | 22,960 |   |
|                                                                                       |       |                      |       |             |       |                            |       |             |       |        |       |       |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | 146               |       | 2               |       | 166                    |       | —     |       | — |   | — |   | 168 |   |
| Common stock issued in IPO, net of IPO costs of  $4,572                                    |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | 3,300             |       | 33              |       | 41,628                 |       | —     |       | — |   | — |   | 41,661 |   |
| Common stock repurchased                                                                   |       | —                    |       | —           |       | (16                             | )          | (150             | )          | —      |       | —     |       | (7                | )          | —          |       | (7                     | )          | —     |       | — |   | (41 | ) | (48 | ) |
| Accretion of common stock redemption                                                       |       | —                    |       | —           |       | —                          |       | 113              |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | (113 | ) | (113 | ) |
| Amortization of deferred  stock-based compensation, net                                    |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | (265                   | )          | 592        |       | — |   | — |   | 327 |   |
| Termination of the redemption feature of the  redeemable common stock                      |       | —                    |       | —           |       | (426                            | )          | (547             | )          | —      |       | —     |       | 426               |       | 4               |       | 543                    |       | —     |       | — |   | — |   | 547 |   |
| Conversion of all outstanding shares of our convertible  preferred stock into common stock |       | —                    |       | —           |       | —                          |       | —           |       | (2,346      | )          | (23        | )          | 2,346             |       | 23              |       | —                 |       | —     |       | — |   | — |   | — |   |
| Tax benefit of stock option exercises                                                      |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | 2                      |       | —     |       | — |   | — |   | 2 |   |
| Unrealized holding loss on investments                                                     |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | (23 | ) | — |   | (23 | ) |
| Net income                                                                                 |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | 4,707 |   | 4,707 |   |
| **Balance at December 31, 2004**                                                      |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | 10,864            |       | 109             |       | 55,402                 |       | (310       | )          | (17 | ) | 15,004 |   | 70,188 |   |
|                                                                                       |       |                      |       |             |       |                            |       |             |       |        |       |       |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |
| Common stock issued                                                                        |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | 464               |       | 4               |       | 2,175                  |       | —     |       | — |   | — |   | 2,179 |   |
| Additional IPO costs                                                                       |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | (99                    | )          | —     |       | — |   | — |   | (99 | ) |
| Amortization of deferred  stock-based compensation, net                                    |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | (46                    | )          | 168        |       |   |   | — |   | 122 |   |
| Tax benefit of stock option exercises                                                      |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | 855                    |       | —     |       | — |   | — |   | 855 |   |
| Unrealized holding loss on investments                                                     |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | (59 | ) | — |   | (59 | ) |
| Net income                                                                                 |       | —                    |       | —           |       | —                          |       | —           |       | —      |       | —     |       | —            |       | —          |       | —                 |       | —     |       | — |   | 8,319 |   | 8,319 |   |
| **Balance at December 31, 2005**                                                      |       | —                    |       | $                | —     |                            | —     |             | $          | —      |       | —     |       | $                 | —     |            | 11,328     |                   | $          | 113        |       | $ | 58,287 |   | $ | (142 | ) | $ | (76 | ) | $ | 23,323 |   | $ | 81,505 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

F-4

----

 

**CascadeMicrotech, Inc.**

**Consolidated Statements of Cash Flows**

**(Inthousands)**

 
| ** **                                                                                       | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Cash flows from operating activities:**                                                        |       |                                     |       |   |   |   |   |
| Net income  (loss)                                                                               |       | $                                        | 8,319      |   | $ | 4,707 |   | $ | (449 | ) |
| Adjustments  to reconcile net income (loss) to net cash flows provided by operating  activities: |       |                                     |       |   |   |   |   |
| Depreciation  and amortization                                                                   |       | 1,859                                    |       | 2,031 |   | 2,230 |   |
| Amortization  of deferred stock-based compensation, net                                          |       | 122                                      |       | 326 |   | 177 |   |
| Loss on  disposal of fixed assets                                                                |       | 27                                       |       | 9 |   | 11 |   |
| Gain on  marketable securities                                                                   |       | —                                   |       | — |   | (3 | ) |
| Deferred  income taxes                                                                           |       | (418                                     | )          | (160 | ) | (295 | ) |
| Tax benefit  from stock options exercised                                                        |       | 855                                      |       | 2 |   | — |   |
| (Increase)  decrease in:                                                                         |       |                                     |       |   |   |   |   |
| Accounts  receivable, net                                                                        |       | (2,542                                   | )          | (3,037 | ) | (1,284 | ) |
| Inventories                                                                                      |       | (709                                     | )          | (2,115 | ) | 1,343 |   |
| Prepaid  expenses and other                                                                      |       | (1,421                                   | )          | (814 | ) | 1,464 |   |
| Increase  (decrease) in:                                                                         |       |                                     |       |   |   |   |   |
| Accounts  payable                                                                                |       | (47                                      | )          | 1,129 |   | (88 | ) |
| Deferred  revenue                                                                                |       | (90                                      | )          | 174 |   | 287 |   |
| Accrued and  other long–term liabilities                                                    |       | (49                                      | )          | 349 |   | 192 |   |
| Net cash  provided by operating activities                                                       |       | 5,906                                    |       | 2,601 |   | 3,585 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Cash flows from investing activities:**                                                        |       |                                     |       |   |   |   |   |
| Purchase of  marketable securities                                                               |       | (46,814                                  | )          | (46,583 | ) | (7,911 | ) |
| Proceeds  from sale of marketable securities                                                     |       | 41,577                                   |       | 9,379 |   | 9,513 |   |
| Purchase of  fixed assets                                                                        |       | (2,018                                   | )          | (926 | ) | (759 | ) |
| Proceeds  from disposal of fixed assets                                                          |       | 29                                       |       | — |   | 7 |   |
| Investment  in patents and other assets                                                          |       | (542                                     | )          | (484 | ) | (342 | ) |
| Net cash  provided by (used in) investing activities                                             |       | (7,768                                   | )          | (38,614 | ) | 508 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Cash flows from financing activities:**                                                        |       |                                     |       |   |   |   |   |
| Principal  payments on capital lease obligations                                                 |       | (27                                      | )          | (46 | ) | (24 | ) |
| Principal  payments on long-term debt                                                            |       | —                                   |       | (7,000 | ) | — |   |
| Cash paid  upon redemption of Series C preferred stock                                      |       | —                                   |       | — |   | (3,000 | ) |
| Proceeds  from issuance of common stock, net of offering costs of $4,572                         |       | —                                   |       | 41,661 |   | — |   |
| Additional  offering costs                                                                       |       | (99                                      | )          | — |   | — |   |
| Proceeds  from other issuances of common stock, net                                              |       | 2,179                                    |       | 168 |   | 163 |   |
| Payments to  repurchase common stock                                                             |       | —                                   |       | (198 | ) | (309 | ) |
| Net cash  provided by (used in) financing activities                                             |       | 2,053                                    |       | 34,585 |   | (3,170 | ) |
|                                                                                             |       |                                     |       |   |   |   |   |
| Increase (decrease) in cash and cash  equivalents                                                |       | 191                                      |       | (1,428 | ) | 923 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Cash and cash equivalents:**                                                                   |       |                                     |       |   |   |   |   |
| Beginning of  year                                                                               |       | 2,033                                    |       | 3,461 |   | 2,538 |   |
| End of year                                                                                      |       | $                                        | 2,224      |   | $ | 2,033 |   | $ | 3,461 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Supplemental disclosure of cash flow  information:**                                           |       |                                     |       |   |   |   |   |
| Cash paid  for interest                                                                          |       | $                                        | 2          |   | $ | 480 |   | $ | 1 |   |
| Cash paid  for income taxes, net                                                                 |       | 2,127                                    |       | 2,893 |   | 99 |   |
|                                                                                             |       |                                     |       |   |   |   |   |
| **Noncash investing and financing activities:**                                                  |       |                                     |       |   |   |   |   |
| Reversal of  deferred stock compensation                                                         |       | $                                        | 46         |   | $ | 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

----

 

**CascadeMicrotech, Inc.**

**Notes to Consolidated Financial Statements**

 

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

 

***Nature of Business***

 

Weare involved in the development, manufacturing and selling of wafer probingsolutions for the electrical measurement and test of integrated circuits, orICs. We design, manufacture and assemble products in Beaverton, Oregon, withglobal sales, service and support centers in North America, Europe, Japan andSingapore.

 

***Principles of Consolidation***

 

Theconsolidated financial statements include the accounts of Cascade Microtech, Inc.and its wholly owned subsidiaries, Cascade Microtech Foreign Sales Inc.,Cascade Microtech Japan, K.K. and Cascade Microtech Europe, Ltd. Allsignificant intercompany accounts and transactions have been eliminated.

 

Thefunctional currency of our foreign subsidiaries is the U.S. dollar. Nonmonetarybalance sheet items are remeasured at historical rates and monetary balancesheet items are remeasured at current rates. Exchange gains and losses fromremeasurement of monetary assets and liabilities are recognized currently inour consolidated statements of operations.

 

***Use of Estimates in FinancialReporting***

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements, aswell as revenues and expenses reported for the periods presented. Significantestimates include allowances for doubtful accounts, inventory valuation, thelives and recoverability of equipment and other long-lived assets, warrantyreserves and deferred tax asset valuation allowances. We regularly assess theseestimates and, while actual results may differ, management believes thatthe estimates are reasonable.

 

***Cash and Cash Equivalents***

 

Includedin cash and cash equivalents were cash equivalents of $213,000 and $1.0 millionat December 31, 2005 and 2004, respectively, which consisted of moneymarket funds, and are stated at cost, which approximates market value. Weconsider all highly liquid investments with an original maturity of threemonths or less to be cash equivalents.

 

***Letter of Credit***

 

AtDecember 31, 2005, we had an unused $150,000 standby letter of credit tobe utilized in the event a customer requires certain guarantees. This letter ofcredit is collateralized by $150,000 of our cash and cash equivalents andexpires August 14, 2006.

 

***Marketable Securities***

 

Weclassify our marketable securities as available-for-sale and, accordingly,record them at current market value. Unrealized holding gains and losses areexcluded from earnings and are reported as a separate component of shareholders’equity until realized. Dividend and interest income is recognized when earned.Realized gains and losses are included in earnings and are derived using thespecific identification method for determining the cost of securities sold.

 

Weperiodically evaluate whether declines in fair values of our investments belowtheir cost are “other-than-temporary.” This evaluation consists of qualitativeand quantitative factors regarding the severity and duration of the unrealizedloss, as well as our ability and intent to hold the investment until aforecasted recovery occurs.

 

F-6

----

 

***Trade Accounts Receivable***

 

Tradeaccounts receivable are recorded at their invoiced amount and do not bearinterest. The allowance for doubtful accounts is our best estimate of theamount of probable credit losses in our existing accounts receivable. Wedetermine our allowance for doubtful accounts utilizing historical collectionpercentages considering the aging of the accounts and known trends with currentcustomers, including recent significant changes in their financial position.

 

Theprovision for doubtful accounts totaled $15,000, $15,000 and $6,000,respectively, in 2005, 2004 and 2003. The allowance for doubtful accountstotaled $97,000 and $86,000, respectively, at December 31, 2005 and 2004.Historically, write-offs have been insignificant.

 

***Inventories***

 

Inventoriesare stated at the lower of standard cost, which approximates cost computed on afirst-in, first-out basis, or market, and include materials, labor andmanufacturing overhead. Demonstration goods represent inventory that is usedfor customer demonstration purposes. This inventory is typically sold after 12to 18 months. We analyze the carrying value of our inventory quarterly,considering a combination of factors including, but not limited to, thefollowing: forecasted sales or usage, historical usage rates, estimated serviceperiod, product end-of-life dates, estimated current and future market values,service inventory requirements and new product introductions. We estimatemarket value based on factors including, but not limited to, replacement costand estimated resale value. Write-downs of inventory totaled $125,000, $159,000and $377,000, respectively, in 2005, 2004 and 2003.

 

***Fair Value of Financial Instruments***

 

Thecarrying value of cash and cash equivalents, marketable securities, accountsreceivable, accounts payable and accrued liabilities approximate fair value dueto their short maturities. The fair value of our capital lease obligationsapproximate carrying value as such instruments’ stated interest rates do notdiffer significantly from current market rates.

 

***Fixed Assets***

 

Equipmentand leasehold improvements are stated at cost. Equipment under capital lease isrecorded at the net present value of the future minimum lease payments at theinception of the lease. Maintenance and repairs are expensed as incurred.Depreciation of owned equipment is primarily provided using the straight-linemethod over the estimated useful lives of the assets, ranging from two to sevenyears. Amortization of equipment under capital leases and leaseholdimprovements is provided using the straight-line method over the life of thelease or the useful life of the asset, whichever is shorter.

 

***Other Assets***

 

Otherassets, which consist primarily of patents and trademarks, are stated athistorical cost less accumulated amortization and reserves. Capitalized patentcosts relate to legal fees incurred to obtain the patents. Costs incurred forpatent related litigation are expensed as incurred. The intangible assets areamortized using the straight-line method over estimated useful lives of five toseven years.

 

***Accounting for the Impairment ofLong-Lived Assets***

 

Long-livedassets held and used by us and intangible assets with determinable lives arereviewed for impairment whenever events or circumstances indicate that thecarrying amount of assets may not be recoverable in accordance with SFAS No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets” We evaluaterecoverability of assets to be held and used by comparing the carrying amountof an asset to future net undiscounted cash flows to be generated by the asset.If such assets are considered to be impaired, the impairment to be recognizedis measured as the amount by which the carrying amount of the assets exceedsthe fair value of the assets. Such reviews assess the fair value of the assetsbased upon estimates of discounted future cash flows that the assets areexpected to generate. We did not record any impairment charges against our long-livedassets during 2005, 2004 or 2003.

 

F-7

----

 

***Revenue Recognition***

 

Wesell or deliver our products to the end-user through distributors,manufacturers’ representatives and integrators:

 

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

 

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

 

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

 

Revenuefrom product sales to customers that do not have special acceptance criteria,including product sales to distributors and manufacturers’ representatives, isrecognized when a written purchase order has been obtained, the price is fixedand determinable, the product is shipped, title has transferred andcollectibility is reasonably assured. Generally, we ship our products FOBshipping point. For any shipments with FOB destination terms, we defer revenueuntil delivery to the customer. Revenue from customers who have specialacceptance criteria is not recognized until all acceptance criteria aresatisfied. Revenue for installation services, consisting of assembly andtesting, is recognized when the services are performed.

 

Ourtransactions may involve the sale of systems and services under multipleelement arrangements. A typical multiple element arrangement may includesome or all of the following: product shipments, accessories, installationservices or extended warranty contracts. For any arrangements with multipleelements, we recognize revenue only after we have determined that elements withstand alone value have been delivered to customers and any undelivered elementshave objective and reliable evidence of fair value.

 

Werecord deferred revenue for service contracts and for custom engineering probestations and other systems requiring special acceptance criteria from thecustomer. Deferred revenue related to service contracts is recognized over thelife of the contract, typically one to two years. For systems shipped tointegrators, no revenue is recognized until shipment to the end user. Deferredrevenue related to shipped systems requiring acceptance by the customer isrecognized upon receipt of such acceptance.

 

***Significant Customers***

 

Nocustomers in 2005 or 2004 accounted for 10% or more of our total sales. In2003, one customer accounted for approximately 11.0% of our total sales. Nocustomers accounted for 5% or more of our gross accounts receivable balance at December 31,2005 or 2004.

 

***Product Warranty***

 

Weestimate a liability for costs to repair or replace products under warrantiesfor a period of approximately six months and technical support costs when therelated product revenue is recognized. The products are sold without a right ofreturn or price protection rights. The liability for product warranties iscalculated as a percentage of sales. The percentage is based on historicalactual product repair costs. The liability for product warranties is includedin accrued liabilities on our consolidated balance sheet.

 

F-8

----

 

Productwarranty activity was as follows (in thousands):

 
| **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  |   |
| Reductions for warranty charges               |   | (501 | )      |
| Additions to warranty reserve                 |   | 624  |   |
| **Warranty accrual, December 31, 2005**  |   | $    | 488    |   |

 

***Advertising***

 

Advertisingcosts are expensed as incurred and amounted to $196,000, $7,000 and $32,000 in2005, 2004 and 2003, respectively.

 

***Research and Development***

 

Researchand development costs are expensed as incurred. See Note 9.

 

***Forward Exchange Contracts***

 

Weaccount for forward exchange contracts in accordance with SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities - anamendment of FASB Statement No. 133” and SFAS No. 137, “Accountingfor Derivative Instruments and Hedging Activities.” SFAS No. 137 is anamendment to SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities.” SFAS Nos. 133, 137 and 138 establish accounting andreporting standards requiring that every derivative instrument (includingcertain derivative instruments embedded in other contracts) be recorded on thebalance sheet as either an asset or liability measured at its fair value. SFASNos. 137 and 138 require that changes in the derivative’s fair value berecognized currently in earnings unless specific hedge accounting criteria aremet. Special accounting for qualifying hedges allows a derivative’s gains andlosses to offset related results on the hedged item in the income statement,and requires that a company must formally document, designate and assess theeffectiveness of transactions that receive hedge accounting.

 

Attimes, we enter into forward foreign currency exchange contracts, whichtypically expire within six months, to manage our exposure against foreigncurrency fluctuations on sales denominated in Japanese yen. These foreignexchange contracts are not considered hedges under SFAS No. 138, and assuch are recorded at fair value on the balance sheet with any changes in fairvalue included as other income (expense), net on our statements of operations.At December 31, 2005 and 2004, we had $2.2 million and $4.7 million,respectively, of forward exchange contracts outstanding. The estimated fairvalue of the contracts outstanding at December 31, 2005 and 2004 was $2.1million and $4.9 million, respectively.

 

***Income Taxes***

 

Weaccount for income taxes in accordance with SFAS No. 109 “Accounting forIncome Taxes.” Accordingly, deferred income taxes are established for thedifference between the financial reporting and income tax basis of assets andliabilities as well as operating loss and tax credit carryforwards. Deferredtax assets are reduced by a valuation allowance when, in the opinion ofmanagement, it is more likely than not that some portion of the deferred taxassets will not be realized. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred taxes of a change in tax rates is recognized in income inthe period that includes the enactment date.

 

F-9

----

 

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

 

Wecompute net income (loss) per share in accordance with SFAS No. 128, “EarningsPer Share.” Under the provisions of SFAS No. 128, basic net income (loss)per share is computed by dividing the net income (loss) attributed to commonshareholders for the period by the weighted average number of shares of commonstock outstanding during the period. Diluted net income (loss) per shareincorporates the incremental shares issuable upon the assumed exercise of stockoptions and warrants using the treasury stock method and assumed conversions ofpreferred stock, if dilutive. In addition, upon assumed conversion of thepreferred stock, the accretion of redeemable stock is added back to net income.Accordingly, the net income used for calculating net income per share for 2004was $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,**                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used to calculate basic earnings per  share                        |       | 11,055   |       | 5,439    |       | 5,089    |       |
|                                                                      |       |     |       |     |       |     |       |
| Dilutive effect of:                                                       |       |     |       |     |       |     |       |
| Outstanding  stock options                                                |       | 761      |       | 776      |       | —   |       |
| Outstanding  warrants                                                     |       | —   |       | —   |       | —   |       |
| Redeemable  and convertible preferred stock                               |       | —   |       | 2,237    |       | —   |       |
| Shares used to calculate diluted earnings  per share                      |       | 11,816   |       | 8,452    |       | 5,089    |       |
|                                                                      |       |     |       |     |       |     |       |
| Dilutive  securities not considered as they would have been antidilutive: |       |     |       |     |       |     |       |
| Outstanding  stock options                                                |       | 296      |       | 273      |       | 1,773    |       |
| Outstanding  warrants                                                     |       | —   |       | —   |       | —   |       |
| Redeemable  and convertible preferred stock                               |       | —   |       | —   |       | 2,346    |       |
|                                                                      |       | 296      |       | 273      |       | 4,119    |       |

 

***Stock-Based Compensation***

 

BeginningJanuary 1, 2006, we account for stock options using SFAS No. 123R, “Share-BasedPayment: an amendment of FASB Statements No. 123 and 95,” which requirescompanies to recognize in their statement of operations the grant-date fairvalue of stock options and other equity-based compensation issued to employees(see Note 2). Prior to January 1, 2006, we accounted for stock optionsissued 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 forour stock-based compensation plans in accordance with the fair value methodprescribed by SFAS No. 123 “Accounting for Stock-Based Compensation” asfollows (in thousands, except per share amounts): 

 
| **Year Ended December 31,**                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income (loss) attributed to common  shareholders, as reported                |       | $        | 8,319      |     | $          | 4,594    |       | $ | (1,032 | ) |
| Add stock-based  compensation included in reported net income (loss), net of tax |       | 107      |       | 252      |       | 105      |       |
| Fair value of stock-based employee  compensation, net of tax                     |       | (1,849   | )          | (1,585   | )          | (657     | )          |
| Net income (loss), pro forma                                                     |       | $        | 6,577      |     | $          | 3,261    |       | $ | (1,584 | ) |
|                                                                             |       |     |       |     |       |     |       |
| Net income (loss) per share – basic, as  reported                           |       | $        | 0.75       |     | $          | 0.84     |       | $ | (0.20 | ) |
| Net income (loss) per share – basic, pro  forma                             |       | $        | 0.59       |     | $          | 0.60     |       | $ | (0.31 | ) |
|                                                                             |       |     |       |     |       |     |       |
| Net income (loss) per share – diluted, as  reported                         |       | $        | 0.70       |     | $          | 0.56     |       | $ | (0.20 | ) |
| Net income (loss) per share – diluted, pro  forma                           |       | $        | 0.56       |     | $          | 0.40     |       | $ | (0.31 | ) |

 

F-10

----

 

Todetermine stock-based compensation included in reported net income (loss), netof tax, we used a tax rate approximating our effective tax rate of 12.4% for2005 and 22.8% for 2004. For 2003, we used a statutory tax rate of 40% due tothe significant variance in our effective tax rate from the statutory tax rate.

 

Expenseassociated with stock-based compensation is amortized on an accelerated basisover the vesting period of the individual award, consistent with the methoddescribed in Financial Accounting Standards Board Interpretation No. 28 “Accountingfor Stock Appreciation Rights and Other Variable Stock Option Award Plans, anInterpretation of APB Opinion No. 15 and 25” (“FIN 28”).

 

Usingthe Black-Scholes methodology, the total value of stock awards and optionsgranted during 2005, 2004 and 2003 was $2.5 million, $3.0 million and$1.1 million, respectively, which would be amortized on a pro forma basisover the vesting period of the options, typically five years. The per shareweighted average fair value of stock options granted during the years ended December 31,2005, 2004 and 2003 was $8.55, $7.39 and $3.40, respectively, using the Black-Scholesoption-pricing model with the following weighted average assumptions:

 
| **Year Ended December 31,** | ** ** | **2005**     | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|--------------|------------|----------|------------|----------|------------|
| **Stock Option Plan**            |       |         |       |     |       |     |       |
| Risk-free interest rate          |       | 3.77% - 4.39 | %          | 3.6      | %          | 3.27     | %          |
| Expected dividend yield          |       | 0.0          | %          | 0.0      | %          | 0.0      | %          |
| Expected lives                   |       | 6 years      |       | 6 years  |       | 6 years  |       |
| Expected volatility              |       | 67.4% - 68.9 | %          | 68.4     | %          | 70.0     | %          |
|                             |       |         |       |     |       |     |       |
| **Employee Stock Purchase Plan** |       |         |       |     |       |     |       |
| Risk-free interest rate          |       | 2.85% - 3.79 | %          | —   |       | —   |       |
| Expected dividend yield          |       | 0.0          | %          | —   |       | —   |       |
| Expected lives                   |       | 6 months     |       | —   |       | —   |       |
| Expected volatility              |       | 43.7% - 56.0 | %          | —   |       | —   |       |

 

Weaccount for stock options issued to consultants and other service providerspursuant to SFAS No. 123 and EITF 96-18, “Accounting for EquityInstruments that are Issued to Other Than Employees for Acquiring, or inConjunction With, Selling Goods or Services.” Accordingly, the value of thestock options is determined based on the fair value of the services or otherconsideration received or the fair value of the stock options issued, whicheveris more reliably measurable. The value is recognized as expense over the periodthe service is provided or upon receipt of the other consideration. There wereno stock options granted to consultants or other service providers during 2005,2004 or 2003.

 

***Comprehensive Income***

 

Wehave adopted the provisions of SFAS No. 130, “Reporting ComprehensiveIncome.” Comprehensive income is defined as changes in shareholders’ equityexclusive of transactions with owners, such as capital contributions anddividends. Unrealized holding gains and losses on our available-for-salemarketable securities are included as a separate component of shareholders’equity until realized. The differences between net income (loss) andcomprehensive income (loss) for the periods presented are not material.

 

***Reclassifications***

 

Certainreclassifications have been made to the prior year balance sheet to conform tothe current year presentation.

 

F-11

----

 

***Certain Risks and Uncertainties***

 

Ourfuture operating results and financial condition are subject to influencesdriven by rapid technological changes, a highly competitive industry, a lengthysales cycle, and the cyclical nature of general economic conditions. Futureoperating results will depend on many factors, including demand for ourproducts, the introduction and industry acceptance of new products and thelevel and timing of available shippable orders and backlog.

 

Inaddition, we rely on several suppliers to provide certain key components usedin our products. Some of these items are available from only one supplier or alimited group of suppliers. Any disruption in the availability and delivery ofthese items could materially adversely affect our revenues.

 

# ***SegmentReporting***

 

Basedupon the requirements of SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” 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.

 

**NOTE 2. NEW ACCOUNTING PRONOUNCEMENTS**

 

***SFAS No. 123R***

 

InDecember 2004, the FASB issued SFAS No. 123R, “Share-Based Payment:an amendment of FASB Statements No. 123 and 95,” which requires companiesto recognize in their statement of operations the grant-date fair value ofstock options and other equity-based compensation issued to employees. SFAS No. 123Ris effective for annual periods beginning after June 15, 2005.Accordingly, we adopted SFAS No. 123R effective January 1, 2006. SeeNote 1*Summary of Significant AccountingPolicies - Stock-Based Compensation*above for an estimate of howSFAS No. 123R would have affected results of operations in 2005, 2004 and2003. We are currently evaluating the provisions of SFAS No. 123Rand expect that the adoption will have a material impact on our consolidatedresults of operations and earnings per share, as the stock-based compensationexpense will be charged directly against our reported earnings. The adoption of SFAS No. 123R will nothave any effect on our cash flows or liquidity as equity-based compensation isa non-cash expense.

 

***SFAS No. 151***

 

In November 2004, the FASB issued SFAS No. 151, “InventoryCosts: an amendment of ARB No. 43, Chapter 4,” to clarify the accountingfor abnormal amounts of idle facility expense, freight, handling costs andwasted material. SFAS No. 151 is effective for inventory costs incurredduring fiscal years beginning after June 15, 2005. Accordingly, we adoptedSFAS No. 151 effective January 1, 2006. While we have not completedour analysis of the impact of SFAS No. 151, we do not currently believethe provisions of SFAS No. 151, when applied, will have a material impacton our financial position, results of operations or cash flows.

 

***SFAS No. 154***

 

InMay 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3,”which requires companies to apply most voluntary accounting changesretrospectively to prior financial statements. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. Any future voluntary accounting changes made byus will be accounted for under SFAS No. 154 and will be appliedretrospectively.

 

F-12

----

 

**NOTE 3. MARKETABLE SECURITIES**

 

Weaccount for our marketable securities in accordance with SFAS No. 115, “Accountingfor Certain 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 was as follows (in thousands): 

 
| **December 31,**            | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Fair market value:               |       |     |       |     |       |
| Municipal  obligations           |       | $        | 48,474     |     | $          | 38,325 |   |
| Agency  discount notes           |       | —   |       | 4,960    |       |
| Government  securities           |       | 1,197    |       | 1,208    |       |
|                             |       | $        | 49,671     |     | $          | 44,493 |   |
| Cost:                            |       |     |       |     |       |
| Municipal  obligations           |       | $        | 48,542     |     | $          | 38,327 |   |
| Agency  discount notes           |       | —   |       | 4,967    |       |
| Government  securities           |       | 1,205    |       | 1,216    |       |
|                             |       | $        | 49,747     |     | $          | 44,510 |   |
|                             |       |     |       |     |       |
| Fair market value by maturity:   |       |     |       |     |       |
| Within one  year                 |       | $        | 48,122     |     | $          | 41,714 |   |
| One to two years                 |       | 1,549    |       | 2,779    |       |
|                             |       | $        | 49,671     |     | $          | 44,493 |   |
|                             |       |     |       |     |       |
| Gross unrealized holding losses: |       |     |       |     |       |
| Municipal  obligations           |       | $        | (68        | )        | $          | (2 | ) |
| Agency  discount notes           |       | —   |       | (7       | )          |
| Government  securities           |       | (8       | )          | (8       | )          |
|                             |       | $        | (76        | )        | $          | (17 | ) |

 
| **Year Ended December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Proceeds from sales              |       | $        | 41,577     |     | $          | 9,379    |       | $ | 9,513 |   |
| Gross realized gains on sales    |       | $        | —     |     | $          | —   |       | $ | 3 |   |
| Gross realized losses on sales   |       | $        | —     |     | $          | —   |       | $ | — |   |

 

Therewe no unrealized holding gains at December 31, 2005 or 2004. We use thespecific identification method for determining gains and losses on ourmarketable securities. At December 31, 2005 and 2004, we determined thatunrealized losses on our marketable securities were temporary based on theduration of the unrealized losses and on our ability to hold the marketablesecurities until maturity.

 

**NOTE 4.INVENTORIES**

 

Inventoriesconsisted of the following (in thousands):

 
| **December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| Raw materials         |       | $        | 4,747      |     | $          | 4,665 |   |
| Work-in-process       |       | 1,138    |       | 1,548    |       |
| Finished goods        |       | 5,004    |       | 3,967    |       |
|                  |       | $        | 10,889     |     | $          | 10,180 |   |

 

F-13

----

 

**NOTE 5. FIXED ASSETS**

 

Fixedassets consisted of the following (in thousands):

 
| **December 31,**         | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Equipment                     |       | $        | 12,996     |     | $          | 12,342 |   |
| Leasehold improvements        |       | 2,743    |       | 2,772    |       |
| Construction in progress      |       | 776      |       | 61       |       |
|                          |       | 16,515   |       | 15,175   |       |
| Less accumulated depreciation |       | (12,093  | )          | (11,167  | )          |
|                          |       | $        | 4,422      |     | $          | 4,008 |   |

 

Depreciationexpense was $1.5 million, $1.8 million and $1.9 million, respectively, in 2005,2004 and 2003.

 

**NOTE 6. OTHER ASSETS**

 

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

 
| **December 31,**    | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Patents                  |       | $        | 3,945      |     | $          | 3,435 |   |
| Accumulated amortization |       | (2,527   | )          | (2,251   | )          |
|                     |       | $        | 1,418      |     | $          | 1,184 |   |

 

Amortizationexpense totaled $311,000, $255,000 and $341,000, respectively, in 2005, 2004and 2003.

 

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

 
| 2006       |   | $   | 244    |   |
|------------|--------|-----|--------|--------|
| 2007       |   | 215 |   |
| 2008       |   | 207 |   |
| 2009       |   | 204 |   |
| 2010       |   | 154 |   |
| Thereafter |   | 394 |   |

 

**NOTE 7. ACCRUED LIABILITIES**

 

Accruedliabilities consisted of the following (in thousands):

 
| **December 31,**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Accrued compensation and benefits |       | $        | 1,775      |     | $          | 1,527 |   |
| Accrued warranty                  |       | 488      |       | 365      |       |
| Other                             |       | 824      |       | 922      |       |
|                              |       | $        | 3,087      |     | $          | 2,814 |   |

 

F-14

----

 

**NOTE 8. INCOME TAXES**

 

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

 
| **Year ended December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Domestic                         |       | $        | 9,215      |     | $          | 6,161    |       | $ | (1,126 | ) |
| Foreign                          |       | 277      |       | (67      | )          | 925      |       |
|                             |       | $        | 9,492      |     | $          | 6,094    |       | $ | (201 | ) |

 

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

 
| **Year ended December 31,**     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                             |       |     |       |     |       |     |       |
| Federal                              |       | $        | 1,443      |     | $          | 1,318    |       | $ | 147 |   |
| State                                |       | 130      |       | 90       |       | 11       |       |
| Foreign                              |       | 5        |       | 139      |       | 385      |       |
| Total  current                       |       | 1,578    |       | 1,547    |       | 543      |       |
|                                 |       |     |       |     |       |     |       |
| Deferred:                            |       |     |       |     |       |     |       |
| Federal                              |       | (373     | )          | (188     | )          | (463     | )          |
| State                                |       | (23      | )          | 17       |       | 291      |       |
| Foreign                              |       | (9       | )          | 11       |       | (123     | )          |
| Total deferred                       |       | (405     | )          | (160     | )          | (295     | )          |
| Provision (benefit) for income taxes |       | $        | 1,173      |     | $          | 1,387    |       | $ | 248 |   |

 

Theprovision (benefit) for income taxes varies from the amounts computed byapplying the Federal statutory rate of 34% to income (loss) before income taxesas follows (in thousands):

 
| **Year ended December 31,**                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal income tax (benefit) computed at  statutory rates |       | $        | 3,228      |     | $          | 2,072    |       | $ | (68 | ) |
| Extraterritorial income exclusion tax  benefit            |       | (286     | )          | (340     | )          | (95      | )          |
| Difference in foreign tax rate                            |       | —   |       | 34       |       | (40      | )          |
| State income taxes, net of federal benefit                |       | 209      |       | 172      |       | (48      | )          |
| Deferred stock–based compensation                    |       | (30      | )          | 92       |       | 46       |       |
| Tax credits (R&D and foreign tax  credit)             |       | (1,289   | )          | (848     | )          | (467     | )          |
| Changes in valuation allowance                            |       | (107     | )          | 35       |       | 781      |       |
| Tax exempt interest income                                |       | (338     | )          | —   |       | —   |       |
| State net operating loss utilized                         |       | (38      | )          | —   |       | —   |       |
| Other                                                     |       | (176     | )          | 170      |       | 139      |       |
| Provision (benefit) for income taxes                      |       | $        | 1,173      |     | $          | 1,387    |       | $ | 248 |   |

 

F-15

----

 

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

 
| **December 31,**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Current deferred tax assets:               |       |     |       |     |       |
| Reserves and  allowances                   |       | $        | 310        |     | $          | 314 |   |
| Inventory  reserves                        |       | 672      |       | 650      |       |
| Accrued  vacation                          |       | 291      |       | 252      |       |
| Deferred  intercompany profit              |       | 384      |       | 159      |       |
| Other  current deferred tax assets         |       | 42       |       | 177      |       |
| Total  current deferred tax assets         |       | 1,699    |       | 1,552    |       |
|                                       |       |     |       |     |       |
| Non-current deferred tax assets:           |       |     |       |     |       |
| Retirement  allowance                      |       | 153      |       | 211      |       |
| State net  operating loss carryforwards    |       | 1        |       | 139      |       |
| State  research tax credits                |       | 1,766    |       | 1,275    |       |
| Foreign tax  credits                       |       | 244      |       | 377      |       |
| Other non-current  deferred tax assets     |       | 512      |       | 335      |       |
| Gross non-current  deferred tax assets     |       | 2,676    |       | 2,337    |       |
| Valuation  allowance                       |       | (1,766   | )          | (1,794   | )          |
| Total net  non-current deferred tax assets |       | 910      |       | 543      |       |
|                                       |       |     |       |     |       |
| Non-current deferred tax liabilities:      |       |     |       |     |       |
| Patents                                    |       | 574      |       | 478      |       |
| Net deferred tax assets                    |       | $        | 2,035      |     | $          | 1,617 |   |

 

Deferredtax assets arise from the tax benefit of amounts expensed for financialreporting purposes but not yet realized for tax purposes and from unutilizedtax credits and net operating loss carry forwards. We evaluate our deferred taxassets on a regular basis to determine if a valuation allowance is required. Tothe extent it is determined that it is more likely than not that we will notrealize the benefit of our deferred tax assets, we record a valuation allowanceagainst deferred tax assets. In 2005, we released $28,000 of valuationallowance related to the future realization of foreign tax credits and foreignnet operating losses. We now believe it is more likely than not that thebenefit of these credits and losses will be realized in future periods based onanticipated future profits.

 

Our2004 tax provision included the reversal of $726,000 of previously recordedvaluation allowance based on our 2004 performance. The reversal primarilyrelated to U.S. research and engineering credits and state net operating losscarryforwards, which were utilized during 2004. In addition, in 2004, we increasedthe valuation allowance by $761,000 for excess foreign tax credits and State ofOregon research and engineering credits, which we believe are more likely thannot to not be utilized in the future. The net result was an increase invaluation allowance in 2004 of $35,000.

 

Thenet increase (decrease) in the total valuation allowance was $28,000, $35,000and $781,000, respectively, in 2005, 2004 and 2003. The valuation allowance asof December 31, 2005 and 2004 was $1.8 million and $1.8 million, respectively.The portion of valuation allowance for deferred tax assets for whichsubsequently recognized tax benefits will be applied directly to contributedcapital is approximately $78,000.

 

In2005, 2004 and 2003, income tax benefits attributable to employee stock optiontransactions of $855,000, $2,000 and $0, respectively, were allocated toshareholders’ equity.

 

Wehad state and foreign net operating loss carryforwards, foreign tax credits andstate research and experimentation credit carryforwards of approximately$11,000, $244,000 and $1.8 million, respectively, at December 31, 2005 tooffset against future taxable income. These carryforwards expire beginning 2006through 2025.

 

F-16

----

 

Wedid not provide for U.S. income taxes on the remaining undistributed earningsof foreign subsidiaries because they were considered permanently investedoutside of the U.S. Upon repatriation, some of these earnings would generateforeign tax credits, which may reduce the U.S. tax liability associatedwith any future foreign dividend. At December 31, 2005, the cumulativeamount of earnings upon which U.S. income taxes have not been provided isapproximately $2.9 million.

 

Aprovision of the Internal Revenue Code requires the utilization of netoperating losses and research and experimentation credits be limited when we achange in ownership of more than 50% occurs. We believe that such a changeoccurred with the issuance of common stock in our initial public offering (“IPO”)in December 2004. Accordingly, the utilization of the net operating lossand credit carryforwards generated from periods prior to December 2004 may belimited in the timing of their utilization.

 

**NOTE 9.RESEARCH AND DEVELOMENT AGREEMENT WITH KEY CUSTOMER**

 

In2002, we entered into a cooperative research and development agreement with akey customer. Pursuant to the terms of the agreement, this customer reimbursesus for certain research and development work performed in relation to thedevelopment of certain probes. Accordingly, in 2005, 2004 and 2003, we receivedzero, $94,000 and $248,000, respectively, which was netted with research anddevelopment expense on our consolidated statements of operations.

 

**NOTE 10.OTHER INCOME (EXPENSE), NET**

 

Otherincome (expense), net consisted of the following (in thousands):

 
| **Year ended December 31,**                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gain on investments, net                               |       | $        | —     |     | $          | —   |       | $ | 3 |   |
| Gains related to foreign currency hedges               |       | 151      |       | 74       |       | 49       |       |
| Remeasurement related foreign currency  gains (losses) |       | (34      | )          | 132      |       | 318      |       |
| Settlement income from a service provider              |       | 700      |       | —   |       | —   |       |
| Other                                                  |       | 131      |       | 9        |       | 20       |       |
|                                                   |       | $        | 948        |     | $          | 215      |       | $ | 390 |   |

 

**NOTE 11.CONVERSION OF REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

In1999, we designated 1.5 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. The $7.0 million note was paid in full in December 2004with proceeds from our IPO.

 

**NOTE 12. SHAREHOLDERS’ EQUITY**

 

***Public Sale of Common Stock***

 

Wecompleted our IPO of 3.3 million shares of our common stock in December 2004for net proceeds of $41.6 million. Offering costs of $4.7 million were offsetagainst the proceeds. Upon completion of the IPO, all of the then outstandingshares of our Series A redeemable convertible preferred stock (“Series A”)and Series B redeemable convertible preferred stock (“Series B”)automatically converted to a total of 2,346,486 shares of our common stock, andthe common stock put agreement with one of our founders expired. Accordingly,the remaining $547,000 related to the put agreement was reclassified to commonstock. In addition, our authorized common stock increased from 12 millionshares to 100 million shares.

 

F-17

----

 

***Registration Rights***

 

Uponcompletion of our IPO, certain holders of shares of common stock haveregistration rights, including the right to require us to register the sale oftheir shares and the right to include their shares in public offerings weundertake in the future. We registered all shares of common stock that areissuable under our stock option plans and employee stock purchase plan, andthey may be freely sold in the public market, subject to certain lock-uprestrictions.

 

***Repurchase Option***

 

Weor our designee had the option to repurchase all shares held by any shareholderthat such shareholder proposed to sell, assign, pledge, encumber, transfer, orotherwise dispose of for value to a competitor. Such repurchases were at thesame terms and conditions specified in a bona fide third party offer for any orall of such securities. The repurchase option lapsed upon our IPO. Werepurchased the following shares pursuant to this repurchase option during theperiods indicated (including shares repurchased pursuant to the Stock PutAgreement described below):

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

 

***Stock Put Agreement***

 

Wehad a common stock put agreement with one of our original founders, whichexpired upon our IPO in December 2004. As part of the agreement, atthe founder’s annual option on or before July 1, we were required topurchase common shares valued at up to $150,000 based on our last annualvaluation. Additional common shares could be purchased at our discretion if soagreed to by the founder. In 2004, we purchased 15,790 shares at $9.50 pershare and in 2003, we repurchased 30,000 shares at $5.00 per share.

 

***Common Stock Warrant***

 

In1998, we issued a warrant for the purchase of 15,000 shares of our common stockat $3.80 per share. The warrant entitled the holder to additional sharesupon the satisfaction of certain conditions, as defined in the agreement.During 1999, one such condition was satisfied, increasing the number of shareseligible for purchase under the warrant to 25,000. In December 2003, weissued 18,091 shares of our common stock upon the exercise of a portion of thewarrants in exchange for $57,000 of cash and the surrender of the remainingwarrants to purchase 6,909 shares of our common stock. The fair value of theinitial 15,000 shares and the additional 10,000 shares under the warrant wasdetermined using the Black-Scholes valuation model with the followingassumptions: no dividend yield; risk-free interest rates of 4.45% and 6.19%,respectively; expected volatility of 81%; and contractual lives of 5.0 and4.5 years, respectively. The fair value of these warrants was not materialto the financial statements.

 

***Stock Option Plans***

 

Ourstock incentive plans include our 1993 Stock Incentive Plan (the “1993 Plan”)and our 2000 Stock Incentive Plan (the “2000 Plan”) (together, the “Plans”) andprovide for the granting to employees of either incentive stock options ornonqualified stock options. Incentive stock options must be granted at anexercise price not less than 100% of the fair market value per share at thegrant date. Nonqualified stock options granted or shares sold under the Planscannot be granted or sold at a price less than 85% of the fair market value pershare at the date of grant or sale. The terms of options granted under thePlans is 10 years, and the right to exercise options granted generally vests20% each year, with varying initial holding periods. The 1993 Plan expiredduring 2003 and any remaining unissued options were canceled. The 2000 Planexpires October 15, 2010. In addition, options currently outstanding underthe 1993 Plan will not be available for reissuance upon cancellation. We haveauthorized a total of 1.8 million shares of common stock for issuanceunder the 2000 Plan.

 

F-18

----

 

AtDecember 31, 2005, 386,500 shares were available for future grants, and wehad 2,107,938 shares of our common stock reserved for future issuance under thePlans. Stock option activity for each of the years in the three-year periodended December 31, 2005 was as follows:

 
| ** **                                | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| **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                                  |       |
| Granted                                   |       | 288,550                  |       | 13.83                                 |       |
| Exercised                                 |       | (433,234                 | )          | (4.39                                 | )          |
| Forfeited                                 |       | (71,966                  | )          | (8.08                                 | )          |
| **Outstanding at December 31, 2005** |       | 1,721,438                |       | $                                     | 8.37       |   |

 

Thefollowing information relates to options outstanding and exercisable under thePlans at December 31, 2005:

 
| **Options Outstanding**       | ** **        | **Options Exercisable** | ** ** |
|-------------------------------|-------------------|-------------------------|------------|
| **Range of  exercise  price** | ** **        | **Number of  options**  | ** ** | **Weighted  average  remaining  contractual  life (years)** | ** ** | **Weighted  average  exercise  price** | ** ** | **Number of  options** | ** ** | **Weighted  average  exercise  price** | ** ** |
| $                             | 3.10 – 3.80  |                    | 332,093    |   | 1.94 |   | $ | 3.33 |   | 332,093 |   | $ | 3.33 |   |
| 5.00 – 5.50              |              | 325,868                 |       | 7.27 |   | 5.24 |   | 175,308 |   | 5.17 |   |
| 7.00 – 9.50              |              | 524,858                 |       | 6.72 |   | 8.04 |   | 341,278 |   | 7.61 |   |
| 11.15 –  12.25           |              | 37,500                  |       | 6.75 |   | 11.30 |   | 17,400 |   | 11.15 |   |
| 13.52 –  14.38           |              | 501,119                 |       | 7.98 |   | 13.86 |   | 161,474 |   | 13.71 |   |
| $                             | 3.10 – 14.38 |                    | 1,721,438  |   | 6.27 |   | $ | 8.37 |   | 1,027,553 |   | $ | 6.83 |   |

 

AtDecember 31, 2004 and 2003, 1,113,562 and 1,028,825 options, respectively,were exercisable at weighted average exercise prices of $5.03 per share and$3.65 per share, respectively.

 

***Deferred Stock-Based Compensation***

 

During2003, we issued 380,450 options to employees and non-employee directors. Due tothe difference between the exercise price and the estimated fair value ofcommon stock, approximately $1.0 million of compensation expense is beingamortized over the vesting period of five years. We recognized compensationexpense of $122,000 in 2005, $326,000 in 2004 and $139,000 in 2003 related tothese options. Additionally, in 2003, we recognized the remaining $38,000 indeferred stock-based compensation related to options issued to employees andnon-employee directors prior to our attempted public offering in 2000.

 

Previouslyrecognized compensation expense related to unvested options that are forfeitedis reversed in the quarter that the options are forfeited and no futureamortization related to the forfeited options is recognized. Reversals ofcompensation expense totaled $46,000, $265,000 and $32,000 in 2005, 2004 and2003, respectively.

 

F-19

----

 

***Employee Stock Purchase Plan***

 

InFebruary 2004, our board of directors approved the 2004 Employee SharePurchase Plan (the “2004 ESPP”) and the reservation of 400,000 shares of ourcommon stock thereunder. The 2004 ESPP consists of two-year offering periodswith four consecutive, overlapping six-month purchase periods commencing on thefirst trading day on or after February 1 and August 1 each year (the “EnrollmentDate”). Based on the effective date of our IPO, the first offering periodcommenced on February 1, 2005 and ended on July 31, 2005. Anyeligible employee may participate in the 2004 ESPP by completing asubscription agreement which allows participants to purchase up to 5,000 sharesper six-month purchase period, at a purchase price of 85% of the fair marketvalue of a share of common stock on the Enrollment Date or on the exercisedate, whichever is lower. The exercise date is the last trading day of eachoffering period. If the purchase price is lower on the exercise date than onthe Enrollment Date, the two-year offering period will terminate and a new two-yearoffering period will begin. Participating employees are automatically enrolledin the new offering period. During 2005, we issued 31,000 shares pursuant tothe 2004 ESPP at a price of $8.93 per share and 369,000 shares remainedavailable for purchase.

 

**NOTE 13. RELATED PARTY TRANSACTIONS**

 

***Agilent Technologies***

 

Priorto our IPO, Agilent Technologies held all of the outstanding shares of Series Aand 87,500 shares of the Series B. Upon our IPO, the Series A and Series Bwere converted into a total of 1,424,819 shares of our common stock and, as of December 31,2005, Agilent held 798,957 shares of our common stock, which representedapproximately 7.1% of our outstanding common stock. Certain other financialinformation related to Agilent was as follows:

 
| **Year Ended December 31,**                                                                                                        | ** ** | **2005** | ** **  | **2004** | ** ** | **2003**    | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------|-------------|----------|------------|-------------|------------|
| Sales to Agilent                                                                                                                        |       | $        | 2.5 million |     | $          | 2.0 million |       | $ | 1.3 million |   |
| Purchases from Agilent                                                                                                                  |       | $        | 548,000     |     | $          | 327,000     |       | $ | 268,000 |   |
| Royalties paid  to Agilent for non-exclusive license to use certain patented technology  relating to electrical measurement apparatuses |       | $        | 11,000      |     | $          | 9,000       |       | $ | 22,000 |   |

 
| **December 31,**   | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Receivable from Agilent |       | $        | 171,000    |     | $          | 328,000 |   |
| Payable to Agilent      |       | $        | 35,000     |     | $          | 79,000 |   |

 

**NOTE 14. EMPLOYEE BENEFIT PLAN**

 

Wesponsor a 401(k) savings plan which allows eligible employees to contribute acertain percentage of their salary. We match 40% of eligible employees’contributions, up to a maximum of 2% of the employees’ earnings. Our matchingcontribution for the savings plan was $230,000, $194,000 and $180,000,respectively, in 2005, 2004 and 2003.

 

F-20

----

 

**NOTE 15. COMMITMENTS AND CONTINGENCIES**

 

***Operating Leases and Subleases***

 

Welease office and manufacturing space under operating leases that expire atvarious dates through 2009. In addition to lease expense, we pay real propertytaxes, insurance and repair and maintenance expenses for our corporate officeand manufacturing facility. We recognize rent expense related to our operatingleases based on a straight-line basis over the life of the lease. Futureminimum lease payments under noncancelable operating leases with initial orremaining terms in excess of one year are as follows (in thousands): 

 
| **Year Ending December 31,** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2006                              |       | $          | 2,410      |   |
| 2007                              |       | 2,127      |       |
| 2008                              |       | 1,518      |       |
| 2009                              |       | 590        |       |
| 2010                              |       | —     |       |
| Thereafter                        |       | —     |       |
|                              |       | $          | 6,645      |   |

 

Leaseexpense was $2.5 million, $2.5 million and $2.4 million, respectively, in 2005,2004 and 2003.

 

Weplan to sublease certain office space to a third party. For this office space,during May 2002, we expensed the rental payments for the period of timethe building would remain unoccupied and the difference between the expectedrental sublease payments and our obligation under the lease. The total amountexpensed was $628,000 and was not included in the total lease expense, but isincluded in the five-year payout table. The balance of the accrual at December 31,2005 and 2004 was $30,000 and $102,000, respectively, and was included inaccrued liabilities and other long-term liabilities on our consolidated balancesheets.

 

***Legal Proceedings***

 

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

 

**NOTE 16. SEGMENT REPORTING AND ENTERPRISE-WIDEDISCLOSURES**

 

Thesegment data below is presented in the same manner that management organizesthe segments for assessing certain performance trends. Our Chief OperatingDecision Maker monitors the revenue streams of engineering products and pyramidproducts.

 

TheChief Operating Decision Maker has determined that the additional informationpreviously prepared was arbitrary and did not provide useful information uponwhich to base operating decisions. As of January 2005, we only collectrevenue data for each segment. Accordingly, the data for 2004 and 2003 has beenreclassified to conform to the current period presentation.

 

Thefollowing table summarizes revenue for each of our business segments. We do nottrack our operating income or assets on a segment level, and, accordingly, thatinformation is not provided (in thousands):

 
| **Year Ended December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| External revenue from EPD        |       | $        | 63,566     |     | $          | 58,467   |       | $ | 47,345 |   |
| External revenue from PPD        |       | 10,071   |       | 5,948    |       | 3,211    |       |
|                             |       | $        | 73,637     |     | $          | 64,415   |       | $ | 50,556 |   |

 

F-21

----

 

Weare not able to provide revenue by product line or group of similar products asit would be impracticable to do so.

 

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

 
| **Year Ended December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States                    |       | $        | 23,877     |     | $          | 24,762   |       | $ | 24,708 |   |
| Japan                            |       | 15,085   |       | 14,909   |       | 11,838   |       |
| Taiwan                           |       | 7,612    |       | 6,853    |       | 3,631    |       |
| Other                            |       | 27,063   |       | 17,891   |       | 10,379   |       |
|                             |       | $        | 73,637     |     | $          | 64,415   |       | $ | 50,556 |   |

 

Long-livedassets, exclusive of long-term investments and deferred income taxes, bygeographic area were as follows (in thousands):

 
| **December 31,** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
| United States         |       | $        | 5,993      |     | $          | 5,230 |   |
| Japan                 |       | 108      |       | 225      |       |
| Other                 |       | 18       |       | 19       |       |
|                  |       | $        | 6,119      |     | $          | 5,474 |   |

 

F-22

----

 

**SCHEDULE II**

 

**Cascade Microtech.Inc.**

**Valuation and qualifying Accounts**

**YearsEnded December 31, 2005, 2004 and 2003**

**(Inthousands)**

 
| **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, 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 |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| **Year Ended December 31, 2005:** |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
|                                   |       |                                 |       |                                |       |                                           |       |                           |       |   |   |
| Allowance for uncollectible accounts   |       | $                                    | 86         |                                | $          | 15                                             |       | $                              | (1         | ) | $ | (3 | ) | $ | 97 |   |
| Inventory reserves                     |       | $                                    | 1,802      |                                | $          | 125                                            |       | $                              | —     |   | $ | (67 | ) | $ | 1,860 |   |

 

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(a) Charges to this account relate tochanges in foreign currency exchange rates.

(b) Charges to the accounts included inthis column are for the purposes for which the reserves were created.

 

F-23

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