##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

|                               |  |                                                                                             
|------------------------------ |  | --------------------------------------------------------------------------------------------
|þ                              |  | ANNUAL REPORT UNDER SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934          
|                               |  | For the fiscal year ended January 3,
    2004                                               
|                              
|or                            
|o                              |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|Commission file number 1-10228

Enterasys Networks, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|Delaware                                                           |  | 04-2797263                              
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer
    Identification No.)

50 Minuteman Road

Andover, Massachusetts 01810


(978) 684-1000


(Address, including zip code, and telephone
number, including area code,


of registrants principal executive
offices)


Securities registered pursuant to
Section 12(b) of the Act:

|                                       |  |                                 
|-------------------------------------- |  | --------------------------------
|Title of Each Class                    |  | Name of Exchange on Which Listed
|                                       |  |                                 
|Common Stock, Par Value $.01 Per Share |  | NYSE                            

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

Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months, (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein and will not be
contained, to the best of the registrants knowledge, in
definitive proxy for information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K. þ

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

As of March 12, 2004,
210,035,307 shares of the Registrants common stock
were outstanding. The aggregate market value of the
registrants voting stock held by non-affiliates of the
registrant as of the last business day of the Registrants
most recently completed second fiscal quarter was approximately
$678.4 million (based upon the closing price for shares of
the Registrants common stock on the New York Stock
Exchange on that date).

Documents Incorporated by Reference

We expect to file a definitive proxy statement
pursuant to Regulation 14A no later than May 3, 2004.
Portions of such proxy statement are incorporated by reference
into Part III of this annual report on Form 10-K.



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TABLE OF CONTENTS

|                                                   |  |                                                                                           |  |      |    |  |  | 
|-------------------------------------------------- |  | ----------------------------------------------------------------------------------------- |  | ---- | -- |  |  | 
|Item                                               |  |                                                                                           |  | Page
|                                                   |  |                                                                                           |  |     
|PART I                                            
|1.                                                 |  | Business                                                                                  |  |      | 2  | 
|2.                                                 |  | Properties                                                                                |  |      | 11 | 
|3.                                                 |  | Legal Proceedings                                                                         |  |      | 11 | 
|4.                                                 |  | Submission of Matters to a
    Vote of Security Holders                                   |  |      | 13 | 
|                                                  
|PART II                                           
|5.                                                 |  | Market for the
    Registrants Common Equity and Related Stockholder
    Matters         |  |      | 13 | 
|6.                                                 |  | Selected Consolidated
    Financial Data                                                  |  |      | 14 | 
|7.                                                 |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations |  |      | 15 | 
|7a.                                                |  | Quantitative and Qualitative
    Disclosures About Market Risk                            |  |      | 44 | 
|8.                                                 |  | Consolidated Financial
    Statements and Supplementary Data                              |  |      | 45 | 
|9.                                                 |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure  |  |      | 45 | 
|9a.                                                |  | Controls and Procedures                                                                   |  |      | 45 | 
|                                                  
|PART III                                          
|10.                                                |  | Directors and Executive
    Officers of the Registrant                                    |  |      | 45 | 
|11.                                                |  | Executive Compensation                                                                    |  |      | 46 | 
|12.                                                |  | Security Ownership of
    Certain Beneficial Owners and Management                        |  |      | 46 | 
|13.                                                |  | Certain Relationships and
    Related Transactions                                        |  |      | 46 | 
|14.                                                |  | Principal Accountant Fees
    and Services                                                |  |      | 46 | 
|                                                  
|PART IV                                           
|15.                                                |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                       |  |      | 47 | 
|EX-3.6 AMENDED AND RESTATED BY-LAWS               
|EX-10.12 CHANGES-IN-CONTROL SEVERANCE BENEFIT PLAN
|EX-10.13 AMENDED EXECUTIVE SEVERANCE PAY PLAN     
|EX-21.1 SUBSIDIARIES OF THE REGISTRANT            
|EX-23.1 CONSENT OF INDEPENDENT AUDITORS           
|EX-31.1 CERTIFICATION OF WILLIAM K. O'BRIEN       
|EX-31.2 CERTIFICATION OF RICHARD S. HAAK          
|EX-32.1 SECT. 906 CERTIFICATION OF WILLIAM O'BRIEN
|EX-32.2 SECT. 906 CERTIFICATION OF RICHARD HAAK   



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PART I






|        |         
|------- | --------
|Item 1. | Business

This annual report on Form 10-K and the
following disclosure contain forward-looking statements. We
caution you that any statements contained in this report which
are not strictly historical statements constitute
forward-looking statements. Such statements include, but are not
limited to, statements reflecting managements expectations
regarding our future financial performance; strategic
relationships and market opportunities; and our other business
and marketing strategies and objectives. These statements may be
identified with such words as we expect, we
believe, we anticipate, or similar indications
of future expectations. These statements are neither promises
nor guarantees, and involve risks and uncertainties that could
cause actual results to differ materially from such
forward-looking statements. Such risks and uncertainties
include, among other things, the following factors: worldwide
and regional economic uncertainty, uncertain market conditions
and recent political and social turmoil may continue to
negatively affect our business and revenue and continue to make
forecasting more difficult; we have a history of losses in
recent years and may not operate profitably in the future; our
quarterly operating results are likely to fluctuate, which could
cause us to fail to meet quarterly operating targets and result
in a decline in our stock price; we earn a substantial portion
of our revenue for each quarter in the last month of each
quarter, which reduces our ability to accurately forecast our
quarterly results and increases the risk that we will be unable
to achieve previously forecasted results; our failure to improve
and successfully implement our management information systems
and internal controls could harm our business; we continue to
introduce new products, and if our customers delay product
purchases or choose alternative solutions, our revenue could
decline, we may incur excess and obsolete inventory charges, and
our financial condition could be harmed; pending and future
litigation could materially harm our business, operating results
and financial condition; the limitations of our director and
officer liability insurance may materially harm our financial
condition; we have experienced significant turnover of senior
management and our current management team has been together for
only a limited time, which could harm our business and
operations; retaining key management and employees is critical
to our success; there is intense competition in the market for
enterprise network equipment, which could prevent us from
increasing our revenue and achieving profitability; we may be
unable to upgrade or maintain our indirect distribution
channels, which may hinder our ability to grow our customer base
and increase our revenue; if we fail to accurately predict our
manufacturing requirements we could incur additional costs or
experience manufacturing delays; we expect the average selling
prices of our products to decrease over time, which may reduce
our revenue and gross margins; we use several key components for
our products that we purchase from single or limited sources,
and we could lose sales if these sources fail to fulfill our
need on a timely basis; we depend upon a limited number of
contract manufacturers for substantially all of our
manufacturing requirements, and the loss of any of our primary
contract manufacturers would impair our ability to meet the
demands of our customers; and those additional risks and
uncertainties discussed in Managements Discussion
and Analysis of Financial Condition and Results of
Operations under Cautionary Statements and
elsewhere in this report. Readers are cautioned not to place
undue reliance on these forward looking statements, which speak
only as of the date hereof. We expressly disclaim any obligation
to publicly update or revise any such statements to reflect any
change in these forward-looking statements, or in events,
conditions, or circumstances on which any such statements may be
based, or that may affect the likelihood that actual results
will differ from those set forth in the forward-looking
statements.

All references in this annual report to
Enterasys, we, our, or
us mean Enterasys Networks, Inc.

Introduction

We design, develop, market, and support
comprehensive networking solutions architected to address the
networking requirements of global enterprises. We believe our
solutions offer customers the secure, high-capacity,
cost-effective, network connectivity required to facilitate the
exchange of information among employees, customers, vendors,
partners and other network users. We are focused on delivering
networking

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solutions that include security features within
the network architecture. We believe our solutions enable
customers to meet their network requirements for continuity,
context, control, compliance and consolidation through an
architecture and management interface designed for ease of use.
Our installed base of customers consists of commercial
enterprises; governmental entities; healthcare, financial,
educational and non-profit institutions; and various other
organizations.


We were founded in 1983 as a Delaware corporation
and are listed on the New York Stock Exchange under the
symbol ETS. Our corporate headquarters is located at
50 Minuteman Road, Andover, MA 01810. Our telephone
number is 978-684-1000, and our web site is located at
www.enterasys.com. We make our periodic and current reports
available, free of charge, on our web site as soon as reasonably
practicable after these reports are filed with, or furnished to,
the SEC. Our code of conduct, our corporate governance
guidelines, and the charters of each of the committees of our
board of directors are also made available, free of charge, on
our website. Our code of conduct, which includes our code of
ethics, is posted on our website along with any related waivers.
Copies of these documents may be obtained, free of charge, upon
written request of our investor relations department at
50 Minuteman Road, Andover, MA 01810.

Enterasys Dragon, Enterasys Matrix,
Enterasys Networks®, Enterasys RoamAbout,
NetSight®, Networks that Know, RoamAbout®,
Secure Networks, and X-Pedition are several of our
trademarks.



| |                        
| | -----------------------
| | Enterprise Requirements

Networks That Know.Todays enterprises require comprehensive network solutions
providing users with secure, reliable, real-time access to
information and applications on-demand, 24 hours a day,
7 days a week, from locations around the world. These
solutions must be accessible to a wide range of users including
employees, customers, vendors, partners and other users across
multiple network types, including hardware-based switching and
routing infrastructures, wireless access networks, and virtual
private networks, or VPNs. In providing network connectivity,
network administrators increasingly worry about eliminating or
limiting the impact of internal and external security threats as
well as facilitating compliance with various regulations dealing
with privacy, security and information availability, integrity
and use. We believe minimizing security threats and complying
with regulations is best accomplished through role-driven,
policy-based network administration. In addition, we believe
networks increasingly must be able to prioritize and route
traffic to users and allocate bandwidth to specified
applications based on business priorities instead of technology
standards. We believe our networking solutions provide
enterprises with the internal infrastructure and connectivity to
meet these needs.

We believe network requirements are fundamentally
changing as enterprises provide connectivity and simultaneously
protect that connectivity from security threats while supporting
network convergence, which is the flow of data, voice, video,
and other media on a single network. This priority shift marks a
departure for information technology, or IT, networking managers
who traditionally measured the value of their networking
solutions primarily based upon the networks ability to
provide reliable connectivity at a low cost through
high-capacity solutions. These features are now minimum
requirements rather than differentiating features for networks
as managers increasingly recognize the need for more automated,
intelligent, policy-based networks, or what we refer to as our
Networks that Know solutions.



| |              
| | -------------
| | Our Solutions

Secure Networks.We
are focused on understanding and addressing the emerging needs
of our customers, and are using our past experiences and broad
networking and security technology to build our Networks that
Know. In doing so, we believe we are differentiating ourselves
in our industry as a networking equipment vendor capable of
meeting the sophisticated network communications needs of
todays enterprise customers, while simultaneously
providing fully integrated security features and functionality.

We believe our Networks that Know solutions
provide networking infrastructures capable of recognizing the
flow of mission critical information as well as eliminating or
limiting the internal and

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external security threats that have become more
frequent, rapid and severe in recent years. Our Networks that
Know solutions are initially focusing on making the network the
central coordination point for integrating enterprise-wide
security technology.


Our focus on developing Networks that Know
solutions has allowed us to build upon our networking and
security innovations to create what we refer to as Secure
Networks solutions. Our Secure Networks solutions enable our
customers to protect against multiple security threats including
intellectual property theft, deliberate or inadvertent misuse,
and direct threats such as denial-of-service, or DoS, attacks,
worms, and viruses. Our Secure Networks solutions embed advanced
security capabilities throughout the network infrastructure in
order to protect against internal and external security threats.
We believe our embedded security features and functions are more
effective than traditional specialized point security
technologies and products, such as firewalls and anti-virus
systems, in lowering a customers exposure to security
threats which can originate at any point within the network.

Our Secure Networks solutions allow us to compete
not only on connectivity, cost and capacity, but to also deliver
the business value we believe customers are seeking by offering
an integrated, scaleable, easily configurable network capable of
becoming an active participant in addressing a customers
security needs. We believe the business value customers are
seeking can be characterized as:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Continuity  capability to continue
    business communications, despite new threats or attacks.
    Networks traditionally were measured on their ability to
    reliably transport packets of information. The increasing threat
    of network attacks coupled with the increasing importance of
    information flow means that concern is now focused on continuous
    communications despite malicious activity. We believe networks
    must both lower the success rate of attacks and limit the impact
    of attacks that do succeed in affecting the network.                                                                                                                                                                                                                                                                                                    
|
| |  | Context  communications with the
    ability to think and operate in more human terms. Networks must
    increasingly be capable of doing more than just transport
    packets of information. Networks must recognize the context of
    an information flow in order to properly prioritize traffic and
    eliminate the flow of undesirable traffic. For example, networks
    must know who sent a packet, from where, to whom and how many
    packets were sent as well as place this information in context
    in order to more effectively prioritize traffic, limit or
    eliminate the flow of undesirable traffic and protect the
    network from internal and external security threats.                                                                                                                                                                    
|
| |  | Control  capability to actively
    control network traffic at the end-user or device level.
    Networks that transport divergent communication types require
    enhanced ability to control network traffic at an end-user or
    device level without significantly increasing the number of
    networking focused, IT professionals. For example, networks
    which are able to automatically limit or eliminate network
    traffic at the end-user or device level in response to emerging
    security threats.                                                                                                                                                                                                                                                                                                                                                   
|
| |  | Compliance  capability to align
    business communications services to a businesses needs.
    Network administrators and security officers share the
    responsibility for ensuring the network is aligned with business
    requirements. These requirements include expectations of privacy
    and accountability of digital information as enforced by an
    increasing number of domestic and foreign laws and regulations.
    Customers require networks that will facilitate their
    compliance efforts by protecting information flows over the
    network.                                                                                                                                                                                                                                                                                               
|
| |  | Consolidation  capability to integrate
    dissimilar communications types and user communities without
    compromising their needs or creating new restrictions. Networks
    have moved beyond supporting only data communications to
    integrating dissimilar communications types from various user
    communities. This handling of diverse communications on a
    single, consolidated network is referred to as convergence.
    Networks must support convergence without compromising
    performance or imposing new restrictions. In other words, the
    network must have the intelligence required to secure and
    prioritize communications flows based upon the type of
    communication and the role of the individual user. For example,
    a network must prioritize voice traffic over less important
    communication traffic such as e-mail.

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We believe our Secure Networks solutions, based
upon our security and networking technologies and innovations,
are uniquely able to fulfill these five requirements. In
developing our Secure Networks solutions we focused on designing
highly intelligent networks with embedded security features,
including policy-based networking, automated network management,
and advanced user authentication. Our Secure Networks solutions
also offer our customers the ability to enhance security and
enforce network policies within multi-vendor network and
security environments. Our Secure Networks solutions have been
implemented in numerous industries, including higher education,
financial services, state and local government, healthcare and
the U.S. government.

Our Products

Our products are classified into the following
principal categories: multilayer switching, routing, wireless
networking and security. We believe our products provide the key
components that enable customers to build secure,
high-performance, highly adaptable networking infrastructures.
We design our products for large multinational enterprises with
many locations, thousands of employees and advanced
communications requirements, and for medium-sized businesses
seeking to take advantage of the latest improvements in network
communications. Our products are built with the common goal of
reducing the cost and complexity of network administration and
management in addition to providing security functionality in
accordance with customer requirements.



| |                     
| | --------------------
| | Multilayer Switching

Switches provide connectivity within a network.
Designed to fit into any environment and grow with a
customers changing requirements, our Matrix, C-Series,
N-Series, and V-Series switches address the broad market for
secure, high-speed connectivity to individual users and
departments within the enterprise network. In 2003, we
introduced new versions of approximately 90 percent of our
switching product line. Of particular note is our Matrix
N-Series switching product family which was introduced in the
second quarter of 2003 and grew to account for 25% of our fourth
quarter 2003 product shipments, largely due to its ability to
provide what we believe is industry-leading security at the edge
of the network.

Our Matrix switches use both commercially
available and proprietary application specific integrated
circuits, or ASICs, which process data and information much
faster than software-based routers while offering the desired
security, network traffic control, performance, auditing and
management services that enterprises require for day-to-day
operation. Our Matrix switches are an integral part of our
Secure Networks solution, enabling these switches to
differentiate among network users and applications. This
functionality, in conjunction with our NetSight Atlas Policy
Manager software, allows our customers to deploy a network that
we believe is more aligned with their business priorities than
more traditional networks. We expect to launch our NetSight
Atlas Automated Security Manager in 2004, which will enable
automated network responses to malicious intrusions such as
viruses and worms.



| |        
| | -------
| | Routing

Routers connect computer networks and transmit
information from one network to another. Specifically designed
for core routing in the enterprise network, our X-Pedition
family of routers combines advanced features and functionality
with high-speed performance and essential security, while
offering precise control over applications. Our routers also
incorporate proprietary hardware-based ASIC designs that enable
them to process information faster than software-based routers.
The X-Pedition routers are able to support the most widely
deployed networking technology, Ethernet, at speeds up to
10 billion bits per second. Our routers are typically
deployed in the core, or center, of the enterprise network,
where security and traffic control are most important to
enterprises. In combination with our multilayer Matrix switches,
our X-Pedition routers provide a complete network solution,
where both switches and routers share similar, complementary
security and management features. We believe this allows network
administrators to better prioritize and more precisely control
network usage, enabling productivity improvements and increased
network availability throughout the enterprise. As a fully
standards-based

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product, the X-Pedition family of routers has the
flexibility to operate in multi-vendor and multi-protocol
network environments with a broad array of local and wide area
network interfaces.




| |                    
| | -------------------
| | Wireless Networking

Wireless local area networks enable mobile
connectivity to the network. Our RoamAbout product family allows
easy, secure, high-speed and economical access to the network
from within enterprise buildings or campuses, using a mobile
device such as a laptop or handheld computer. Our RoamAbout
wireless networks function like standard wired Ethernet
networks, but use radio frequencies instead of cables for
network connection. Our RoamAbout access products have the
ability to be powered from an existing Ethernet connection,
allowing enterprises to deploy wireless local area networks
without concern for the location of power supplies.

RoamAbout technology is based on industry
standards, which currently enable two connection speeds to
support higher bandwidth applications. Our RoamAbout Access
Point 2000 provides a secure, 11 megabits per second,
or Mbps, wireless connection. The RoamAbout R2 Access Point
provides support for multiple wireless networks enabling secure
connections at speeds of 11 Mbps and 54 Mbps. The
RoamAbout AP3000 series offers support for the new
802.11g standard for WLANs offering 54 Mbps
performance with full backward compatibility to earlier
standards. The AP3000 series offers both single and dual
antenna variants at a significantly lower price point than our
previous wireless devices.



| |         
| | --------
| | Security

Most of our products incorporate security
features, using methods such as authentication procedures,
encryption, and network monitoring to prevent unauthorized
access to the network. We believe our security solutions offer a
high level of protection against both external and internal
security threats. We also offer dedicated security devices and
products, which include our Dragon and NetSight Atlas product
lines. Our Dragon intrusion detection system, or IDS, detects a
wide variety of security attacks using sophisticated algorithms
and an extensive library of over 2,000 patterns. Our Dragon
technology also offers an integrated management system for
monitoring selected devices throughout the network, enabling an
enterprise to quickly respond to security threats. NetSight
Atlas is a multi-device management application that provides
system level configuration and administration of our products
within the enterprise network. NetSight Atlas has several
modules beyond the base console. Of particular note are NetSight
Atlas Policy Manager, which supports advanced, policy-based
network administration, and NetSight Atlas Automated Security
Manager, which, upon its anticipated release in 2004, will
enable automatic, policy-based responses to network intrusions.

High-Quality Customer Support

We believe high-quality comprehensive customer
support is essential to building long-term customer
relationships. We offer a comprehensive portfolio of support
services, including pre-installation assessment, system
installation and integration assistance, and post-installation
maintenance and support services designed to address our
enterprise customers unique needs. Our support services
are designed to help customers simplify network operation and
maintenance, with the goal of maximizing network availability
and performance.

We provide high-quality support for both standard
and mission-critical network environments using the appropriate
level of expertise and resources to supplement a customers
internal capabilities. To provide service at all levels, we
complement our internal service staff with those of our channel
partners.

Our post-installation maintenance and technical
support help customers minimize network interruption and
downtime, and consist of the following options:



| |   |                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Extended Warranty consists of technical telephone
    support during our normal business hours, around the clock
    on-line support, and repair or replacement of failed products.

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| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Technical Access Service represents around the
    clock technical telephone support and on-line support, access to
    upgrades and repair or replacement of failed products.                 
|
| |  | Express Parts Service includes Technical Access
    Service and express shipment of products and parts in the event
    of equipment failure.                                                  
|
| |  | On-Site Response includes all the features of our
    Express Parts Service and the on-site assistance of our customer
    support engineers.                                                  
|
| |  | Smart Source Service includes a full complement
    of support services along with network equipment usage for
    customers looking to outsource portions of their network
    infrastructure.

Sales Overview

We sell most of our products and services to
enterprise customers through stocking distributors and channel
partners such as systems integrators, value-added resellers,
telecommunications service providers and managed security
service providers. Our distributors sell our products to these
channel partners as well, and provide us and these partners with
inventory management, credit and collection, product shipment
and other services. Our network of distributors allows us to
sell to and support a wide range of channel partners across the
world and in specific industries. We believe our channel
partners benefit from the broad service and product fulfillment
capabilities these distributors offer.

Our channel partners, often working with our
field personnel, identify, qualify and design optimal networking
solutions to meet the needs of end-users and, as necessary, seek
guidance from our sales and technical support personnel. We have
established, and continue to establish, relationships with
value-added resellers worldwide in order to increase our market
penetration and leverage the expertise of these resellers in
particular industries, applications and/or geographic areas. In
addition, we have formed and continue to form relationships with
system integrators that provide complete technology solutions,
international reach, broad technology integration and
development capabilities, and generally high-level service and
outsourcing offerings, as well as with large telecommunications
service providers that offer data, voice and/or video
communication services to businesses, governments, utilities and
consumers and that will remarket our products to their installed
customer base. Such service providers include regional, national
and international telecommunications carriers, as well as
Internet, cable and wireless service providers.

International sales represent a significant
portion of our business. We conduct sales operations primarily
in four regions around the world including North America (United
States and Canada), EMEA (Europe, the Middle East and Africa),
Asia Pacific (Asia and Australia), and Latin America (South
America, Mexico and Caribbean). Key countries include the United
States, Germany, the United Kingdom, France, Italy, Spain,
Japan, Australia, Korea and China. Asia Pacific and Latin
American sales are generated primarily through channel partners.
In the fiscal year ended January 3, 2004, sales to
customers outside of North America, including exports, accounted
for approximately 51% of our consolidated net revenue, compared
to approximately 44% for fiscal year 2002, and 50% for the
ten-month transition period ended December 29, 2001.

Marketing

Our marketing objectives are to build awareness
and acceptance of our brand and products, create demand for our
products and solutions, develop successful channel partnerships
to improve our market coverage and grow new business, and
provide education and training to end-user customers and channel
partners. To accomplish these objectives, we market our products
using direct advertising, indirect publicity, press releases,
publication of educational articles in industry journals, and
participation in industry roundtables and speaker venues. We
also maintain relationships with industry analysts, such as
Gartner, Current Analysis, IDC and Meta Group, that produce
and distribute industry information and product analysis to
end-user customers. Our marketing activities also include
participation in prominent industry trade shows, co-sponsorship
of seminar series with other industry leaders and communication
of

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virtual advertorials to broad audiences, as well
as local and field-based customer and tradeshow activities in
targeted geographic regions.


Our current marketing efforts are primarily
focused upon increasing awareness and demand by re-positioning
the company as a differentiated secure networks vendor. Our
branding campaign is focused on increasing awareness of
Enterasys as a provider of secure, automated, intelligent,
policy-driven networks which we refer to as our Networks that
Know. The goal of our marketing efforts is to clearly delineate
our ability to both solve traditional networking issues and
address the control, context, continuity, compliance, and
consolidation needs associated with todays enterprise
networks. Our focus on our Secure Networks solutions reflects
our belief that security is the highest priority of the chief
information officer.

Our demand generation activities will focus
heavily on the over 20,000 end-user customers who have bought
networking and security products from Enterasys or our partners
since 1997. Information about our installed base of customers is
allowing us to conduct targeted marketing campaigns by combining
a customers intrinsic characteristics, such as firm size
and industry, with detailed facts on its historical relationship
with Enterasys. We anticipate this data will improve the
effectiveness of our marketing campaigns.

Our channel partners and distributors extend our
direct marketing efforts to our current and prospective
customers. We provide some of these partners with marketing
funds to facilitate their marketing efforts and have developed
various incentive programs designed to encourage these partners
to market and sell our products.

Customers

Over the years we have developed a significant
installed base of end-user customers, which is an important
source of revenue. We seek to generate revenue from sales of our
Secure Networks products and solutions to new end-user customers
and by upgrading the technology used by existing end-user
customers. Our end-user customers include commercial
enterprises, government entities; healthcare, educational and
non-profit institutions; and other organizations. We believe it
is significant that many of these end-user customers have
already deployed and are obtaining the benefits of our Secure
Networks solutions.

During the fiscal year ended January 3,
2004, one distributor, Tech Data, accounted for approximately
23% of net revenue. During the fiscal year ended
December 28, 2002, two distributors, Tech Data and Ingram
Micro, accounted for approximately 17% and 12% of net revenue,
respectively. No individual direct sales customer accounted for
more than 10% of net revenue. During the ten months ended
December 29, 2001, Azlan Group PLC, a European distributor,
and Tech Data accounted for approximately 14% and 10% of net
revenue, respectively. On March 31, 2003, Tech Data and
Azlan Group PLC merged. Combined net revenue from Tech Data and
Azlan accounted for 27%, 26% and 24% of net revenue for fiscal
year 2003, fiscal year 2002 and transition year 2001,
respectively. Our top ten customers represented in the
aggregate, approximately 58% of our net revenue for the year
ended January 3, 2004, 62% of our net revenue for the
fiscal year ended December 28, 2002, and 56% of our net
revenue for the ten month-period ended December 29, 2001.
The U.S. government and its various agencies accounted for
approximately 8%, 11%, and 13% of net revenue for fiscal year
2003, fiscal year 2002 and transition year 2001, respectively.

Competition

The market for enterprise network communications
products is very competitive, subject to rapid technological
change and significantly affected by new product introductions
and other market activities of industry participants. This
market is dominated by several large companies, both
domestically and internationally, many of which, in particular
Cisco Systems, have substantially greater market share than
other competitors, including us. The remainder of the network
communications products market is highly fragmented. Our
principal competitors include Alcatel, Cisco Systems, Extreme
Networks, Foundry Networks, Hewlett-Packard, Huawei, Nortel
Networks and 3Com, although we experience competition from a
number of smaller public and private companies. Prospective
customers may be reluctant to replace

8



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or expand their current infrastructure solutions,
which may have been supplied by one or more of these established
competitors, with our products.


We believe that the principal competitive factors
in the enterprise networking market are:



| |   |                                                                                        
| | - | ---------------------------------------------------------------------------------------
| |  | effective and reliable customer solutions and
    service offerings;                   
|
| |  | technology leadership;                                                                 
|
| |  | ability to provide communications in a secure
    environment;                         
|
| |  | compatibility with industry standards, other
    vendor products and prior generations;
|
| |  | price of products, total cost of ownership and
    cost to change vendors;             
|
| |  | access to customers and size of installed
    customer base; and                       
|
| |  | customer service and support.                                                          

We believe that we compete favorably with our
competitors on the basis of many of the foregoing factors.
Additionally, we believe we can fulfill the emerging
requirements of enterprises in the areas of control, context,
continuity, compliance, and consolidation as they apply to
network infrastructure. We believe our ability to fulfill these
requirements is based upon underlying metrics such as control at
the user level, fewer successful DoS attacks, and reduced time
to respond to an attack. However, we operate in an extremely
competitive marketplace and may not compete favorably on the
basis of one or more of these factors in the future. We intend
to compete by investing in product development, expanding our
customer base, developing our name recognition and branding, and
focusing on operating efficiencies. Because some of our
competitors have greater name recognition, larger installed
customer bases and greater financial, technical, sales,
marketing and other resources, they may have increased access to
customers, the ability to more aggressively adjust product
pricing, and more resources to devote to product development.

Manufacturing and Components

We outsource the manufacture of our products to
third party contractors that provide comprehensive services,
including procurement of raw materials and components, assembly
and repair work. Our contract manufacturers use automated
testing equipment to perform inspection testing and use
statistical process controls to assure the quality and
reliability of our products. Our engineering and supply chain
management personnel work closely with our contract
manufacturers to ensure that products are manufactured to
specifications and supplied on a timely basis. We design and
develop most of the key components of our products, including
ASICs and printed circuit boards. We also determine the
components that are incorporated in our products and select the
appropriate suppliers of these components. In addition, we
conduct quality assurance, manufacturing, engineering, document
control and test development.

Flextronics International, Ltd. is presently our
primary contract manufacturer. Flextronics manufactures our
products primarily at its facility in Cork, Ireland as well
as at its newly constructed facility in Portsmouth, New
Hampshire. Our contract with Flextronics expired in February
2002. Since that time, we have been operating under extensions
of the expired contract that include modifications primarily to
provide us with more flexibility with respect to production lead
times and payment. In addition, we have been negotiating a new
manufacturing agreement with Flextronics.

We also contract with Accton Technology
Corporation, which manufactures certain of our products at its
facility in Taiwan. Our agreement with Accton renews for
successive one year periods unless terminated by written notice
from either party at least ninety days prior to the expiration
of the then current term of the contract.

We source several key components used in the
manufacture of our products that may be considered custom or
unique, including ASICs, from single or limited sources and are
dependent upon these sources to meet our needs. These custom
components typically require longer lead times in order to
minimize the

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impact of shortages and delays. Although we may
have encountered shortages and delays in obtaining custom
components in the past, we do not believe that such shortages
have impaired our ability to provide products to customers on a
timely basis. Historically, we have relied heavily on custom
components and components that are not used across multiple
products, resulting in excess raw materials and finished goods
inventory. We continuously seek to incorporate fewer custom
components in our products and use more common components across
multiple products.


Research and Development

The networking industry is highly competitive and
subject to evolving industry standards and continuous
technological advancements. We believe that strong product
development capabilities are essential to our strategy of
enhancing our core technology, which we use across multiple
product lines, and developing new and enhanced products to
maintain our competitiveness in the enterprise networking
market. Accordingly, our research and development efforts are
focused on improving our existing products and developing
innovative products that meet the evolving networking needs of
enterprises.

As of January 3, 2004, we had approximately
450 engineers in our research and development organization,
located in five research and development facilities in the
United States and Canada. Our research and development
organization has produced an international patent portfolio that
protects our advanced technologies within our network solutions.
Our engineers and technologists are active in key industry
standards organizations, and have leadership roles in several,
allowing us to better understand and influence technological
developments in the networking industry. We also have
relationships with leading component suppliers, including
Intel, IBM, Broadcom, Motorola, Marvell and LSI, which
provide us with early insight into new technologies.

We have made and will continue to make a
substantial investment in research and development. We plan to
continue to invest in emerging technologies for use in existing
and future products primarily through internal efforts as well
as through alliances, out-sourcing, and acquisitions. However,
we cannot assure you that our investment in research and
development will enable us to successfully introduce new and
enhanced products or maintain our competitiveness in the
enterprise networking market. For the fiscal year ended
January 3, 2004, the fiscal year ended December 28,
2002, and the ten-month transition period ended
December 29, 2001, we spent approximately $84 million,
$85 million and $76 million, respectively, on research
and development.

Intellectual Property

We generally rely on a combination of patent,
copyright, trademark and trade secret laws and contractual
restrictions to establish and protect our technology. As of
January 3, 2004, we had a total of 668 issued patents and
an additional 132 patents pending for examination worldwide. Our
products are also protected by trade secret and copyright laws
of the United States and other jurisdictions. However, these
legal protections provide only limited protection. Further, the
market for network communications solutions is subject to rapid
technological change. Accordingly, while we intend to continue
to protect our proprietary rights where appropriate, we believe
that our success in maintaining a technology leadership position
is more dependent on the technical expertise and innovative
abilities of our personnel than on these legal protections.

Despite our efforts to protect our proprietary
technology, we cannot assure you that the steps we take will be
adequate to prevent misappropriation of our technology or that
our competitors will not independently develop technologies that
are substantially equivalent or superior to our technology. The
laws of many countries do not protect proprietary technology as
extensively as the laws of the United States. We may need to
resort to litigation in the future to enforce our intellectual
property rights, to protect our trade secrets, or to determine
the validity and scope of our proprietary rights or those of
others. We are also subject to the risk of adverse claims and
litigation alleging infringement of the intellectual property
rights of others. Any resulting litigation could result in
substantial costs and diversion of management and adverse effect
on our business and financial condition.

10



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Backlog

Our products are often sold on the basis of
standard purchase orders that are cancelable prior to shipment
without significant penalties. In addition, purchase orders are
subject to changes in quantities of products and delivery
schedules in order to reflect changes in customer requirements
and manufacturing capacity. Our business is characterized by
quarter-end variability in demand and short lead-time orders and
delivery schedules. Actual shipments depend on the then-current
capacity of our contract manufacturers and the availability of
materials and components from our vendors. We believe that only
a small portion of our order backlog is non-cancelable and that
the dollar amount associated with the non-cancelable portion is
immaterial. Accordingly, we do not believe that backlog at any
given time is a meaningful indicator of future sales.

Employees

As of January 3, 2004, we had approximately
1,400 full-time employees, compared with approximately
1,630 full-time employees as of December 28, 2002. The
decrease in the number of employees was largely a result of the
termination of employees in connection with our cost reduction
initiatives. Our employees are not represented by a union or
other collective bargaining agent and we consider our relations
with our employees to be good.






|        |           
|------- | ----------
|Item 2. | Properties

We lease several facilities, including our
corporate headquarters, a 152,000 square foot facility in
Andover, Massachusetts. We also lease a 75,000 square foot
warehousing and distribution center located in
Shannon, Ireland, and a 27,000 square foot building in
Toronto, Canada. Remaining leased sales offices range from 1,000
to 16,000 square feet.

We own one building totaling 210,750 square
feet in Rochester, New Hampshire. This building accommodates
certain distribution, warehousing, engineering, information
technology and customer support departments.

We are continuing efforts to consolidate and
reduce our worldwide facilities and as a part of this process
may pursue the lease or sublease of one or more of our existing
facilities. Certain exited facilities are not yet sublet,
including our 110,000 square foot former distribution and
warehousing location in Rochester, New Hampshire.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

In the normal course of our business, we are
subject to proceedings, litigation and other claims. Litigation
in general, and securities and intellectual property litigation
in particular, can be expensive and disruptive to normal
business operations. Moreover, the results of litigation are
difficult to predict. The uncertainty associated with these and
other unresolved or threatened legal actions could adversely
affect our relationships with existing customers and impair our
ability to attract new customers. In addition, the defense of
these actions may result in the diversion of managements
resources from the operation of our business, which could impede
our ability to achieve our business objectives. The unfavorable
resolution of any specific action could materially harm our
business, operating results and financial condition, and could
cause the price of our common stock to decline significantly.

Described below are the material legal
proceedings in which we are involved:

Securities Class Action in the District
of Rhode Island.Between
October 24, 1997 and March 2, 1998, nine shareholder
class action lawsuits were filed against us and certain of our
officers and directors in the United States District Court for
the District of New Hampshire. By order dated March 3,
1998, these lawsuits, which are similar in material respects,
were consolidated into one class action lawsuit, captioned In
re Cabletron Systems, Inc. Securities Litigation (C.A.
No. 97-542-SD). The case was transferred to the
District of Rhode Island. The complaint alleges that we and
several of our officers and directors disseminated materially
false and misleading information about our operations and acted
in violation of

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Section 10(b) of the Exchange Act and
Rule 10b-5 thereunder during the period between
March 3, 1997 and December 2, 1997. The complaint
further alleges that certain officers and directors profited
from the dissemination of such misleading information by selling
shares of our common stock during this period. The complaint
does not specify the amount of damages sought on behalf of the
class. The defendants have filed an answer denying the
allegations in all material respects, and the parties are
engaged in limited discovery. If the plaintiffs prevail on the
merits of this case, we could be required to pay substantial
damages.


Securities Class Action in the District
of New Hampshire.Between
February 7, 2002 and April 9, 2002, six class action
lawsuits were filed in the United States District Court for the
District of New Hampshire. Defendants were us, former chairman
and chief executive officer Enrique Fiallo and former chief
financial officer Robert Gagalis. By orders dated August 2,
2002 and September 25, 2002, these lawsuits, which are
similar in material respects were consolidated into one class
action lawsuit, captioned In re Enterasys Networks, Inc.
Securities Litigation (C.A. No. 02-CV-71). On
December 9, 2002, the plaintiffs filed an amended
consolidated complaint, adding two additional defendants, Piyush
Patel, former chief executive officer of Cabletron
Systems, Inc. (Cabletron) and David
Kirkpatrick, former chief financial officer of Cabletron. The
amended complaint alleged violations of Sections 10(b) and
20(a) of the Exchange Act and Rule 10b-5 thereunder.
Specifically, plaintiffs alleged that during periods spanning
from June 28, 2000 and August 3, 2001 and in the
period between August 6, 2001 and February 1, 2002
(together the Class Period), defendants issued
materially false and misleading financial statements and press
releases that overstated our revenues, income, and cash, and
understated our net losses, in violation of Generally Accepted
Accounting Principles (GAAP) and our own accounting
policies in connection with various sales and/or investment
transactions. On December 19, 2003, the court granted final
approval of the terms of the settlement reached by the parties
in this matter under which, without admitting liability, we
agreed to pay approximately $17.0 million in cash, to
distribute shares of common stock with a settlement date value
of $33.0 million, and to adopt corporate governance changes.

Shareholder Derivative Action in State of New
Hampshire.On February 22, 2002,
a shareholder derivative action was filed on our behalf in the
Superior Court of Rockingham County, State of New Hampshire. The
suit was captioned Nemes v. Fiallo, et al.
Individual defendants were former chairman and chief executive
officer Enrique Fiallo and certain members of our Board of
Directors. Plaintiffs alleged that the individual defendants
breached their fiduciary duty to shareholders by causing or
allowing us to conduct our business in an unsafe, imprudent, and
unlawful manner and failing to implement and maintain an
adequate internal accounting control system. Plaintiffs alleged
that this breach caused us to improperly recognize revenue in
violation of GAAP and our own accounting policies in connection
with transactions in our Asia Pacific region, and that this
alleged wrongdoing resulted in damages to us. On
December 18, 2003, the court granted final approval of the
terms of the settlement reached by the parties in this matter
under which, without admitting liability, we agreed to adopt
corporate governance changes and pay attorneys fees up to
$0.4 million.

Shareholder Derivative Action in State of
Delaware.On April 16, 2002, a
shareholder derivative action was filed on our behalf in the
Court of Chancery of the State of Delaware in and for New Castle
County. The suit was captioned Meisner v. Enterasys
Networks, Inc., et al. Individual defendants were
former chairman and chief executive officer Enrique Fiallo and
members of our Board of Directors. Plaintiffs alleged that the
individual defendants permitted wrongful business practices to
occur which had the effect of manipulating revenues and
earnings, inadequately supervised our employees and managers,
and failed to institute legal actions against those officers,
directors and employees responsible for the alleged conduct. The
complaint alleged counts for breach of fiduciary duty,
misappropriation of confidential information for personal
profit, and contribution and indemnification. The parties
settled this action in connection with the settlement of the New
Hampshire derivative action. On January 15, 2004, the court
granted final approval of the terms of the settlement.

Other.In addition,
we are involved in various other legal proceedings and claims
arising in the ordinary course of business. Management believes
that the disposition of these additional matters, individually
or in the aggregate, is not expected to have a materially
adverse effect on our financial

12



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condition. However, depending on the amount and
timing of such disposition, an unfavorable resolution of some or
all of these matters could materially affect our future results
of operations or cash flows in a particular period.







|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

None.




PART II






|        |                                                                              
|------- | -----------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
    Equity and Related Stockholder Matters

Stock Price History

The following table sets forth the high and low
sale prices for our Common Stock as reported on the
New York Stock Exchange (symbol  ETS
) during the last two fiscal years.

|                                       |  |      |      |     |  |   |      | 
|-------------------------------------- |  | ---- | ---- | --- |  | - | ---- | 
|Year Ended January 3, 2004             |  | High |      | Low
|                                       |  |      |      |    
|First quarter ended March 29, 2003     |  | $    | 2.30 |     |  | $ | 1.50 | 
|Second quarter ended June 28, 2003     |  |      | 3.87 |     |  |   | 1.73 | 
|Third quarter ended September 27, 2003 |  |      | 6.70 |     |  |   | 2.84 | 
|Fourth quarter ended January 3, 2004   |  | $    | 5.80 |     |  | $ | 3.40 | 

|                                       |  |      |       |     |  |   |      | 
|-------------------------------------- |  | ---- | ----- | --- |  | - | ---- | 
|Year Ended December 28, 2002           |  | High |       | Low
|                                       |  |      |       |    
|First quarter ended March 30, 2002     |  | $    | 11.20 |     |  | $ | 3.50 | 
|Second quarter ended June 29, 2002     |  |      | 4.25  |     |  |   | 1.02 | 
|Third quarter ended September 28, 2002 |  |      | 1.69  |     |  |   | 0.80 | 
|Fourth quarter ended December 28, 2002 |  | $    | 1.82  |     |  | $ | 0.81 | 

As of March 12, 2004, we had approximately
2,411 stockholders of record. We have not paid dividends on our
common stock, and do not anticipate paying dividends in the
future. We expect we will continue to reinvest any earnings to
finance future growth.

Equity Compensation Plan Information

The information required under this item may be
found under the section captioned Equity Compensation
Plans in our 2004 Proxy Statement, which will be filed
with the SEC no later than May 3, 2004, and is incorporated
by reference herein.

Recent Sales of Unregistered
Securities

In December 2003, we distributed
1,304,340 shares of our treasury stock with a value of
$4.9 million in connection with a court approved settlement
of our outstanding shareholder litigation related to the
restatement of our financial results for our 2001 fiscal and
transition years. These shares were distributed to the
plaintiffs counsel and no underwriter was used in
connection with this distribution. These shares were issued in
reliance on the exemption from registration provided under
Section 3(a)(10) of the Securities Act of 1933, as
securities issued in exchange for a bonafide outstanding claim
where the terms and conditions of such issuance are approved,
after a fairness hearing, by a court authorized to grant
approval.

13



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##### Table of Contents








|        |                                         
|------- | ----------------------------------------
|Item 6. | Selected Consolidated Financial
    Data

The following table sets forth selected
consolidated financial data for the fiscal years ended
January 3, 2004 and December 28, 2002, the ten-month
transition period ended December 29, 2001 and the fiscal
years ended March 3, 2001 and February 29, 2000, which
has been derived from our Consolidated Financial Statements. For
a detailed analysis of the fiscal years ended January 3,
2004 and December 28, 2002 and the ten-month period ended
December 29, 2001, please refer to
Item 7  Managements Discussion and
Analysis of Financial Condition and Results of Operations
and Item 8  Consolidated Financial
Statements and Supplementary Financial Data.

|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |           |         | 
|----------------------------------------------------------------------------------------------- | ------------------------ | ------------------------------------------------------------------------------------------------------------------------------ | ------- | ------------ | -------- | ------------ | ------- | ---------- | -------- | ------------ | ------- | ------- | -------- | - | -------- | ------- | -------- | - | ------- | --------- | ------- | 
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |           
|                                                                                                |                          |                                                                                                                                |         |              |          | Ten Months   |         | Year Ended
|                                                                                                |                          | Year Ended                                                                                                                     |         | Year Ended   |          | Ended        |         |           
|                                                                                                |                          | January 3,                                                                                                                     |         | December 28, |          | December 29, |         | March 3,   |          | February 29,
|                                                                                                |                          | 2004                                                                                                                           |         | 2002         |          | 2001         |         | 2001       |          | 2000        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |             
|                                                                                                |                          |                                                                                                                               
|                                                                                                |                          | (In thousands, except per share data)                                                                                         
|Consolidated Statements of Operations
    Data:                                                 |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|Net revenue:                                                                                    |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                | Enterasys segment        |                                                                                                                                | $       | 414,538      |          |              | $       | 484,797    |          |              | $       | 394,545 |          |   | $        | 704,665 |          |   | $       | 638,235   |        
|                                                                                                | Other segment(1)         |                                                                                                                                |         |             |          |              |         |           |          |              |         |        |          |   |          | 69,702  |          |   |         | 712,462   |        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                | Total net revenue        |                                                                                                                                |         | 414,538      |          |              |         | 484,797    |          |              |         | 394,545 |          |   |          | 774,367 |          |   |         | 1,350,697 |        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|Gross margin                                                                                    |                          |                                                                                                                                | 208,375 |              |          |              | 209,795 |            |          |              | 44,169  |         |          |   | 342,600  |         |          |   | 597,698 |          
|Research and development                                                                        |                          |                                                                                                                                | 84,029  |              |          |              | 85,019  |            |          |              | 76,471  |         |          |   | 81,723   |         |          |   | 131,852 |          
|Selling, general and administrative                                                             |                          |                                                                                                                                | 173,933 |              |          |              | 234,960 |            |          |              | 284,735 |         |          |   | 335,303  |         |          |   | 348,922 |          
|Amortization of intangible assets                                                               |                          |                                                                                                                                | 6,503   |              |          |              | 8,708   |            |          |              | 32,366  |         |          |   | 23,176   |         |          |   | 28,952  |          
|Stock-based compensation                                                                        |                          |                                                                                                                                | 158     |              |          |              | 2,644   |            |          |              | 30,572  |         |          |   | 1,442    |         |          |   |        |          
|Special charges                                                                                 |                          |                                                                                                                                | 17,532  |              |          |              | 31,978  |            |          |              | 47,168  |         |          |   | 63,187   |         |          |   | 21,096  |          
|Shareholder litigation expense(2)                                                               |                          |                                                                                                                                | 15,900  |              |          |              |        |            |          |              |        |         |          |   |         |         |          |   |        |          
|Impairment of intangible assets                                                                 |                          |                                                                                                                                |        |              |          |              |        |            |          |              | 104,147 |         |          |   | 14,104   |         |          |   | 12,318  |          
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                | Total operating expenses |                                                                                                                                |         | 298,055      |          |              |         | 363,309    |          |              |         | 575,459 |          |   |          | 518,935 |          |   |         | 543,140   |        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                |                          | Income (loss) from operations                                                                                                  |         |              | (89,680  | )            |         |            | (153,514 | )            |         |         | (531,290 | ) |          |         | (176,335 | ) |         |           | 54,558  | 
|Interest income, net                                                                            |                          |                                                                                                                                | 5,132   |              |          |              | 8,347   |            |          |              | 17,672  |         |          |   | 29,981   |         |          |   | 18,614  |          
|Other income (expense), net                                                                     |                          |                                                                                                                                | (27,354 | )            |          |              | (42,625 | )          |          |              | (41,209 | )       |          |   | (557,355 | )       |          |   | 746,282 |          
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                |                          | Income (loss) from continuing operations before
    income taxes and cumulative effect of a change in
    accounting principle |         |              | (111,902 | )            |         |            | (187,792 | )            |         |         | (554,827 | ) |          |         | (703,709 | ) |         |           | 819,454 | 
|Income tax expense (benefit)                                                                    |                          |                                                                                                                                | 749     |              |          |              | (85,247 | )          |          |              | 60,242  |         |          |   | (98,187  | )       |          |   | 317,185 |          
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                |                          | Income (loss) from continuing operations before
    cumulative effect of a change in accounting principle                      |         | $            | (112,651 | )            |         | $          | (102,545 | )            |         | $       | (615,069 | ) |          | $       | (605,522 | ) |         | $         | 502,269 | 
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|Income (loss) from continuing operations
    available to common shareholders per common share: |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                | Basic                    |                                                                                                                                | $       | (0.56        | )        |              | $       | (0.57      | )        |              | $       | (3.24   | )        |   | $        | (3.40   | )        |   | $       | 2.83      |        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          
|                                                                                                | Diluted                  |                                                                                                                                | $       | (0.56        | )        |              | $       | (0.57      | )        |              | $       | (3.24   | )        |   | $        | (3.40   | )        |   | $       | 2.66      |        
|                                                                                                |                          |                                                                                                                                |         |              |          |              |         |            |          |              |         |         |          |   |          |         |          |   |         |          

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##### Table of Contents



|                                       |  |                |         |              |  |              |         |          |  |              |         |  |  |   |           |  |  |   |           | 
|-------------------------------------- |  | -------------- | ------- | ------------ |  | ------------ | ------- | -------- |  | ------------ | ------- |  |  | - | --------- |  |  | - | --------- | 
|                                       |  | January 3,     |         | December 28, |  | December 29, |         | March 3, |  | February 29,
|                                       |  | 2004           |         | 2002         |  | 2001         |         | 2001     |  | 2000        
|                                       |  |                |         |              |  |              |         |          |  |             
|                                       |  |               
|                                       |  | (In thousands)
|Consolidated Balance Sheet Data:       |  |                |         |              |  |              |         |          |  |              |         |  |  |   |           |  |  |   |           | 
|Working capital(3)                     |  | $              | 54,120  |              |  | $            | 38,249  |          |  | $            | 134,324 |  |  | $ | 848,179   |  |  | $ | 469,364   | 
|Total assets                           |  | $              | 388,610 |              |  | $            | 581,347 |          |  | $            | 750,038 |  |  | $ | 1,733,514 |  |  | $ | 3,121,705 | 
|Redeemable convertible preferred stock |  | $              |        |              |  | $            |        |          |  | $            | 61,789  |  |  | $ | 109,589   |  |  | $ |          | 
|Stockholders equity                   |  | $              | 180,061 |              |  | $            | 245,950 |          |  | $            | 329,704 |  |  | $ | 1,214,319 |  |  | $ | 2,147,439 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Other Segment included the revenue and cost
    of revenue relating to legacy products based on non-Ethernet
    standards that are no longer sold by us.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   
|(2) | During the fourth quarter of fiscal year 2003, we
    finalized our agreements to settle the outstanding shareholder
    litigation against us, and certain of our directors and former
    officers filed in connection with the financial restatements for
    the 2001 fiscal and transition years. Under the financial terms
    of the settlements, we agreed to pay $17.4 million in cash
    and to distribute 8,727,851 shares of our stock with a
    settlement date value of $33.0 million. The
    $50.4 million total cost of the settlements was partially
    offset by the receipt of approximately $34.5 million in
    cash proceeds from certain of our insurers, resulting in a net
    litigation expense of $15.9 million.
|   
|(3) | Working capital includes the $94.8 million
    current portion of redeemable convertible preferred stock as a
    liability at December 28, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

You should read the following discussion in
conjunction with the section below titled Cautionary
Statements, our Consolidated Financial Statements and
related Notes, and other financial information appearing
elsewhere in this annual report on Form 10-K. We refer to
our current fiscal year, the twelve-month period ending
January 1, 2005 as fiscal year 2004, the
twelve-month period ending January 3, 2004 as fiscal
year 2003 and our prior fiscal year, the twelve-month
period ended December 28, 2002 as fiscal year
2002 throughout this Item. We refer to the ten-month
transition period from March 4, 2001 through
December 29, 2001 as transition year 2001 and
the twelve-month period ended March 3, 2001 as fiscal
year 2001. We refer to the twelve-month period ended
February 29, 2000 as fiscal year
2000.

Business Overview

We design, develop, market, and support
comprehensive networking solutions architected to address the
networking requirements of global enterprises. We believe our
solutions offer customers the secure, high-capacity,
cost-effective, network connectivity required to facilitate the
exchange of information among employees, customers, vendors,
partners and other network users. We are focused on delivering
networking solutions that include security features within the
network architecture. We believe our solutions enable customers
to meet their requirements for network continuity, context,
control, compliance and consolidation through an architecture
and management interface designed for ease of use. Our installed
base of customers consists of commercial enterprises;
governmental entities; healthcare, financial, educational and
non-profit institutions; and various other organizations. Our
product revenue consists primarily of sales of our network
hardware, including switches, routers, wireless devices and
other networking equipment. Product revenue also includes
revenue from the sale of our software products, including our
Dragon intrusion detection software and our NetSight Atlas
network management software. Our services revenue is derived
from our contracts with customers to provide on-going
maintenance and support services around the world, 7 days a
week, 24 hours a day, network outsourcing contracts, as
well as provide installation and professional services to
install, develop and improve network performance and
capabilities.

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Our company has undergone significant changes in
recent years, including discontinuance or sale of certain
product lines during fiscal year 2001 and the spin-off of our
wholly owned subsidiary, Riverstone Networks, during transition
year 2001. During fiscal year 2002, we began an internal
investigation and cooperated fully with an SEC investigation,
into our accounting and reporting practices. Our internal
investigation was completed during the fourth quarter of fiscal
year 2002, and the SEC investigation was settled during the
first quarter of fiscal year 2003. Additionally, during fiscal
year 2002 we made significant changes to our management team
including the appointment of a new Chief Executive Officer and
Executive Vice President of Supply Chain Management, as well as
promoting our Vice President of Finance to the position of Chief
Financial Officer.

During fiscal year 2003, we continued to make
significant changes designed to improve our competitive position
including significant upgrades to our portfolio of products,
further enhancements to our management team, the initiation of a
sales and marketing improvement program, and the implementation
of additional restructuring initiatives to reduce our costs.
Enhancements to our product portfolio during fiscal year 2003
included the release of our new modular switching platform, the
Matrix N Series. The Matrix N Series products were
released during the second quarter of fiscal year 2003, and
accounted for 8% of product shipments for the second quarter of
fiscal year 2003, growing to 25% of product shipments for the
fourth quarter of fiscal year 2003. Other new products
introduced during fiscal year 2003 include the Matrix V2
stackable switch, a high performance Matrix E1 edge switch,
our Matrix C1 Series switches for small to medium sized
enterprise networks, the RoamAbout R2 wireless access point
along with our 802.11a and 802.11 a/b/g wireless cards, and
several new releases of our NetSight and Dragon software. We
anticipate making further enhancements to our product portfolio
including additional enhancements to our switching product line,
introduction of a new core router platform, and the release of
additional software based solutions to enhance network security.

We have continued to enhance our management team
during fiscal year 2003, including the addition of our
President, Mark Aslett, in April 2003. Mr. Aslett joined us
from Marconi Plc, where he held positions as the Executive Vice
President of Marketing, and earlier in his tenure at Marconi, as
the President of Marconi Communications North America. Also in
April 2003, we appointed Leon K. Woo as our Executive Vice
President, Engineering. Mr. Woo joined us from Tenor
Networks, a router start-up venture, following our acquisition
of certain intellectual property and assets of Tenor. In March
2004, we appointed Michael Rivers as our Executive Vice
President of Worldwide Sales and Service. Mr. Rivers has
over 20 years of executive leadership experience with
global enterprise networking companies.

As part of our sales and marketing improvement
program, we have developed a market differentiation strategy
based on our Secure Networks solutions, established new sales
partnerships, and enhanced sales tools designed to improve sales
execution. Our Secure Networks solutions embed security
pervasively into the network infrastructure itself in order to
provide protection against internal and external security
threats. We began a marketing and advertising campaign during
the first quarter of fiscal year 2004 which emphasizes our
Secure Networks solutions. Since the fourth quarter of fiscal
year 2002, we have formed new sales partnerships with IBM and
SAIC, formed a new distributor relationship with Westcon, and
during the first quarter of fiscal year 2004, we initiated a new
partnership with Lucent Technologies which is aimed at
broadening our market reach through the Lucent professional
services organization. In an effort to improve internal sales
execution we have developed a historical customer database
designed to improve our coverage of customer accounts, and
implemented new sales tools including a sales opportunity
management system and e-commerce tools with our partners.

We have also implemented a number of cost
reduction initiatives designed to improve gross margins and
reduce fixed operating costs in the past two fiscal years. Since
the beginning of fiscal year 2002, we have reduced our headcount
by approximately 39%, resulting in cumulative annualized labor
cost reductions of approximately $65.0 million. During the
same time period, we have closed or reduced the size of eleven
facilities. The workforce reductions during fiscal year 2003
were the result of an evaluation of our workforce and skill
levels necessary to satisfy the expected future requirements of
the business. We have recorded restructuring charges of
$17.5 million in fiscal year 2003, which included
$14.7 million in employee severance related costs for
approximately 405 individuals, plus $2.8 million in
facility exit costs

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##### Table of Contents



primarily as a result of consolidation of our
North American distribution center into an owned facility with
excess space. Net of new hires, we expect to decrease our
workforce of 1,400 employees at January 3, 2004 by
approximately 50 employees, once all the planned actions are
completed. The fiscal year 2003 reductions in the global
workforce involved most functions within the Company.


Since fiscal year 2001, we have incurred losses
from our operations. We incurred a net loss from operations of
$89.7 million for fiscal year 2003, down from
$153.5 million in fiscal year 2002 and $531.3 million
for transition year 2001. The decrease in the net loss from
operations is due to improved gross margins and decreased
operating costs. Gross margin percentage improved to 50.3% for
fiscal year 2003, as compared to 43.3% for fiscal year 2002 and
11.2% for transition year 2001. The improvement in gross margin
is primarily a result of decreases in charges for excess and
obsolete inventory, lower overhead costs for supply chain
management due to cost reduction initiatives, and higher margins
on new products. Operating expenses decreased to
$298.1 million for fiscal year 2003, as compared to
$363.3 million in fiscal year 2002 and $575.5 million
in transition year 2001. The reduction in operating expenses is
primarily a result of implementing various cost reduction
initiatives, lower costs associated with the SEC investigation
and our internal investigation into our financial accounting and
reporting practices, along with lower special charges for
severance, facility exit costs, entity spin-off costs and asset
impairments. Improved gross margins and lower operating
expenses, as well as the receipt of net tax refunds of
$34.6 million and net insurance recoveries of
$17.5 million from our shareholder litigation settlement
enabled us to achieve positive cash flow provided by operations
of $5.4 million for fiscal year 2003.

Net revenues decreased 14.5% in fiscal
year 2003 as compared to fiscal year 2002. The decline
in net revenues is due to a 13.4% decrease in product revenue
primarily due to lower sales of certain routing products for
which we are in the process of developing a replacement, and
increased competition for certain lower technology based
switching products. In addition, service revenue declined 17.2%
primarily due to the expiration of maintenance contracts on
discontinued products. These decreases were partially offset by
increased sales of our new switching products.

During the fourth quarter of fiscal
year 2003, we finalized our agreements to settle the
outstanding shareholder litigation against us, and certain of
our former directors and officers filed in connection with the
financial restatements for the 2001 fiscal and transition
years. Under the financial terms of the settlements, we agreed
to pay $17.4 million in cash and to distribute
8,727,851 shares of our stock with a settlement date value
of $33.0 million. During the fourth quarter of fiscal
year 2003, we paid $17.0 million of our cash
obligation, and distributed 1,304,340 shares of our stock.
We paid the remaining cash obligation of $0.4 million in
January 2004, and we expect to distribute the remaining stock
obligation of 7,423,511 shares of our stock during fiscal
year 2004. The $50.4 million total cost of the
settlements was partially offset by the receipt of approximately
$34.5 million in cash proceeds from certain of our insurers
during the fourth quarter of fiscal year 2003. We recorded
a net litigation charge of $15.9 million during the third
quarter of fiscal year 2003 to reflect the net result of
the settlements. We are currently engaged in legal proceedings
against certain other insurers to recover a portion of the
remaining expenses incurred by us in connection with the
shareholder litigation and other related matters.

17



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##### Table of Contents



Results of Operations

The table below sets forth the principal line
items from our consolidated statements of operations, each
expressed as percentages of net revenue for the three years
ended January 3, 2004:

|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |       |        |   
|----------------------------------- | --------------------- | ------------------------ | ---- | ----------- | ----- | --------------- | ---- | ---- | ----- | -- | ---- | ----- | ------ | --
|                                    |                       | Fiscal Year              |      | Fiscal Year |       | Transition Year
|                                    |                       | 2003                     |      | 2002        |       | 2001           
|                                    |                       |                          |      |             |       |                
|Net revenue:                        |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    | Product               |                          |      | 72.4        | %     |                 |      | 71.5 | %     |    |      | 65.4  | %     
|                                    | Services              |                          |      | 27.6        |       |                 |      | 28.5 |       |    |      | 34.6  |       
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    |                       | Total revenue            |      |             | 100.0 |                 |      |      | 100.0 |    |      |       | 100.0  |   
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|Cost of revenue:                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    | Product               |                          |      | 53.0        |       |                 |      | 66.7 |       |    |      | 117.4 |       
|                                    | Services              |                          |      | 41.1        |       |                 |      | 31.6 |       |    |      | 34.8  |       
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    |                       | Total cost of revenue    |      |             | 49.7  |                 |      |      | 56.7  |    |      |       | 88.8   |   
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|Gross margin:                       |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    | Product gross margin  |                          |      | 47.0        |       |                 |      | 33.3 |       |    |      | (17.4 | )     
|                                    | Services gross margin |                          |      | 58.9        |       |                 |      | 68.4 |       |    |      | 65.2  |       
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    |                       | Total gross margin       |      |             | 50.3  |                 |      |      | 43.3  |    |      |       | 11.2   |   
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|Research and development            |                       |                          | 20.3 |             |       |                 | 17.5 |      |       |    | 19.4 |      
|Selling, general and administrative |                       |                          | 42.0 |             |       |                 | 48.5 |      |       |    | 72.2 |      
|Amortization of intangible assets   |                       |                          | 1.6  |             |       |                 | 1.8  |      |       |    | 8.2  |      
|Stock-based compensation            |                       |                          |     |             |       |                 | 0.6  |      |       |    | 7.7  |      
|Shareholder litigation expense      |                       |                          | 3.8  |             |       |                 |     |      |       |    |     |      
|Special charges                     |                       |                          | 4.2  |             |       |                 | 6.6  |      |       |    | 12.0 |      
|Impairment of intangible assets     |                       |                          |     |             |       |                 |     |      |       |    | 26.4 |      
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    |                       | Total operating expenses |      |             | 71.9  |                 |      |      | 75.0  |    |      |       | 145.9  |   
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      
|                                    |                       | Loss from operations     |      |             | (21.6 | )%              |      |      | (31.7 | )% |      |       | (134.7 | )%
|                                    |                       |                          |      |             |       |                 |      |      |       |    |      |      

Comparison of Fiscal Year 2003 with
Fiscal Year 2002



| |            
| | -----------
| | Net Revenue

Net revenue decreased by $70.3 million, or
14.5%, from $484.8 million in fiscal year 2002 to
$414.5 million in fiscal year 2003, primarily due to
lower unit sales volume, as well as lower revenue from
maintenance contracts. Geographically, net revenue decreased in
fiscal year 2003 compared to fiscal year 2002 in all
regions except for Asia Pacific, which increased
$11.2 million or 30.9%, primarily due to growth in China.
Net revenue to customers in North America decreased by
$68.7 million, or 25.1%; net revenue to customers in
Europe, the Middle East and Africa decreased by
$6.3 million, or 4.4%; and, net revenue to customers in
Latin America decreased by $6.5 million, or 20.1%.

Product revenue decreased by $46.5 million,
or 13.4%, from $346.6 million in fiscal year 2002 to
$300.1 million in fiscal year 2003. The decline in net
product revenue is primarily a result of lower sales of our
X-Pedition routing products, and increased competition for our
lower technology switching products, such as our Vertical
Herizon and Matrix V2 switching products. These decreases
in product revenue have been partially offset by increased sales
of our new Matrix N Series modular switching products which
accounted for approximately 25% of product shipments during the
fourth quarter of fiscal year 2003, as well as increased
sales of our new stand-alone Matrix E1 switch. We are
continuing to upgrade our portfolio of products to improve our
competitive position including the anticipated introduction of
next generation core routing technologies at or near the end of
fiscal year 2004. We have also implemented a

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number of sales and marketing initiatives aimed
at improving our market share, including the formation of new
relationships with distributors and resellers, the
implementation of new sales tools to improve sales execution,
and the initiation of a new marketing and advertising campaign
in fiscal year 2004.


Services revenue decreased by $23.8 million,
or 17.2%, from $138.2 million in fiscal year 2002 to
$114.4 million in fiscal year 2003. The decrease in
services revenue is primarily due to a declining maintenance
revenue base resulting from the expiration of higher priced
maintenance contracts on discontinued products, which in some
cases have been replaced by lower priced contracts for new
products. Sales of new product maintenance contracts were not
sufficient to offset the decline in our maintenance revenue
base. For the first quarter of fiscal year 2004, we expect
services revenue to decline $3 million to $4 million
from the previous quarter to approximately $24 million to
$25 million. We believe that services revenue will remain
weak in fiscal year 2004 until growth in new product sales
and associated maintenance contracts are sufficient to replace
the expiration of higher-priced maintenance contracts on
discontinued products.

We expect the market for enterprise networking
equipment to remain relatively flat in the near term, which may
result in increased competition. Increased competition could
negatively impact product revenue, and combined with the
expected decline in net services revenue, could result in a
reduction in total net revenues in the near term.



| |             
| | ------------
| | Gross Margin

Although net revenues decreased by 14.5%, total
gross margin as a percentage of net revenue increased to 50.3%
in fiscal year 2003, as compared to 43.3% in fiscal
year 2002. This increase is primarily the result of
improved product gross margin.

Product gross margin increased to 47.0% in fiscal
year 2003 compared to 33.3% in fiscal year 2002. The
product gross margin percentage improvement was primarily due to
a reduction of $11.1 million in charges for excess and
obsolete inventory, which increased gross margin by 3.0%, as
well as initiatives designed to lower supply costs from our
contract manufacturers, and higher margins on new products. Our
product gross margin percentage varies depending on unit volumes
and product mix sold as well as other factors such as
competitors pricing. In addition, the nature and timing of
our new product introductions, as well as our competitors
new products entering the markets we serve, could adversely
affect our inventory levels in the future and may result in
additional excess and obsolete inventory provisions. Since our
new products generally have higher margins than the products
they replace, we believe that an increasing proportion of new
product sales should result in fiscal year 2004 product
gross margins higher than those attained for fiscal
year 2003.

Services gross margin percentage decreased from
68.4% in fiscal year 2002 to 58.9% in fiscal
year 2003, primarily due to a decrease of 17.2% in net
services revenue and charges for the write-down of service
spares inventory to net realizable value. These decreases to
services gross margin were partially offset by $9.3 million
in reduced labor costs due to workforce reductions. Increased
sales of newer products, as well as recent and anticipated
expirations of legacy maintenance contracts, resulted in an
excess of certain service parts during fiscal year 2003.
Based on the revised usage estimates, service spares inventory
was written down by $5.4 million to net realizable value.
We expect that services gross margin percentage will not
increase much above 60% until the growth in new product sales
and associated maintenance contracts are sufficient to replace
the expiration of legacy maintenance contracts.



| |                   
| | ------------------
| | Operating Expenses

Research and development expense decreased by
$1.0 million from $85.0 million in fiscal
year 2002 to $84.0 million in fiscal year 2003,
primarily due to decreases in facility costs due to certain
facility closures, and decreased depreciation expense as certain
assets became fully depreciated. These decreases in research and
development expenses were partially offset by increased labor
costs related primarily to development of our next generation
core routing platform. Fourth quarter fiscal year 2003
research and development expense was $20.7 million. We
expect quarterly research and development expense for the first
half of

19



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##### Table of Contents



fiscal year 2004 to increase to
approximately $22.0 million to $23.0 million as we
invest in additional enhancements to our portfolio of products.
Once these additional investments are complete, we expect
quarterly research and development expenses to fall below
$20.0 million by the fourth quarter of fiscal
year 2004.


Selling, general and administrative, or SG&A,
expense decreased by $61.1 million from $235.0 million
in fiscal year 2002, to $173.9 million in fiscal
year 2003. The decrease in SG&A expense was primarily
the result of a $25.6 million decrease in costs, including
related audit fees, associated with the settled SEC
investigation, our internal investigation and the various
pending shareholder lawsuits discussed in this annual report; a
decrease of $16.2 million in labor related costs associated
with workforce reductions; a $9.5 million decrease in
provisions for bad debts primarily due to recoveries of
$7.9 million in fiscal year 2003; a $6.5 million
decrease in provisions for customer lease guarantees primarily
due to recoveries of $4.2 million in fiscal year 2003; and
a $1.5 million decrease in facility costs as a result of
facility consolidations. Fourth quarter fiscal year 2003
SG&A expenses were $40.2 million and included
approximately $4.0 million of recoveries primarily related
to bad debt and insurance claims. We expect that the amount of
recoveries related to bad debt and insurance claims will decline
significantly in fiscal year 2004 compared to the fourth quarter
of fiscal year 2003. In connection with our brand awareness
campaign, we expect to increase marketing and advertising
expenses by approximately $5 million to $6 million in
fiscal year 2004 as compared to the prior year.



| |                                      
| | -------------------------------------
| | Amortization of Intangible
    Assets

Amortization of intangibles decreased by
$2.2 million from $8.7 million in fiscal year 2002 to
$6.5 million in fiscal year 2003, primarily as a result of
certain patents and technology related intangibles becoming
fully amortized. We expect the amortization of intangible assets
for fiscal year 2004 to remain approximately at the fiscal year
2003 amount.



| |                         
| | ------------------------
| | Stock-based Compensation

Stock-based compensation decreased by
$2.4 million from $2.6 million in fiscal year 2002 to
$0.2 million in fiscal year 2003 as a result of the
underlying stock options, granted in connection with
acquisitions in prior years, becoming fully vested. We do not
expect to incur charges for stock-based compensation for fiscal
year 2004.



| |                                   
| | ----------------------------------
| | Shareholder Litigation
    Expense

During the fourth quarter of fiscal year 2003, we
finalized our agreements to settle the outstanding shareholder
litigation against us, and certain of our directors and former
officers filed in connection with the financial restatements for
the 2001 fiscal and transition years. Under the financial terms
of the settlements, we agreed to pay $17.4 million in cash
and to distribute 8,727,851 shares of our stock with a
settlement date value of $33.0 million. The
$50.4 million total cost of the settlement was partially
offset by the receipt of approximately $34.5 million in
cash proceeds from certain of our insurers during the fourth
quarter of fiscal year 2003. We recorded a net litigation charge
of $15.9 million during the third quarter of fiscal year
2003 to reflect the net result of the settlements.



| |                
| | ---------------
| | Special Charges

We recorded restructuring charges of
$17.5 million during fiscal year 2003, which included
$14.7 million in employee severance related costs for
approximately 405 individuals and $2.8 million of facility
exit costs primarily as a result of consolidation of our North
American distribution center into an owned facility with excess
space and a decrease in estimated future sublease income
anticipated from a vacated facility. The fiscal year 2003
workforce reductions involved most functions within the
business. During fiscal year 2002, we recorded special charges
of $32.0 million related to restructuring costs, which
included exit costs of $6.2 million related to the closure
or reduction in size of ten facilities and $25.8 million
for employee severance costs.

20



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##### Table of Contents





| |                     
| | --------------------
| | Interest Income, net

Interest income, net declined from
$8.3 million in fiscal year 2002 to $5.1 million in
fiscal year 2003, primarily due to lower average cash and
investment balances available for investing.



| |                   
| | ------------------
| | Other Expense, net

Other expense, net decreased to
$27.4 million for fiscal year 2003 as compared to
$42.6 million for fiscal year 2002, primarily due to a
$20.0 million loss incurred on the Riverstone stock
derivative in fiscal year 2002. The Riverstone stock derivative
was related to our convertible preferred stock redemption
liability, which was redeemed during the first quarter of fiscal
year 2003. Other expense, net consisted primarily of investment
impairments of $27.8 million for fiscal year 2003 as
compared to $22.1 million of investment impairments for
fiscal year 2002. The investment impairments are primarily
related to our legacy investments in non-marketable equity
securities of privately-held technology companies and
value-added resellers, many of which are in the start-up or
development stage. Investments in these companies are inherently
risky, which could lead to additional impairment charges in
fiscal year 2004. At January 3, 2004, these investments on
the consolidated balance sheet totaled approximately
$11.4 million, as compared to $39.1 million as of
December 28, 2002.



| |                             
| | ----------------------------
| | Income Tax Expense (Benefit)

For fiscal year 2003, we did not record an income
tax benefit for losses generated in the U.S. due to the
uncertainty of realizing such benefits and the fact that we have
fully utilized our tax loss carryback benefits. During fiscal
year 2003, we incurred net tax expense of $0.7 million
associated with certain foreign and state taxes. For fiscal year
2002, we recorded an income tax benefit of $85.2 million
primarily due to the utilization of tax loss carryback benefits
associated with the passage of the Job Creation and Worker
Assistance Act of 2002 which changed the allowable period to
carry back net operating losses from two to five years.



| |                                      
| | -------------------------------------
| | Loss from Discontinued
    Operations

During fiscal year 2002, we recorded an
additional charge of $11.7 million due to a change in
estimate of the loss on disposal of our wholly owned subsidiary
Aprisma, which was sold in August of 2002. The original
provision of $1.3 million for the loss on the disposal of
Aprisma was recorded in transition year 2001.

Comparison of Fiscal Year 2002 with Transition
Year 2001



| |            
| | -----------
| | Net Revenue

Net revenue increased by $90.3 million, or
22.9%, from $394.5 million in transition year 2001 to
$484.8 million for fiscal year 2002, primarily because
transition year 2001 included only ten months of operations
compared with twelve months in fiscal year 2002 as a result of
the change in our fiscal year end. Fiscal year 2002 revenue also
benefited from four quarterly sales cycles, compared with only
three quarterly sales cycles in transition year 2001, since our
product revenue is significantly higher in the last month of a
quarterly sales cycle. Additionally, during the third quarter of
transition year 2001, we determined that we could no longer
estimate the amount of future product returns from certain
stocking distributors located in the United States and Europe
and recorded a revenue adjustment of approximately
$76.0 million related to inventory on hand at these
distributors that had previously been recorded as revenue based
on shipments to them. This revenue adjustment was approximately
72.0% of net product revenue for the second quarter of
transition year 2001. Since that time, we have recognized
revenue from these distributors when they ship our product to
their customers.

Product revenue increased by $88.7 million,
or 34.4%, from $257.9 million in transition year 2001 to
$346.6 million in fiscal year 2002 primarily due to the
$76.0 million revenue adjustment for the change in revenue
recognition method for distributors as noted above. Services
revenue increased by $1.6 million, or

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1.2% from $136.6 million in transition year
2001 to $138.2 million in fiscal year 2002. The slight
increase was due to the shorter fiscal period in the prior
ten-month transition year offsetting lower fiscal year 2002
maintenance revenue renewal rates related to our discontinued
products.




| |             
| | ------------
| | Gross Margin

Total gross margin as a percentage of net revenue
was 43.3% in fiscal year 2002, compared with 11.2% in transition
year 2001. The margin percentage improvement was principally due
to product gross margin, which increased to 33.3% compared to a
negative gross margin of 17.4% in transition year 2001. The
product gross margin percentage improvement was primarily due to
the lower provision for excess and obsolete inventory in fiscal
year 2002. In transition year 2001, we recorded a
$72.9 million provision for excess and obsolete inventory,
principally as a result of lower sales volume than forecast.
Fiscal year 2002 excess and obsolete charges of
$17.9 million related principally to a reserve for the
carrying value of inventory held by certain cash-basis partners
in Asia-Pacific where we concluded that neither payment nor
return of the inventory held by them was probable, and increased
reserves for customer evaluation inventories as well as
increased reserves for certain excess raw materials. The fiscal
year 2002 provision negatively impacted product margin by
5.2 percentage points compared with 28.3 percentage
points in transition year 2001. Other contributing factors to
the product margin improvement included increased product
revenue, and lower supply chain overhead costs resulting from
headcount reductions and process improvement initiatives.
Services margin percentage improved slightly from 65.2% in
transition year 2001 to 68.4% in fiscal year 2002, primarily due
to higher service revenues in fiscal year 2002 and workforce
reduction initiatives designed to lower fixed service operating
costs.



| |                   
| | ------------------
| | Operating Expenses

Research and development expense increased by
$8.5 million from $76.5 million in transition year
2001 to $85.0 million in fiscal year 2002, due to the fact
that transition year 2001 included only ten months of operations
compared with twelve months in fiscal year 2002. Based on
average monthly spending during transition year 2001, annualized
research and development expense for transition year 2001 would
have been slightly higher than fiscal year 2002. Cost reduction
initiatives implemented during fiscal year 2002, which included
workforce reductions and facilities closings, decreased research
and development expense in fiscal year 2002 as compared to
transition year 2001.

Selling, general and administrative, or SG&A,
expense decreased by $49.7 million from $284.7 million
in transition year 2001 to $235.0 million in fiscal year
2002 despite the fact that transition year 2001 includes only
ten months of operations compared with twelve months in fiscal
year 2002. The decrease is primarily due to a decrease of
$26.0 million in provisions for bad debt and lease
guarantees, a $15.2 million decrease in marketing and
advertising expenses, other cost reductions for various
workforce reductions and reduced rent and overhead associated
with the closure of various sales offices, and the dissolution
of a former holding company and the related costs of that entity
as part of the spin-off events which took place during
transition year 2001. During fiscal year 2002 we ceased
guaranteeing equipment leases for our customers. The decreases
in SG&A expenses were partially offset by $21.0 million
in costs incurred in fiscal year 2002 associated with the SEC
investigation and our internal investigation into our financial
accounting and reporting practices, the subsequent restatement
of our fiscal year and transition year 2001 financial
statements, and the various shareholder lawsuits discussed in
this annual report.



| |                                      
| | -------------------------------------
| | Amortization of Intangible
    Assets

Amortization of intangibles decreased by
$23.7 million from $32.4 million in transition year
2001 to $8.7 million in fiscal year 2002, primarily because
we discontinued amortizing goodwill as of the beginning of
fiscal year 2002 in conjunction with our adopting
SFAS No. 142, Goodwill and Other Intangible
Assets.See Note 9 to our consolidated financial
statements included in Item 8 of this annual report on
Form 10-K.

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| |                         
| | ------------------------
| | Stock-based Compensation

Stock-based compensation related to stock options
issued in connection with fiscal year 2001 acquisitions of
Network Security Wizards and Indus River Networks was
$2.6 million in fiscal year 2002 and $30.6 million in
transition year 2001.



| |                
| | ---------------
| | Special Charges

Special charges decreased from $47.2 million
in transition year 2001 to $32.0 million in fiscal year
2002. During fiscal year 2002, we recorded special charges of
$32.0 million which included exit costs of
$6.2 million related to the closure or reduction in size of
ten facilities and $25.8 million for employee severance
costs. Special charges incurred during transition year 2001
included $24.5 million of costs related to the spin-off of
Riverstone and $22.7 million of restructuring costs. The
transition year 2001 restructuring costs included a write-down
of $2.2 million for a vacant office building in Rochester,
New Hampshire, to its estimated fair value, facility exit costs
of $2.6 million and severance costs of $17.9 million.



| |                                    
| | -----------------------------------
| | Impairment of Intangible
    Assets

Impairment of intangible assets in transition
year 2001 reflected a fourth quarter charge of
$104.1 million relating to goodwill recorded in connection
with our acquisition of Indus River Networks. The impairment was
primarily due to the complex, proprietary nature of the Indus
River VPN technology, which had to be substantially redesigned
in order to conform with emerging industry standards; the
introduction of new, low cost VPN products and technologies by a
leading provider of network security products who captured a
market leadership position during transition year 2001; and
abandonment of our development efforts in conjunction with a
significant reduction in the acquired workforce during
transition year 2001.



| |                     
| | --------------------
| | Interest Income, net

Interest income, net declined from
$17.7 million in transition year 2001 to $8.3 million
in the fiscal year 2002, due to lower average cash, cash
equivalents and marketable securities balances and lower
interest rates.



| |                   
| | ------------------
| | Other Expense, net

Other expense, net increased to
$42.6 million in fiscal 2002 as compared to other expense,
net of $41.2 million in transition year 2001, primarily due
to a $20.0 million loss incurred on the Riverstone stock
derivative in fiscal year 2002 compared to a gain of
$4.0 million in transition year 2001. The increase in the
loss on the Riverstone stock derivative was offset by a decrease
in investment impairments to $22.1 million for fiscal year
2002 compared to $65.9 million in transition year 2001. In
addition, during transition year 2001, we entered into a number
of transactions in which we made an investment in a customer in
exchange for cash and/or our products and services. In certain
of these transactions we recorded the difference between the
cost of the consideration given and the fair value of the
investment received as other expense. These transactions
resulted in losses of $17.1 million for the transition year
2001. Lastly, during transition year 2001, we sold
2.0 million shares of Efficient Networks, Inc., or
Efficient, common stock, which we received in connection with
the sale of our FlowPoint, Inc. subsidiary during fiscal
year 2000, and tendered our remaining 8.5 million shares
for proceeds of $242.7 million in connection with a tender
offer to acquire the outstanding shares of Efficient common
stock made by Siemens A.G. In connection with these
transactions, we recognized the remaining deferred gain of
$46.8 million during the transition year 2001.



| |                             
| | ----------------------------
| | Income Tax Expense (Benefit)

For fiscal year 2002, we recorded an income tax
benefit of $85.2 million primarily due to the utilization
of tax loss carryback benefits associated with the passage of
the Job Creation and Worker Assistance Act of 2002 which changed
the allowable period to carry back net operating losses from two
to

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five years. For the transition year 2001, we
incurred income tax expense of $60.2 million due primarily
to the increase in the deferred tax asset valuation allowance of
$82.3 million, partially offset by a reduction in current
tax liabilities of $22.0 million. In addition, we did not
record any income tax benefit relating to losses incurred in the
period because expected income from operations and gains did not
materialize in transition year 2001.




| |                                      
| | -------------------------------------
| | Loss from Discontinued
    Operations

During fiscal year 2002, we recorded a charge of
$11.7 million due to a change in estimate of the loss on
disposal of Aprisma. During transition year 2001, we recorded a
loss from discontinued operations of $101.9 million that
consisted of $59.1 million of operating losses from
discontinued operations of our wholly owned subsidiaries,
Aprisma, Riverstone, and GNTS and provision for losses on
disposal of GNTS and Aprisma of $41.5 million and
$1.3 million, respectively.



| |                                                          
| | ---------------------------------------------------------
| | Cumulative Effect of a Change in Accounting
    Principle

During the first quarter of transition year 2001,
we adopted SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities,and
recorded a transition adjustment, which resulted in an after tax
increase in net income of $12.7 million related to our
written call options on Efficient common stock held as of
March 4, 2001. This transition adjustment is reflected in
our results of operations for transition year 2001 as the
cumulative effect of a change in accounting principle.

Business Acquisitions and
Dispositions

In July 2001, we distributed our shares of
Riverstone common stock to our shareholders and recorded a
non-cash charge to retained earnings of approximately
$329.6 million, which reflected the distribution of the net
value of the Riverstone shares to our shareholders. In July
2001, the operations of our GNTS subsidiary were discontinued
through the acquisition of a small portion of GNTS by a third
party. The remaining results were either absorbed by us or our
Aprisma subsidiary or discontinued. In August 2002, we sold
Aprisma to a third party. As a result, we have presented Aprisma
as a discontinued operation for all periods presented and GNTS
and Riverstone as discontinued operations for transition year
2001.

Liquidity and Capital Resources

The sections below discuss the commitments on our
liquidity and capital resources, and the effects of changes in
our balance sheet and cash flows.



| |            
| | -----------
| | Commitments

The following is a summary of our significant
contractual cash obligations and other commercial commitments as
of January 3, 2004:

|                                    |  |               |      |           |  |           |      |           |  |         |      |  |  |   |     |  |  |   |     | 
|----------------------------------- |  | ------------- | ---- | --------- |  | --------- | ---- | --------- |  | ------- | ---- |  |  | - | --- |  |  | - | --- | 
|                                    |  |               |      | Less Than |  |           |      |           |  | Over   
|Contractual Cash Obligations        |  | Total         |      | 1 Year    |  | 1-3 Years |      | 4-5 Years |  | 5 Years
|                                    |  |               |      |           |  |           |      |           |  |        
|                                    |  |              
|                                    |  | (In millions)
|Non-cancelable lease obligations    |  | $             | 45.8 |           |  | $         | 12.6 |           |  | $       | 17.7 |  |  | $ | 8.4 |  |  | $ | 7.1 | 
|Non-cancelable purchase commitments |  |               | 12.8 |           |  |           | 12.8 |           |  |         |     |  |  |   |    |  |  |   |    | 
|                                    |  |               |      |           |  |           |      |           |  |         |      |  |  |   |     |  |  |   |     | 
|Total contractual cash obligations  |  | $             | 58.6 |           |  | $         | 25.4 |           |  | $       | 17.7 |  |  | $ | 8.4 |  |  | $ | 7.1 | 
|                                    |  |               |      |           |  |           |      |           |  |         |      |  |  |   |     |  |  |   |     | 

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|                                    |  |               |      |           |  |           |     |           |  |         |     |  |  |   |     |  |  |   |     | 
|----------------------------------- |  | ------------- | ---- | --------- |  | --------- | --- | --------- |  | ------- | --- |  |  | - | --- |  |  | - | --- | 
|                                    |  |               |      | Less Than |  |           |     |           |  | Over   
|Other Commercial Commitments        |  | Total         |      | 1 Year    |  | 1-3 Years |     | 4-5 Years |  | 5 Years
|                                    |  |               |      |           |  |           |     |           |  |        
|                                    |  |              
|                                    |  | (In millions)
|Aprisma lease payment guarantees(1) |  | $             | 4.0  |           |  | $         |    |           |  | $       |    |  |  | $ |    |  |  | $ | 4.0 | 
|Venture capital commitments(2)      |  |               | 12.0 |           |  |           | 3.0 |           |  |         | 9.0 |  |  |   | n/a |  |  |   | n/a | 
|                                    |  |               |      |           |  |           |     |           |  |         |     |  |  |   |     |  |  |   |     | 
|Total commercial commitments        |  | $             | 16.0 |           |  | $         | 3.0 |           |  | $       | 9.0 |  |  | $ |    |  |  | $ | 4.0 | 
|                                    |  |               |      |           |  |           |     |           |  |         |     |  |  |   |     |  |  |   |     | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Aprisma lease guarantee reduces to
    $3.0 million in 2009, $2.0 million in 2010,
    $1.0 million in 2011 and terminates in 2012. We are
    indemnified for up to $3.5 million in losses.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(2) | We are committed to make up to $12.0 million
    of additional capital contributions among two venture capital
    funds in which we are already an investor. In the event of
    future capital calls, we could be required to fund some or all
    of this commitment. If we fail to make a required contribution,
    then our existing investments with a carrying value of
    $1.5 million at January 3, 2004 would be significantly
    diluted. Based on recent communications from these funds, we
    expect approximately $2.0 million to $3.0 million of
    the remaining commitment could be called by the funds during
    fiscal year 2004. We cannot predict the likelihood or timing of
    capital calls for the remaining commitment.

Accrued severance costs of $3.8 million as
of January 3, 2004 will be paid out during fiscal year
2004; and the remaining accrued exit costs of $6.7 million,
which consisted of long-term lease commitments, will be paid as
follows: $2.6 million in fiscal year 2004,
$1.0 million in fiscal year 2005, $0.8 million in
fiscal year 2006, $0.7 million in fiscal year 2007, and
$1.6 million thereafter.

Our certificate of incorporation provides that we
will indemnify and advance expenses to our directors and
officers to the maximum extent permitted by Delaware law.
Accordingly, we are obligated to indemnify our former directors
and officers named as defendants in the shareholder litigation,
which is described in this annual report on Form 10-K under
Part 1, Item 3, Legal Proceedings. Although we have
director and officer liability insurance, our insurance for the
period during which events related to the shareholder litigation
are alleged to have occurred provides us with only limited
liability protection. We are unable to estimate our future
indemnification obligations or predict whether our director and
officer liability insurance will cover these obligations in
whole or in part.



| |                             
| | ----------------------------
| | Balance Sheet and Cash Flows

As of January 3, 2004, our liquid
investments totaled $202.5 million, as compared to
$288.8 million at December 28, 2002, and consisted of
$136.8 million of cash and cash equivalents,
$29.9 million of marketable securities and
$35.8 million of long-term marketable securities. In
connection with the issuance of letters of credit by several
banking institutions, we have agreed to maintain specified
amounts of cash, cash equivalents and marketable securities in
collateral accounts controlled by those institutions. These
assets totaled $18.7 million at January 3, 2004, and
are classified as Restricted cash, cash equivalents and
marketable securities on our balance sheet. The decrease
in liquid investments during fiscal year 2003 is the result of
the redemption of the Series D&E preferred stock, and
the loss from operations, which were partially offset by the
receipt of income tax refunds, and insurance proceeds. Based on
our liquid investment position at January 3, 2004, we
believe that we have sufficient liquid investments to fund our
on-going operations and future obligations for at least the next
twelve months.

Net cash provided by operating activities was
$5.4 million for the year ended January 3, 2004 and
was positively impacted by the receipt of $34.6 million in
net income tax refunds, and $17.5 million in insurance
proceeds received, net of settlement costs, in connection with
the shareholder litigation settlement. We do not expect any
significant tax refunds in the near future. Cash provided by
operations was negatively impacted by $14.7 million in
payments related to severance and facility exit costs. Cash
payments relating to severance and facility exit initiatives
implemented to date are expected to be approximately
$6.4 million for fiscal year 2004. We are currently engaged
in legal proceedings against certain other insurers to recover a
portion of the remaining expenses incurred by us in connection
with the shareholder litigation and other related matters. We
are also engaged in proceedings against our former

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subsidiary, Riverstone Networks, to recover
approximately $13.0 million based on indemnity claims
related to their obligations to us. There can be no assurance as
to the timing or ultimate outcome of these matters.


Net cash from operating activities is expected to
be negative in the first half of fiscal year 2004. The expected
negative operating cash flow is due in part to the timing of
trade accounts payable obligations as well as certain payments
for accrued expenses and other liabilities, including accruals
for compensation and benefits, legal and litigation costs,
restructuring charges, and sales and VAT expense.

Capital expenditures for the fiscal year 2003
were $18.6 million and consisted of internal information
technology purchases and upgrades, including the cost to
implement our enterprise resource planning system, or ERP
system, in our Asia Pacific and EMEA regions, assets purchased
to support outsourcing contracts, equipment and software used in
research and development activities, as well as equipment and
certain fixed assets and intellectual property purchased from
Tenor Networks. We expect capital spending of approximately
$18.0 million to $20.0 million for fiscal year 2004.

On February 21, 2003, the holders of our
Series D and E Preferred Stock notified us of their
intention to exercise their right to redeem these shares
effective as of February 23, 2003. We redeemed all
outstanding shares of our Series D and E Preferred Stock
during the first quarter of fiscal year 2003 for
$96.8 million, which is net of the value of the Riverstone
shares sold by the holders of these shares which partially
offset our redemption liability.

Accounts receivable, net of allowance for
doubtful accounts, were $37.5 million at January 3,
2004 compared with $41.7 million at December 28, 2002.
The decrease in accounts receivable is due primarily to the
decline in net revenue. The number of days sales outstanding was
33 days at January 3, 2004, compared to 31 days
at December 28, 2002. The increase in the number of days
sales outstanding is primarily due to the increase in the
percentage of sales outside of North America, to customers with
longer payment terms and the conversion of one of our larger
distributors in Asia Pacific from revenue recognition upon cash
receipt to revenue recognition when the distributor ships our
products to their customers.

Inventories were $29.0 million at
January 3, 2004 or 5.6 turns per annum, compared with
$44.6 million at December 28, 2002 or 5.2 turns
per annum. Inventories have decreased during fiscal year 2003
primarily as a result of $12.2 million in inventory
write-downs, and a $4.3 million reduction in channel
inventories due to improved channel inventory management. We
expect future cash commitments related to inventory purchases to
vary based on sales order demand. In addition, the nature and
timing of our new product introductions as well as our
competitors new products entering the markets we serve
could have an adverse affect on our inventory levels in the
future and may result in additional excess and obsolete
inventory provisions.

Accounts payable at January 3, 2004 of
$39.7 million declined from $47.6 million at
December 28, 2002 due in part to decreased expenses for
professional fees and the timing of payments related to product
purchases.

Application of Critical Accounting
Estimates

Our significant accounting policies are described
in the consolidated financial statements included in Item 8
of this annual report on Form 10-K. The preparation of
consolidated financial statements in conformity with generally
accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
period. We base our estimates on historical experience, current
conditions and various other assumptions that are believed to be
reasonable under the circumstances. The markets for our products
are characterized by rapid technological development, intense
competition and frequent new product introductions, any of which
could affect the future realizability of our assets. Estimates
and

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assumptions are reviewed on an ongoing basis and
the effects of revisions are reflected in the consolidated
financial statements in the period they are determined to be
necessary. Actual results could differ from those estimates
under different assumptions or conditions. We believe the
following critical accounting policies impact our judgments and
estimates used in the preparation of our consolidated financial
statements.


Revenue Recognition.We recognize revenue on arrangements where products and services
were bundled in accordance with EITF 00-21,
Revenue Arrangements with Multiple Deliverables.In accordance with EITF 00-21, we determine whether the
deliverables are separable into multiple units of accounting. We
allocate the total fee on such arrangements to the individual
deliverables based on their relative fair values or using the
residual method. The application of EITF 00-21 includes
judgments as to whether the delivered item has value to the
customer on a standalone basis and whether we have established
objective and reliable evidence of fair value for the
undelivered items. Our ability to recognize revenue in the
future may be affected if actual selling prices are
significantly less than the fair values.

We recognize revenue on arrangements where
software and services were bundled in accordance with
SOP 97-2 Software Revenue Recognition,as amended by SOP 98-9, Modification of
SOP 97-2, Software Recognition, With Respect to Certain
Transactions.We allocate the total fee on such
arrangements based on the fair values of each element or using
the residual method. Our ability to recognize revenue in the
future may be affected if actual selling prices are
significantly less than the fair values.

Allowance for Doubtful Accounts and Notes
Receivable.We estimate the
collectibility of our accounts receivable and notes receivable
and the related amount of bad debts that may be incurred in the
future. The allowance for doubtful accounts results from an
analysis of specific customer accounts, historical experience,
customer concentrations, credit ratings and current economic
trends. Based on this analysis, we provide allowances for
specific accounts where collectibility is not reasonably
assured. In addition, we provide a full allowance for any
customer balances that are greater than 180 days past due.
The allowance for notes receivable is based on specific customer
accounts.

Provision for Inventory
Valuation.Inventory purchases and
commitments are based upon future demand forecasts. Reserves for
excess and obsolete inventory are established to account for the
potential differences between our forecasted demand and the
amount of purchased and committed inventory. We periodically
experience variances between the amount of inventory purchased
and contractually committed to and our demand forecasts,
resulting in excess and obsolete inventory charges. In addition,
we periodically adjust service spares inventory to net
realizable value, as well as reserve for service parts in excess
of usage estimates. At January 3, 2004, our provision for
inventory valuation was $35.2 million.

Valuation of
Goodwill.Goodwill is the excess of
the purchase price over the fair value of identifiable net
assets acquired in business combinations. In accordance with
Financial Accounting Standards Board, or FASB, Statement of
Financial Standards, or SFAS, No. 142, goodwill is subject
to an annual impairment test using a fair-value-based approach.
In assessing the fair value of goodwill, we make projections
regarding future cash flow and other estimates. If these
projections or other estimates change in the future, we may be
required to record an impairment charge. At January 3,
2004, the carrying value of goodwill on our balance sheet was
$15.1 million. Based on our annual impairment test, we did
not record an impairment charge during fiscal year 2003.

Valuation of Long-lived
Assets.Long-lived assets are
comprised of property, plant and equipment and intangible assets
with finite lives. We assess the impairment of long-lived assets
whenever events or changes in circumstances indicate that the
carrying value may not be recoverable through projected
undiscounted cash flows expected to be generated by the asset.
When we determine that the carrying value of intangible assets
and fixed assets may not be recoverable, we measure impairment
by the amount by which the carrying value of the asset exceeds
the related fair value. Estimated fair value is generally based
on a projected discounted cash flow method using a discount rate
determined by management to be commensurate with the risk
inherent in the business underlying the asset in question. At
January 3, 2004, the carrying value of long-lived assets,
including fixed assets and intangible assets, was
$55.2 million. We did not incur any impairment charges
relating to these assets during fiscal year 2003.

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Valuation of
Investments.We maintain certain
minority investments in debt and equity securities of companies
that were acquired for cash and in non-monetary transactions
whereby we exchanged inventory or product credits for preferred
or common stock or convertible notes. We review investments for
potential impairment whenever events or changes in circumstances
indicate that the carrying value may not be recoverable. Many
factors are considered in assessing potential impairments. Such
events or factors include declines in the investees stock
price in new rounds of financing, market capitalization relative
to book value, deteriorating financial condition or results of
operations and bankruptcy or insolvency. From time to time we
may engage third party experts to estimate the recoverable value
of investments management may consider selling. Appropriate
reductions in carrying value are recognized in other expense,
net in the consolidated statements of operations. We are
currently considering selling our interests in several private
venture funds, which would eliminate future capital call
obligations. At January 3, 2004, the carrying value of
these investments on our balance sheet was $11.4 million.
We incurred impairment charges of $27.8 million relating to
these investments during fiscal year 2003.

Restructuring
Reserves.We have periodically
recorded restructuring charges in connection with our plans to
reduce the cost structure of our business. These restructuring
charges, which reflect managements commitment to a
termination or exit plan that will be completed within twelve
months, require managements judgment and may include
severance benefits and costs for future lease commitments or
excess facilities, net of estimated future sublease income. In
determining the amount of the facility exit costs, we are
required to estimate such factors as future vacancy rates, the
time required to sublet properties and sublease rates. If the
actual cost incurred exceeds the estimated cost, an additional
charge to earnings will result. If the actual cost is less than
the estimated cost, a reduction to special charges will be
recognized in the statement of operations. During fiscal year
2003, we incurred charges of approximately $0.8 million due
to a change in estimated sublease income for a vacated facility.
At January 3, 2004, we have estimated sublease income
associated with vacated facilities of approximately
$1.4 million. This estimate of sublease income is subject
to change based on known real estate market conditions.

Income Taxes.We
estimate our income taxes in each of the jurisdictions in which
we operate. This process involves estimating our actual current
tax exposure together with assessing temporary differences
resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are
included within our consolidated balance sheet. We then assess
the likelihood that our deferred tax assets will be recovered
from future taxable income and to the extent we believe that
recovery is not likely, we establish a valuation allowance. To
the extent we establish a valuation allowance or increase this
allowance in a period, we increase or decrease our income tax
provision in our statement of operations. If any of our
estimates of our prior period taxable income or loss prove to be
incorrect, material differences could impact the amount and
timing of income tax benefits or payments for any period. In
addition, the calculation of our tax liabilities involves
dealing with uncertainties in the application of complex tax
regulations in a multitude of jurisdictions. We recognize
potential liabilities for anticipated tax audit issues in the
U.S. and other tax jurisdictions based on our estimate of
whether, and the extent to which, additional taxes will be due.
If payment of these amounts ultimately proves to be unnecessary,
the reversal of the liabilities would result in tax benefits
being recognized in the period when we determine the liabilities
are no longer necessary. If our estimate of tax liabilities
proves to be less than the ultimate assessment, a further charge
to expense would result.

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Summary of Critical Estimates Included in Our
Consolidated Results of Operations.The following table summarizes the (income) expense impact on
our results of operations arising from our critical accounting
estimates:

|                                                                           |                                                  |               |       |             |  |                 |      |      |  |   |       |       | 
|-------------------------------------------------------------------------- | ------------------------------------------------ | ------------- | ----- | ----------- |  | --------------- | ---- | ---- |  | - | ----- | ----- | 
|                                                                           |                                                  | Fiscal Year   |       | Fiscal Year |  | Transition Year
|                                                                           |                                                  | 2003          |       | 2002        |  | 2001           
|                                                                           |                                                  |               |       |             |  |                
|                                                                           |                                                  |              
|                                                                           |                                                  | (In millions)
|Net (recoveries) provision for losses on
    accounts and notes receivable |                                                  | $             | (10.3 | )           |  | $               | (0.9 | )    |  | $ | 18.6  |      
|Provision for inventory write-downs                                        |                                                  |               | 12.2  |             |  |                 | 17.9 |      |  |   | 72.9  |      
|Impairment of goodwill                                                     |                                                  |               |      |             |  |                 |     |      |  |   | 104.1 |      
|Impairment of investments                                                  |                                                  |               | 27.8  |             |  |                 | 22.1 |      |  |   | 65.9  |      
|Restructuring charges                                                      |                                                  |               | 17.5  |             |  |                 | 32.0 |      |  |   | 22.7  |      
|Deferred tax asset valuation provision                                     |                                                  |               | 30.3  |             |  |                 | 19.8 |      |  |   | 260.0 |      
|                                                                           |                                                  |               |       |             |  |                 |      |      |  |   |       |      
|                                                                           | Total expense from critical accounting estimates |               | $     | 77.5        |  |                 | $    | 90.9 |  |   | $     | 544.2 | 
|                                                                           |                                                  |               |       |             |  |                 |      |      |  |   |       |      

New Accounting Pronouncements

In July 2002, the FASB issued
SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities,which requires
companies to recognize costs associated with exit or disposal
activities when a liability is incurred rather than at the date
of a commitment to an exit or disposal plan. This statement is
effective for exit or disposal activities initiated after
December 31, 2002. We recorded restructuring charges of
$17.5 million in fiscal year 2003 in accordance with the
new requirements.

In November 2002, the FASB issued EITF
No. 00-21, Revenue Arrangements with Multiple
Deliverables,which provides guidance on how to
account for revenue arrangements that involve the delivery or
performance of multiple products, services and/or rights to use
assets. The provisions of this pronouncement were effective for
revenue arrangements entered into beginning in our third quarter
of fiscal year 2003. The adoption of EITF No. 00-21 did not
have a material effect on our consolidated financial statements.

In January 2003, FASB interpretation No. 46,
Consolidation of Variable Interest Entities,or VIEs, was issued and in December 2003, a revision
of FIN No. 46 was issued. FIN No. 46 requires
identification of the Companys participation in
VIEs, which are defined as entities with a level of
invested equity that is not sufficient to fund future activities
to permit them to operate on a stand-alone basis, or whose
equity holders lack certain characteristics of a controlling
financial interest. For entities identified as VIEs, FIN
No. 46 sets forth a model to evaluate potential
consolidation based on an assessment of which party to a VIE, if
any, bears a majority of the risk of the VIEs expected
losses, or stands to gain from a majority of the VIEs
expected returns. FIN No. 46 also sets forth certain
disclosures regarding interests in VIEs that are deemed
significant, even if consolidation is not required. This
interpretation is effective for all VIEs created after
January 31, 2003. We are not the primary beneficiary of any
minority investment that would be considered a variable interest
entity and, as such, the adoption of FIN No. 46 did
not have an effect on the consolidated financial statements.

In April 2003, the FASB issued
SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities,
which amends and clarifies financial accounting and reporting
for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging
activities under SFAS No. 133 Accounting for
Derivative Instruments and Hedging Activities. This
statement was effective for contracts entered into or modified
after June 30, 2003 and for hedging relationships
designated after June 30, 2003 and is to be applied
prospectively. We have no derivatives imbedded in other
contracts and no hedging relationships at this time and, as
such, the adoption of SFAS No. 149 did not have an
effect on our consolidated financial statements.

In May 2003, the FASB issued
SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities
and Equity, which establishes standards for how an
issuer classifies and

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measures certain financial instruments with
characteristics of both liabilities and equity.
SFAS No. 150 requires that an issuer classify a
financial instrument that is within its scope as a liability (or
an asset in some circumstances). This statement is effective for
financial instruments entered into or modified after
May 31, 2003 and otherwise is effective at the beginning of
the first interim period beginning after June 15, 2003. The
adoption of SFAS No. 150 did not have a material
impact on our consolidated financial statements.


In May 2003, the consensus on EITF Issue
No. 01-08, Determining Whether an Arrangement
Contains a Lease,was issued. The guidance in the
consensus applies to the purchase or sale of goods and services
under various types of contracts, including outsourcing
arrangements. Based on the criteria in the consensus, both
parties to an arrangement are required to determine whether the
arrangement includes a lease within the scope of
SFAS No. 13, Accounting for Leases.The new requirement applies prospectively to new or modified
arrangements for reporting periods beginning after May 28,
2003. We did not enter into or modify any arrangements covered
by EITF 01-08 during fiscal year 2003 and, as such, the
adoption of EITF No. 01-08 did not have an effect on our
consolidated financial statements.

In May 2003, the FASB issued EITF No. 03-5,
Applicability of AICPA Statement of Position 97-2,
Software Revenue Recognition, to Non-Software Deliverables in an
Arrangement Containing More-Than-Incidental Software,which provides guidance on how to account for non-software
deliverables included in an arrangement that contains software
that is more than incidental to the products or services as a
whole. The provisions of this pronouncement are effective for
revenue arrangements entered into after the beginning of our
third quarter of fiscal year 2003. The adoption of EITF
No. 03-05 did not have a material effect on our
consolidated financial statements.

In December 2003, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 104, or SAB
No. 104, Revenue Recognitionwhich
revises or rescinds portions of the interpretative guidance
included in Topic 13 of the codification of staff accounting
bulletins in order to provide consistent guidance with respect
to selected revenue recognition issues. The adoption of SAB
No. 104 did not have a material effect on our consolidated
financial statements.

CAUTIONARY STATEMENTS

We may occasionally make forward-looking
statements and estimates such as forecasts and projections of
our future performance or statements of our plans and
objectives. These forward-looking statements may be contained
in, among other things, SEC filings, including this annual
report on Form 10-K, press releases made by us, and in oral
statements made by our officers. Actual results could differ
materially from those contained in such forward-looking
statements. Important factors that could cause our actual
results to differ from those contained in such forward-looking
statement include, among other things, the risks described
below.

Risks Related to our Financial Results and
Condition



| |                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Worldwide and regional economic
    uncertainty, increased market competition and recent political
    and social turmoil may continue to negatively affect our
    business and revenue and continue to make forecasting more
    difficult

Our business is subject to the effects of general
worldwide economic conditions, particularly in the United States
and Europe, the Middle East and Africa, and market conditions in
the networking industry, which have been particularly uncertain.
Recent political and social turmoil, such as terrorist and
military actions, as well as the effects of hostilities
involving the U.S. in the Middle East, North Korea or
anywhere else in the world, and any continuation or
repercussions thereof or responses thereto, may put further
pressure on uncertain worldwide economic conditions,
particularly if they continue for an extended period of time. If
economic or market conditions remain uncertain, fail to improve
or worsen, our business, revenue, and forecasting ability will
continue to be negatively affected, which could harm our results
of operations and financial condition.

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Competition in the networking industry has
increased over the past two years as enterprises more closely
monitor their costs and investments in response to continued
economic uncertainty. In recent quarters, our product revenue
has declined as a result of increased competition and a
lengthened sales cycle attributable in part to uncertain
economic and market conditions as well as other factors.
Continued economic uncertainty could further increase
competition in our industry, reduce demand for our products and
increase our risk of additional excess and obsolete inventory
provisions and service spare inventory write-downs, any of which
could harm our revenue and reduce our gross margin.

These uncertain political, social and economic
conditions and uncertainties also make it extremely difficult
for us, our customers and our vendors to accurately forecast and
plan future business activities. In particular, it is difficult
for us to develop and implement strategies, forecast demand for
our products, and effectively manage contract manufacturing and
supply chain relationships. This reduced predictability
challenges our ability to operate profitably and to grow our
business.



| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | We have a history of losses in recent years
    and may not operate profitably in the future

We have experienced losses in recent years and
may not achieve or sustain profitability in the future. We will
need to either generate higher revenue or reduce our costs to
achieve and maintain consistent profitability. We may not be
able to generate higher revenue or reduce our costs, and if we
do achieve profitability, we may not be able to sustain or
increase our profitability over subsequent periods. Our revenue
has been negatively affected by weaker economic conditions
worldwide, which has increased price and technological
competition for most of our products, as well as resulted in
longer selling cycles. If uncertain worldwide economic
conditions continue for an extended period of time, our ability
to maintain and increase our revenue may be significantly
limited. In addition, while we continue to implement cost
reduction plans designed to decrease our expenses, including
reductions in the size of our workforce, we will continue to
have large fixed expenses and expect to continue to incur
significant sales and marketing, product development, customer
support and service and other expenses. We continue to assess
whether additional cost-cutting efforts may be required.
Additional cost-cutting efforts may result in the recording of
additional financial charges, such as workforce reduction costs,
facilities reduction costs, asset write downs and contractual
settlements. Further, our workforce reductions may impair our
ability to realize our current or future business objectives.
Costs incurred in connection with our cost-cutting efforts may
be higher than the estimated costs of such actions and may not
lead to anticipated cost savings. As a result, our cost-cutting
efforts may not result in a return to profitability.



| |                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our quarterly operating results are likely
    to fluctuate, which could cause us to fail to meet quarterly
    operating targets and result in a decline in our stock
    price

Our operating expenses are largely based on
anticipated organizational size and revenue trends, and a high
percentage of these expenses are, and will continue to be, fixed
in the short term. As a result, if our revenue for a particular
quarter is below our expectations, we will be unable to
proportionately reduce our operating expenses for that quarter.
Any revenue shortfall in a quarter may thus cause our financial
results for that quarter to fall below the expectations of
public market analysts or investors, which could cause the price
of our common stock to fall. Any increase in our fixed expenses
will increase the magnitude of this risk. In addition, the
unpredictability of our operating results from quarter to
quarter could cause our stock to trade at lower prices than it
would if our results were consistent from quarter to quarter.

Our quarterly operating results may vary
significantly from quarter to quarter in the future due to a
number of factors, including:



| |   |                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------
| |  | fluctuations in the demand for our products and
    services;                                                              
|
| |  | the timing and size of sales of our products or
    the cancellation or rescheduling of significant orders;                
|
| |  | the length and variability of the sales cycle for
    our products;                                                        
|
| |  | the timing of implementation and product
    acceptance by our customers and by customers of our distribution
    partners;

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| |   |                                                                                                                                   
| | - | ----------------------------------------------------------------------------------------------------------------------------------
| |  | the timing and success of new product
    introductions;                                                                          
|
| |  | increases in the prices or decreases in the
    availability of the components we purchase;                                       
|
| |  | price and product competition in the networking
    industry;                                                                     
|
| |  | our ability to source and receive from third
    party sources appropriate product volumes and quality;                           
|
| |  | our ability to execute on our operating plan and
    strategy;                                                                    
|
| |  | manufacturing lead times and our ability to
    maintain appropriate inventory levels;                                            
|
| |  | the timing and level of research, development and
    prototype expenses;                                                         
|
| |  | the mix of products and services sold;                                                                                            
|
| |  | Changes in the distribution channels through
    which we sell our products and the loss of distribution partners;                
|
| |  | the uncertainties inherent in our accounting
    estimates and assumptions and the impact of changes in
    accounting principles;
|
| |  | our ability to achieve targeted cost reductions;                                                                                  
|
| |  | the outcome of pending securities
    litigation; and                                                                             
|
| |  | general economic conditions as well as those
    specific to the networking industry.                                             

Due to these and other factors, you should not
rely on quarter-to-quarter comparisons of our operating results
as an indicator of our future performance.



| |                                                                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We earn a substantial portion of our
    revenue for each quarter in the last month of each quarter,
    which reduces our ability to accurately forecast our quarterly
    results and increases the risk that we will be unable to achieve
    previously forecasted results

We have derived and expect to continue to derive
a substantial portion of our revenue in the last month of each
quarter, with such revenue frequently concentrated in the last
two weeks of the quarter. Because we rely on the generation of a
large portion of revenue at the end of the quarter, we
traditionally have not been able, and in the future do not
expect to be able, to predict our financial results for any
quarter until very late in the quarter. Due to this
end-of-quarter buying pattern, we may not achieve our financial
forecasts, either because expected sales do not occur in the
anticipated quarter or because they occur at lower prices or on
terms that are less favorable to us than anticipated.



| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | Our failure to improve and successfully
    implement our management information systems and internal
    controls could harm our business

Through the end of fiscal year 2003, we used
three disparate information systems in our domestic and
international operations, resulting in delays in obtaining
timely information on a worldwide basis and the use of manual
procedures to review our consolidated financial results.
Further, we have reviewed our systems controls and operating
procedures and identified improvements which could be made.
Pursuant to new SEC rules under the Sarbanes-Oxley Act of 2002,
we are required to include in our future Form 10-K filings
a report by our management as to the effectiveness of our
internal controls and procedures for financial reporting.
Beginning with our Form 10-K for fiscal year 2004, our
independent auditors will be required to attest to and report on
the evaluation by management. Although we have implemented a
number of changes designed to improve our systems and controls,
including organizational changes, implementation of new business
systems, communication of revenue recognition and other
accounting policies to all of our employees, implementation of
an internal audit function, new approval procedures and various
other initiatives, including extensive supervisory and
management oversight along with process improvement programs, we
anticipate making additional changes to improve our systems
controls and procedures, some of which may result in higher
future operating expenses and capital

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expenditures. In addition, we made significant
upgrades to our management information systems during fiscal
year 2003, and plan to make continued upgrades to these systems.
The implementation of these upgrades involves significant effort
and is complex. If we are unable to successfully and/or timely
implement these upgrades, our business could be disrupted and
our financial condition harmed.


If we fail to strengthen our management
information systems and internal controls, our ability to manage
our business and implement our strategies may be impaired,
irregularities may occur or fail to be identified, and our
financial condition could be harmed. In addition, even if we are
successful in strengthening these systems and controls, they may
not sufficiently improve our ability to manage our business and
implement our strategies, or be adequate to prevent or identify
irregularities and ensure the effectiveness of our system of
controls and procedures.



| |                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We continue to introduce new products, and
    if our customers delay product purchases or choose alternative
    solutions, our revenue could decline, we may incur excess and
    obsolete inventory charges, and our financial condition could be
    harmed

We are in the process of introducing new versions
of our entire product portfolio. Many of our customers may
initially require additional time to evaluate our new products,
extending the sales cycle, or may choose alternative solutions.
In addition, sales of our existing products could decline as
customers await the release of our new products and, as a
result, we could be exposed to an increased risk of inventory
obsolescence. If customers defer purchasing decisions or choose
alternative solutions in connection with our new product
introductions, our revenue could decline and our financial
condition could be harmed.



| |                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------
| | Pending and future litigation could
    materially harm our business, operating results and financial
    condition

Several lawsuits have been filed against us and
our directors in recent years, including nine shareholder class
action lawsuits filed between October 24, 1997 and
March 2, 1998. See
Part I, Item 3  Legal
Proceedings of this annual report for a more detailed
discussion of pending litigation. The unfavorable resolution of
any specific lawsuit could materially harm our business,
operating results and financial condition, and could cause the
price of our common stock to decline significantly.

The uncertainty associated with these lawsuits
could seriously harm our business, financial condition and
reputation by, among other things, harming our relationships
with existing customers and impairing our ability to attract new
customers, and we may be required to pay significant damages in
connection with the 1997 and 1998 securities lawsuits which
remain pending. In addition, the defense of the 1997 and 1998
lawsuits will continue to result in significant expense and the
continued diversion of our managements time and attention
from the operation of our business, which could impede our
ability to achieve our business objectives. Although we have
insurance designed to cover claims under these lawsuits, this
insurance may not be adequate to cover expenses and certain
liabilities relating to these lawsuits, and we may need to
litigate with our insurance carriers to obtain coverage under
our insurance policies. For example, with respect to our
recently settled 2002 class action litigation, although we
received cash proceeds of approximately $34.5 million from
our insurers and have engaged in legal proceedings against other
insurers to recover a portion of the remaining expenses
incurred, we do not expect these proceeds will fully cover all
of our costs and expenses incurred in connection with this and
other related matters and we may be unsuccessful in our
litigation against the other insurers.



| |                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------
| | The limitations of our director and officer
    liability insurance may materially harm our financial
    condition

Our director and officer liability insurance for
the period during which events related to securities class
action lawsuits against us and certain of our current and former
officers and directors are alleged to have occurred, provides
only limited liability protection. If these policies do not
adequately cover expenses and certain liabilities relating to
these lawsuits, our financial condition could be materially
harmed. Our

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certificate of incorporation provides that we
will indemnify and advance expenses to our directors and
officers to the maximum extent permitted by Delaware law. The
indemnification covers any expenses and liabilities reasonably
incurred by a person, by reason of the fact that such person is
or was or has agreed to be a director or officer, in connection
with the investigation, defense and settlement of any
threatened, pending or completed action, suit, proceeding or
claim.


The facts underlying the SEC investigation
against us, which was settled in February 2003, and the
shareholder lawsuits have increased the premiums we must pay for
director and officer liability insurance, and may make this
insurance coverage prohibitively expensive or unavailable in the
future. Increased premiums for this insurance could materially
harm our financial results in future periods. The inability to
obtain this coverage due to its unavailability or prohibitively
expensive premiums would make it significantly more difficult
for us to retain and attract officers and directors.



| |                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have experienced significant turnover of
    senior management and our current management team has been
    together for only a limited time, which could harm our business
    and operations

Since August 2001 there have been numerous
changes in our senior management team. In August 2001, our
management team was restructured to include several senior
executives of one of our operating subsidiaries. Then in April
2002, we announced the departure of several of these senior
executives, including our President and Chief Executive Officer.
We appointed a new Chief Executive Officer and a new President
in April 2002, and, in the period from March 2002 to March 2004,
we appointed a number of other senior officers, including
promoting our Vice President of Finance to the position of Chief
Financial Officer, appointing a new Executive Vice President of
Sales, Executive Vice President of Worldwide Marketing and
Product Management and Vice President of Human Resources, and
adding an Executive Vice President of Supply Chain Management.
In December 2002, our President resigned upon the completion of
his employment agreement with us, and, in April 2003, we
appointed a new President. In May 2003 we appointed a new
Executive Vice President of Engineering and in March 2004 we
appointed a new Executive Vice President of Worldwide Sales and
Service. Because of these recent changes and their recent
recruitment, our current management team has not worked together
for a significant length of time and may not be able to work
together effectively to successfully develop and implement
business strategies. In addition, as a result of these
management changes, management will need to devote significant
attention and resources to preserve and strengthen relationships
with employees and customers. If our new management team is
unable to develop successful business strategies, achieve our
business objectives, or maintain positive relationships with
employees and customers, our ability to grow our business and
successfully meet operational challenges could be impaired.



| |                                                                      
| | ---------------------------------------------------------------------
| | Retaining key management and employees is
    critical to our success

Our future success depends to a significant
extent on the continued services of our key employees, many of
whom have significant experience with the network communications
market, as well as relationships with many of our existing and
potential enterprise customers and business partners. The loss
of several of our key employees or any significant portion of
them could have a significant detrimental effect on our ability
to execute our business strategy. Our future success also
depends on our continuing ability to identify, hire, train,
assimilate and retain large numbers of highly qualified
engineering, sales, marketing, managerial and support personnel.
If we cannot successfully recruit and retain such persons,
particularly in our engineering and sales departments, our
development and introduction of new products could be delayed
and our ability to compete successfully could be impaired.

Despite the current economic downturn, the
competition for qualified employees in our industry is
particularly intense in the New England area, where our
principal operations are located, and it can be difficult to
attract and retain quality employees at reasonable cost. We have
from time to time experienced, and we expect to continue to
experience in the future, difficulty in hiring and retaining
highly skilled employees with appropriate qualifications. In
addition, the significant downturn in our business environment
has caused us to significantly reduce our workforce and
implement other cost-containment activities, including
consolidating our operating locations and relocating some of our
personnel to

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Rochester, New Hampshire and Andover,
Massachusetts. These actions, as well as the pending securities
litigation, may lead to disruptions in our business, reduced
employee morale and productivity, increased attrition and
difficulty retaining existing employees and recruiting future
employees, any of which could harm our business and operating
results.




| |                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We maintain investments in early stage,
    privately held technology companies and value-added resellers,
    and we could lose our entire investment in these
    companies

We have made investments in privately-held
technology companies and value-added resellers, many of which
are in the start-up or development stage. Investments in these
companies are inherently risky as the technologies or products
they have under development, or the services they propose to
provide, are often in early stages of development and may never
materialize. We may never realize any benefits or financial
returns from these investments, and, if these companies are not
successful, we could lose our entire investment. The
concentration of our investments in a small number of related
industries, primarily telecommunications, exposes our
investments to increased risk, particularly if these industries
continue to be adversely affected by continued worldwide
economic uncertainty. At January 3, 2004, these investments
totaled approximately $11.4 million. During the year ended
January 3, 2004, we recorded impairment losses of
$27.8 million relating to these investments.



| |                                                               
| | --------------------------------------------------------------
| | We are exposed to the credit risk of some
    of our customers

Our payment terms are typically 30 days in
the United States, and sometimes longer internationally. We
assess the payment ability of our customers in granting such
terms and maintain reserves that we believe are adequate to
cover doubtful accounts, however, as a result of current
economic uncertainty, our exposure to the credit risk of our
customers has increased. Some of our customers are experiencing,
or may experience, reduced revenue and cash flow problems, and
may be unable to pay, or may delay payment for, amounts owed to
us. Although we monitor the credit risk of our customers, we may
not be effective in managing our exposure. If our customers are
unable to pay amounts owed to us or cancel outstanding orders,
our forecasting ability, cash flow and revenue could be harmed
and our business and results of operations may be adversely
affected.



| |                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may need additional capital to fund our
    future operations, commitments and contingencies and, if it is
    not available when needed, our business and financial condition
    may be harmed

We believe our existing working capital and cash
available from operations will enable us to meet our working
capital requirements for at least the next twelve months. Our
working capital requirements and cash flows historically have
been, and are expected to continue to be, subject to quarterly
and yearly fluctuations, depending on such factors as capital
expenditures, sales levels, collection of receivables, inventory
levels, supplier terms and obligations, and other factors
impacting our financial performance and condition. Our inability
to manage cash flow fluctuations resulting from these and other
factors could impair our ability to fund our working capital
requirements from operating cash flows and other sources of
liquidity or to achieve our business objectives in a timely
manner. We have not established any borrowing relationships with
financial institutions and are primarily reliant on cash
generated from operations to meet our cash requirements. If cash
from future operations is insufficient, or if cash must be used
for currently unanticipated uses, we may need to raise
additional capital or reduce our expenses.

We cannot assure you that additional capital, if
required, will be available on acceptable terms, or at all. As a
result of the current capital market environment, as well as the
pending securities litigation against us, our ability to access
the capital markets and establish borrowing relationships with
financial institutions has been impaired and may continue to be
impaired for the foreseeable future. If we are unable to obtain
additional capital when needed or must reduce our expenses, it
is likely that our product development and marketing efforts
will be restricted, which would harm our ability to develop new
and enhanced products, expand our distribution relationships and
customer base, and grow our business. This could adversely
impact our competitive position and cause our revenue to
decline. To the extent that we raise additional capital through
the sale of equity or convertible debt securities, existing
stockholders may

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suffer dilution. Also, these securities may
provide the holders with rights, privileges and preferences
senior to those of common stockholders. If we raise additional
capital through the sale of debt securities, the terms of the
debt could impose restrictions on our operations.


Risks Related to the Markets for our
Products



| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | There is intense competition in the market
    for enterprise network equipment, which could prevent us from
    increasing our revenue and achieving profitability

The network communications market is dominated by
a small number of competitors, some of which, Cisco Systems in
particular, have substantially greater resources and market
share than other participants in that market, including us. In
addition, this market is intensely competitive, subject to rapid
technological change and significantly affected by new product
introductions and other market activities of industry
participants. Competitive pressures could result in price
reductions, reduced margins or loss of market share, which would
materially harm our ability to increase revenue and
profitability.

Our principal competitors include Alcatel; Cisco
Systems; Extreme Networks; Foundry Networks; Hewlett-Packard;
Huawei; Nortel Networks; and 3Com. We also experience
competition from a number of other smaller public and private
companies. We may experience reluctance by our prospective
customers to replace or expand their current infrastructure
solutions, which may be supplied by one or more of these
competitors, with our products. There has also been a trend
toward consolidation in our industry for several years, and we
expect this trend will continue as companies attempt to
strengthen or maintain their market share positions.
Consolidation among our competitors and potential competitors
may result in stronger competitors with expanded product
offerings and a greater ability to accelerate their development
of new technologies.

Some of our competitors have significantly more
established customer support and professional services
organizations and substantially greater selling and marketing,
technical, manufacturing, financial and other resources than we
do. Many of our competitors also have more customers, greater
market recognition and more established relationships and
alliances in the industry. As a result, these competitors may be
able to develop, enhance and expand their product offerings more
quickly, adapt more swiftly to new or emerging technologies and
changes in customer demands, devote greater resources to the
marketing and sale of their products, pursue acquisitions and
other opportunities more readily and adopt more aggressive
pricing policies. Additional competitors with significant market
presence and financial resources may enter our rapidly evolving
market, thereby further intensifying competition.



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be unable to upgrade our indirect
    distribution channels, which may hinder our ability to grow our
    customer base and increase our revenue

Our sales and distribution strategy relies
heavily on our indirect sales efforts, including sales through
distributors and channel partners, such as value-added
resellers, systems integrators and telecommunications service
providers. We believe that our future success will depend in
part upon our ability to maintain and upgrade existing
relationships, as well as establish successful new
relationships, with a variety of these partners. If we are
unable to upgrade our indirect distribution channels, we may be
unable to increase or sustain market awareness or sales of our
products and services, which may prevent us from maintaining or
increasing our customer base and revenue.

Even if we are able to upgrade our indirect
distribution channels, our revenue may not increase. Our
distribution partners are not prohibited from selling products
and services that compete with ours and may not devote adequate
resources to selling our products and services. In addition, we
may be unable to maintain our existing agreements or reach new
agreements with distribution partners on a timely basis or at
all.

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| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | We expect the average selling prices of our
    products to decrease over time, which may reduce our revenue and
    gross margins

Our industry has experienced erosion of average
selling prices in recent years, particularly as products reach
the end of their life cycles. We anticipate that the average
selling prices of our products will decrease in the future in
response to increased sales discounts and new product or
technology introductions by us and our competitors. Our prices
will also likely be adversely affected by downturns in regional
or industry economies. We also expect our gross margins may be
adversely affected by increases in material or labor costs and
an increasing reliance on third party distribution channels. If
we are unable to achieve commensurate cost reductions and
increases in sales volumes, any decline in average selling
prices will reduce our revenue and gross margins.



| |                                                                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we do not anticipate and respond to
    technological developments and evolving customer requirements
    and introduce new products in a timely manner, we may not retain
    our current customers or attract new customers

The markets for our products are characterized by
rapidly changing technologies and frequent new product
introductions. The introduction by us or our competitors of new
products and the emergence of new industry standards and
practices can render existing products obsolete and
unmarketable, increasing our risk of excess and obsolete
inventory charges. Our success will depend upon our ability to
enhance our existing products and to develop and introduce, on a
timely and cost-effective basis, new products and functionality
that keep pace with technological developments and emerging
standards. Any failure to introduce new products and
enhancements on a timely basis will harm our future revenue and
prospects.

Our future success will also depend upon our
ability to develop and manage customer relationships and to
introduce a variety of new products and product enhancements
that address the increasingly sophisticated needs of our
customers. Our current and prospective customers may require
product features and capabilities that our products do not have.
We must anticipate and adapt to customer requirements and offer
products that meet those demands in a timely manner. Our failure
to develop products that satisfy evolving customer requirements
could seriously harm our ability to achieve or maintain market
acceptance for our products and prevent us from recovering our
product development investments.



| |                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our focus on sales to enterprise customers
    subjects us to risks that may be greater than those for
    providers with a more diverse customer base

We focus principally on sales of products and
services to enterprises, such as large corporations and
government agencies that rely on network communications for many
important aspects of their operations. This focus subjects us to
risks that are particular to this customer segment. For example,
many of our current and potential customers are health care,
education and governmental agencies, all of whom are generally
slower to incorporate information technology into their business
practices due to the regulatory and privacy issues that must be
addressed with respect to the sharing of their information. In
addition, the use and growth of the Internet is critical to
enterprises, which often have electronic networks, applications
and other mission-critical functions that use the Internet. To
the extent that there is any decline in use of the Internet for
electronic commerce or communications, for whatever reason,
including performance, reliability or security concerns, we may
experience decreased demand for our products and lower than
expected revenue growth.

Many of our competitors sell their products to
both enterprises and service providers, which are companies who
provide Internet-based services to businesses and individuals.
In the future, the demand for network communications products
from enterprises may not grow as rapidly as the demand from
service providers. Enterprises may turn to service providers to
supply them with services that obviate the need for enterprises
to implement many of our solutions. Because we sell our products
primarily to enterprises, our exposure to these risks is greater
than that of vendors that sell to a more diversified customer
base.

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Risks Related to our Products



| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our products are very complex, and
    undetected defects may increase our costs, harm our reputation
    with our customers and lead to costly litigation

Our network communications products are extremely
complex and must operate successfully with complex products of
other vendors. Our products may contain undetected errors when
first introduced or as we introduce product upgrades. The
pressures we face to be the first to market new products or
functionality increases the possibility that we will offer
products in which we or our customers later discover problems.
We have experienced new product and product upgrade errors in
the past and expect similar problems in the future. These
problems may cause us to incur significant costs to support our
service contracts and other costs and divert the attention of
our engineering personnel from our product development efforts.
If we are unable to repair these problems in a timely manner, we
may experience a loss of or delay in revenue and significant
damage to our reputation and business prospects.

Many of our customers rely upon our products for
business-critical applications. Because of this reliance,
errors, defects or other performance problems in our products
could result in significant financial and other damage to our
customers. Our customers could attempt to recover these losses
by pursuing product liability claims against us, which, even if
unsuccessful, would likely be time-consuming and costly to
defend and could adversely affect our reputation.



| |                                                                                                                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our products do not comply with complex
    governmental regulations and evolving industry standards, our
    products may not be widely accepted, which may prevent us from
    sustaining our revenue or achieving profitability

The market for network communications equipment
is characterized by the need to support industry standards as
different standards emerge, evolve and achieve acceptance. In
the past, we have had to delay the introduction of new products
to comply with third party standards testing. We may be unable
to address compatibility and interoperability problems that
arise from technological changes and evolving industry
standards. We also may devote significant resources developing
products designed to meet standards that are not widely adopted.
In the United States, our products must comply with various
governmental regulations and industry regulations and standards,
including those defined by the Federal Communications
Commission, Underwriters Laboratories and Networking Equipment
Building Standards. Internationally, our products are required
to comply with standards or obtain certifications established by
telecommunications authorities in various countries and with
recommendations of the International Telecommunications Union.
If we do not comply with existing or evolving industry
standards, fail to anticipate correctly which standards will be
widely adopted or fail to obtain timely domestic or foreign
regulatory approvals or certificates, we will be unable to sell
our products where these standards or regulations apply, which
may prevent us from sustaining our revenue or achieving
profitability.

The United States government may impose unique
requirements on network equipment providers before they are
permitted to sell to the government, such as that supplied
products qualify as made in the United States. Such requirements
may be imposed on some or all government procurements. We may
not always satisfy all such requirements. Other governments or
industries may establish similar performance requirements or
tests that we may be unable to satisfy. If we are unable to
satisfy the performance or other requirements of the United
States government or other industries that establish them, our
revenue growth may be lower than expected.

Because several of our significant competitors
maintain dominant positions in selling network equipment
products to enterprises and others, they may have the ability to
establish de facto standards within the industry. Any actions by
these competitors or other industry leaders that diminish
compliance by our products with industry or de facto standards
or the ability of our products to interoperate with other
network communication products would be damaging to our
reputation and our ability to generate revenue.

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| |                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may periodically establish relationships
    with other companies to develop, manufacture and sell products,
    which could increase our reliance on others for development or
    supply capabilities or generation of revenue and may lead to
    disputes about ownership of intellectual property

We may periodically establish relationships with
other companies to incorporate our technology into products and
solutions sold by these organizations as well as to jointly
develop, manufacture and/or sell new products and solutions with
these organizations. We may be unable to enter into agreements
of this type on favorable terms, if at all. If we are unable to
enter into these agreements on favorable terms, or if our
partners do not devote sufficient resources to developing,
manufacturing and/or selling the products that incorporate our
technology or the new products we have jointly developed, our
revenue growth could be lower than expected. If we are able to
enter into these agreements, we will likely be unable to control
the amount and timing of resources our partners devote to
developing products incorporating our technology or to jointly
developing new products and solutions. Further, although we
intend to retain all rights in our technology in these
arrangements, we may be unable to negotiate the retention of
these rights and disputes may arise over the ownership of
technology developed as a result of these arrangements. These
and other potential disagreements between us and these
organizations could lead to delays in the research, development
or sale of products we are jointly developing or more serious
disputes, which may be costly to resolve. Disputes with
organizations that also serve as indirect distribution channels
for our products could also reduce our revenue from sales of our
products.



| |                                                                                                   
| | --------------------------------------------------------------------------------------------------
| | Our limited ability to protect our
    intellectual property may hinder our ability to
    compete

We regard our products and technology as
proprietary. We attempt to protect them through a combination of
patents, copyrights, trademarks, trade secret laws, contractual
restrictions on disclosure and other methods. These methods may
not be sufficient to protect our proprietary rights. We also
generally enter into confidentiality agreements with our
employees, consultants and customers, and generally control
access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be
possible for a third party to copy or otherwise misappropriate
and use our products or technology without authorization,
particularly in foreign countries where the laws may not protect
our proprietary rights to the same extent as do the laws of the
United States, or to develop similar technology independently.
We have resorted to litigation in the past and may need to
resort to litigation in the future to enforce our intellectual
property rights, to protect our trade secrets or to determine
the validity and scope of the proprietary rights of others.
Litigation of this type could result in substantial costs and
diversion of resources and could harm our business.



| |                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be subject to claims that our
    intellectual property infringes upon the proprietary rights of
    others, and a successful claim could harm our ability to sell
    and develop our products

We license technology from third parties and are
continuing to develop and acquire additional intellectual
property. Although we have not been involved in any material
litigation relating to our intellectual property, we expect that
participants in our markets will be increasingly subject to
infringement claims. Third parties may try to claim our products
infringe their intellectual property, in which case we would be
forced to defend ourselves or our customers, manufacturers and
suppliers against those claims. Any claim, whether meritorious
or not, could be time consuming, result in costly litigation
and/or require us to enter into royalty or licensing agreements.
Although we carry general liability insurance, our insurance may
not cover potential claims of this type or may not be adequate
to indemnify us for all liability that may be imposed. In
addition, any royalty or licensing agreements might not be
available on terms acceptable to us or at all, in which case we
would have to cease selling, incorporating or using the products
that incorporate the challenged intellectual property and expend
substantial amounts of resources to redesign our products. If we
are forced to enter into unacceptable royalty or licensing
agreements or to redesign our products, our business and
prospects would suffer.

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Risks Related to our Manufacturing and
Components



| |                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We use several key components for our
    products that we purchase from single or limited sources, and we
    could lose sales if these sources fail to fulfill our
    needs

We currently work with third parties to
manufacture our key proprietary application-specific integrated
circuits, which are custom designed circuits built to perform a
specific function more rapidly than a general purpose
microprocessor. These proprietary circuits are very complex, and
these third parties are our sole source suppliers for the
specific types of application specific integrated circuits that
they supply to us. We also have limited sources for
semiconductor chips that we use in some of our products, as well
as several other key components used in the manufacture of our
products. We do not carry significant inventories of these
components, and we do not have a long-term, fixed price or
minimum volume agreements with these suppliers. If we encounter
future problems with these vendors, we likely would not be able
to develop an alternate source in a timely manner. We have
encountered shortages and delays in obtaining these components
in the past and may experience similar shortages and delays in
the future. If we are unable to purchase our critical
components, particularly our application-specific integrated
circuits, at such times and in such volumes as our business
requires, we may not be able to deliver our products to our
customers in accordance with schedule requirements. In addition,
any delay in obtaining key components for new products under
development could cause a significant delay in the initial
launch of these products. Any delay in the launch of new
products could harm our reputation and operating results.

Even if we are able to obtain these components in
sufficient volumes and on schedules that permit us to satisfy
our delivery requirements, we have little control over their
cost. Accordingly, the lack of alternative sources for these
components may force us to pay higher prices for them. If we are
unable to obtain these components from our current suppliers or
others at economical prices, our margins could be adversely
impacted unless we raise the prices of our products in a
commensurate manner. The existing competitive conditions may not
permit us to do so, in which case our operating results may
suffer.



| |                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend upon a limited number of contract
    manufacturers for substantially all of our manufacturing
    requirements, and the loss of either of our primary contract
    manufacturers would impair our ability to meet the demands of
    our customers

We do not have internal manufacturing
capabilities. We outsource most of our manufacturing to two
companies, Flextronics International, Ltd. and Accton Technology
Corporation, which procure material on our behalf and provide
comprehensive manufacturing services, including assembly, test,
control and shipment to our customers. Our agreement with
Flextronics expired in February 2002 and, since that time, we
have been operating under an informal extension of the expired
contract while negotiating a new agreement with Flextronics. If
we experience increased demand for our products, we will need to
increase our manufacturing capacity with Flextronics and Accton
or add additional contract manufacturers. Flextronics and Accton
also build products for other companies, and we cannot be
certain that they will always have sufficient quantities of
inventory and capacity available or that they will allocate
their internal resources to fulfill our requirements. Further,
qualifying a new contract manufacturer and commencing volume
production is expensive and time consuming. The loss of our
existing contract manufacturers, the failure of our existing
contract manufacturers to satisfy their contractual obligations
to us or our failure to timely qualify a new contract
manufacturer to meet anticipated demand increases could result
in a significant interruption in the supply of our products. In
this event, we could lose revenue and damage our customer
relationships. In addition, our business interruption insurance
contains standard limitations and, as a result of these
limitations, may not adequately cover damages we incur in the
event of a supply interruption.



| |                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------
| | If we fail to accurately predict our
    manufacturing requirements, we could incur additional costs or
    experience manufacturing delays

We use a forward-looking forecast of anticipated
product orders to determine our product requirements for our
contract manufacturers. The lead times for materials and
components we order vary

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significantly and depend on factors such as the
specific supplier, contract terms and demand for each component
at a given time. For example, some of our application-specific
integrated circuits have a lead time of up to six months. If we
overestimate our requirements, our contract manufacturers may
have excess inventory, which we may be obligated to pay for. If
we underestimate our requirements, our contract manufacturers
may have inadequate inventory, which could result in delays in
delivery to our customers and our recognition of revenue.


In addition, because our contract manufacturers
produce our products based on forward-looking demand projections
that we supply to them, we may be unable to respond quickly to
sudden changes in demand. With respect to sudden increases in
demand, we may be unable to satisfy this demand with our
products, thereby forfeiting revenue opportunities and damaging
our customer relationships, and with respect to sudden decreases
in demand, we may find ourselves with excess inventory, which
could expose us to high manufacturing costs compared to our
revenue in a financial quarter and increased risks of inventory
obsolescence. These factors contributed to a total of
$12.2 million provision for inventory write-downs for
fiscal year 2003, a $17.9 million charge in fiscal year
2002, and a $72.9 million charge in transition
year 2001.



| |                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We plan to continue introducing new and
    complex products, and if our contract manufacturers are unable
    to manufacture these products consistently and in required
    quantities, we could lose sales

Due to the complexity of our new products, the
manufacturing process for these new products and/or the new
products themselves may require adjustments and refinements
during the first several months of initial manufacture. In
addition, it may be difficult for our contract manufacturers to
produce these complex products consistently with the level of
quality we require. We depend on the highly trained and
knowledgeable employees of our contract manufacturers to
assemble and test our products. Given the significant training
required to manufacture our products, the loss of a number of
these employees could also impair the ability of our contract
manufacturers to produce sufficient quantities of our products
in a timely manner with the quality we require.

Other Risks Related to our Business



| |                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our significant sales outside the United
    States subject us to increasing foreign political and economic
    risks, including foreign currency fluctuations

Our sales to customers outside of the United
States accounted for approximately 50.7%, 43.6% and 50.1% of our
revenue for fiscal year 2003, 2002 and transition year 2001,
respectively. We are seeking to expand our international
presence by establishing arrangements with distribution partners
as well as through strategic relationships in international
markets. Consequently, we anticipate that sales outside of the
United States will continue to account for a significant portion
of our revenue in future periods.

The sales of our products are denominated
primarily in United States dollars. As a result, increases in
the value of the United States dollar relative to foreign
currencies could cause our products to become less competitive
in international markets and could result in reductions in sales
and profitability. To the extent our prices or expenses are
denominated in foreign currencies, we will be exposed to
increased risks of currency fluctuations.

Our international presence subjects us to risks,
including:



| |   |                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------
| |  | political and economic instability and changing
    regulatory environments in foreign countries;                                              
|
| |  | increased time to deliver solutions to customers
    due to the complexities associated with managing an
    international distribution system;
|
| |  | increased time to collect receivables caused by
    slower payment practices in many international markets;                                    
|
| |  | managing export licenses, tariffs and other
    regulatory issues pertaining to international trade;                                           

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| |   |                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------
| |  | increased effort and costs associated with the
    protection of our intellectual property in foreign
    countries; and
|
| |  | difficulties in hiring and managing employees in
    foreign countries.                                                 



| |                                                                                                    
| | ---------------------------------------------------------------------------------------------------
| | We have made and may make future
    acquisitions or dispositions, which involve numerous
    risks

We periodically evaluate our business and our
technology needs, and evaluate alternatives for acquisitions,
dispositions and other transfers of businesses, assets,
technologies and product lines, and we have made, and may in the
future make, acquisitions and dispositions. Any future
acquisitions and/or dispositions would expose us to various
risks associated with such transactions and could harm our
results of operations and financial condition.

Although we may seek to make acquisitions, we may
be unable to identify and acquire suitable businesses, assets,
technology or product lines on reasonable terms, if at all. Our
financial condition or stock price may make it difficult for us
to complete acquisitions and we may compete for acquisitions
with other companies that have substantially greater financial,
management and other resources than we do. This competition may
increase the prices we pay to make acquisitions, which are often
high when compared to the assets and sales of acquisition
candidates. Also, our acquisitions may not generate sufficient
revenue to offset increased expenses associated with the
acquisition in the short term or at all. We may also consider
discontinuing or disposing of businesses, assets, technologies
or product lines; however, any decision to limit our investment
in or dispose of businesses, assets, technologies or product
lines may result in the recording of charges to our income
statement, such as inventory and technology related write-downs,
workforce reduction costs, contract termination costs, fixed
asset write-downs or claims from third party resellers or users
of the discontinued products. In addition, to the extent we are
required to sell intellectual property rights in disposing of
these businesses, assets, technologies or product lines, we may
need to re-license the right to use this intellectual property
for a fee.

Acquisitions and dispositions, particularly
multiple transactions over a short period of time, involve
transaction costs and a number of risks that may result in our
failure to achieve the desired benefits of the transaction.
These risks include, among others, the following:



| |   |                                                                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | difficulties and unanticipated costs incurred in
    assimilating the operations of the acquired business,
    technologies or product lines or of segregating, marketing and
    disposing of a business, technology or product line;
|
| |  | potential disruption of our existing operations;                                                                                                                                                                                      
|
| |  | an inability to successfully integrate, train and
    retain key personnel, or transfer or eliminate positions or key
    personnel;                                                                                                  
|
| |  | diversion of management attention and employees
    from day-to-day operations;                                                                                                                                                       
|
| |  | an inability to incorporate, develop or market
    acquired businesses, technologies or product lines, or realize
    value from technologies, products or businesses;                                                                
|
| |  | operating inefficiencies associated with managing
    companies in different locations, or separating integrated
    operations; and                                                                                                  
|
| |  | impairment of relationships with employees,
    customers, suppliers and strategic partners.                                                                                                                                          

We may finance acquisitions by issuing shares of
our common stock, which could dilute our existing stockholders.
We may also use cash or incur debt to pay for these
acquisitions. In addition, we may be required to expend
substantial funds to develop acquired technologies in connection
with future acquisitions, which could adversely affect our
financial condition or results of operations. We have made
acquisitions and may make future acquisitions that result in
in-process research and development expenses being charged in a
particular quarter, which could adversely affect our operating
results for that quarter.

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| |                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The market price of our common stock has
    historically been volatile, and declines in the market price of
    our common stock may negatively impact our ability to make
    future strategic acquisitions, raise capital, issue debt, and
    retain employees

Shares of our common stock may continue to
experience substantial price volatility, including significant
decreases, as a result of variations between our actual or
anticipated financial results and the published expectations of
analysts, announcements by our competitors and us, and pending
class action lawsuits against us. In addition, the stock markets
have experienced extreme price fluctuations that have affected
the market price of many technology companies. These price
fluctuations have, in some cases, been unrelated to the
operating performance of these companies. A major decline in
capital markets generally, or in the market price of our shares
of common stock, may negatively impact our ability to make
future strategic acquisitions, raise capital, issue debt, or
retain employees. These factors, as well as general economic and
political conditions and the outcome of the pending class action
lawsuits, may in turn materially adversely affect the market
price of our shares of common stock.



| |                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have not established a comprehensive
    disaster recovery plan and if we are unable to quickly and
    successfully restore our operations our revenue and our business
    could be harmed

We have not established and tested a
comprehensive disaster recovery plan for our business operations
or for recovering or otherwise operating our information
technology systems in the event of a catastrophic systems
failure or a natural or other disaster. If there is a natural or
other disaster which impacts our operations or a failure or
extended inoperability of our information technology systems,
our ability to service customers, ship products, process
transactions, test and develop products, and communicate
internally and externally could be materially impaired and our
revenue and business could be harmed. We are in the process of
developing a disaster recovery plan which we expect will conform
to industry standards and is intended to limit our business and
financial exposure in the event of a disaster or catastrophic
systems failure. Nevertheless, in the event of a disaster or
catastrophic systems failure, we may be unable to successfully
implement any plan we develop and restore, or operate at an
alternate location, our business or our information technology
systems and, to the extent it is implemented, any plan we
develop may not adequately prevent or limit the adverse effects
on our business of such a disaster or catastrophic systems
failure. Additionally, our business interruption insurance has
certain limitations and, as a result of these limitations, may
not adequately cover damages we incur in the event our business
is interrupted by such a disaster or catastrophic systems
failure.



| |                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Provisions of our articles of incorporation
    and by-laws and our investor rights plan could delay or prevent
    a change in control, which could reduce our stock
    price

Pursuant to our certificate of incorporation, our
Board of Directors has the authority to issue preferred stock
and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without
any vote or action by our stockholders. The issuance of
preferred stock could have the effect of making it more
difficult for a third party to acquire a majority of our
outstanding voting stock. Our certificate of incorporation
requires the affirmative vote of the holders of not less than
85% of the outstanding shares of our capital stock for the
approval or authorization of certain business combinations as
described in our certificate of incorporation. In addition, our
staggered Board of Directors and certain advance notification
requirements for submitting nominations for election to our
Board of Directors contained in our bylaws, as well as other
provisions of Delaware law and our certificate of incorporation
and bylaws, could delay or make a change in control more
difficult to accomplish.

In April 2002, our Board of Directors adopted a
stockholder rights plan pursuant to which we paid a dividend of
one right for each share of common stock held by stockholders of
record on June 11, 2002. As a result of the plan, our
acquisition by a party not approved by our Board of Directors
could be prohibitively expensive. This plan is designed to
protect stockholders from attempts to acquire us while our stock
price is inappropriately low or on terms or through tactics that
could deny all stockholders the opportunity to realize the full
value of their investment. Under the plan, each right initially
represents the right, under certain circumstances, to purchase
1/1,000 of a share of a new series of our preferred stock at

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an exercise price of $20 per share.
Initially the rights will not be exercisable and will trade with
our common stock. If a person or group acquires beneficial
ownership of 15% or more of the then outstanding shares of our
common stock or announces a tender or exchange offer that would
result in such person or group owning 15% or more of our then
outstanding common stock, each right would entitle its holder
(other than the holder or group which acquired 15% or more of
our common stock) to purchase shares of our common stock having
a market value of two times the exercise price of the right. Our
Board of Directors may redeem the rights at the redemption price
of $.01 per right, subject to adjustment, at any time prior
to the earlier of June 11, 2012, the expiration date of the
rights, or the date of distribution of the rights, as determined
under the plan.







|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

The following discussion about our market risk
involves forward-looking statements. Actual results could differ
materially from those projected in the forward-looking
statements. We are exposed to market risk primarily related to
changes in interest rates and foreign currency exchange rates.
Our hedging activity is intended to offset the impact of
currency fluctuations on certain nonfunctional currency assets
and liabilities.

Interest Rate
Sensitivity.We maintain an investment
portfolio consisting partly of debt securities of various
issuers, types and maturities. The securities that we classify
as held-to-maturity are recorded on the balance sheet at
amortized cost, which approximates market value. Unrealized
gains or losses associated with these securities are not
material. The securities that we classify as available-for-sale
are recorded on the balance sheet at fair market value with
unrealized gains or losses reported as part of accumulated other
comprehensive income, net of tax as a component of
stockholders equity. A hypothetical 10 percent
increase in interest rates would not have a material impact on
the fair market value of these securities due to their short
maturity. We expect to be able to hold our fixed income
investments until maturity, and therefore we do not expect our
operating results or cash flows to be materially affected by the
effect of a sudden change in market interest rates on our
securities portfolio, unless we are required to liquidate these
securities earlier to satisfy immediate cash flow requirements.

Foreign Currency Exchange
Risk.Due to our global operating and
financial activities, we are exposed to changes in foreign
currency exchange rates. At January 3, 2004, we had net
asset exposures to the Australian Dollar, Eurodollar, Japanese
Yen and Brazilian Real. These exposures may change over time as
business practices evolve and could materially harm our
financial results and cash flows.

To minimize the potential adverse impact of
changes in foreign currency exchange rates, we, at times, have
used foreign currency forward and option contracts to hedge the
currency risk inherent in our global operations. We do not use
financial instruments for trading or other speculative purposes,
nor do we use leveraged financial instruments. Gains and losses
on these contracts are largely offset by gains and losses on the
underlying assets and liabilities. We had no foreign exchange
forward or option contracts outstanding at January 3, 2004.

Equity Price Risk.We maintain a small amount of investments in marketable equity
securities of publicly-traded companies. At January 3,
2004, these investments were considered available-for-sale with
any unrealized gains or losses deferred as a component of
stockholders equity. It is not customary for us to make
investments in equity securities of publicly traded companies as
part of our investment strategy. In the past, we have also made
strategic equity and convertible debt investments in
privately-held technology companies, many of which are in the
start-up or development stage. Investments in these companies
are highly illiquid and inherently risky as the technologies or
products they have under development, or the services they
propose to provide, are typically in early stages of development
and may never materialize. If these companies are not
successful, we could lose our entire investment. The
concentration of our investments in a small number of related
industries, primarily telecommunications, exposes our
investments to increased risk, particularly if these industries
continue to be adversely affected by the worldwide economic
slowdown. At January 3, 2004, these investments totaled
$11.4 million. During fiscal year 2003, we recorded
impairment losses of $27.8 million relating to these
investments. While our

44



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##### Table of Contents



financial results may be materially adversely
affected by fluctuations in the value of these investments, we
do not expect a material impact in our cash flows.







|        |                                                             
|------- | ------------------------------------------------------------
|Item 8. | Consolidated Financial Statements and
    Supplementary Data

Our consolidated financial statements and related
notes and report of independent auditors are included beginning
on page F-1 of this annual report on Form 10-K.






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

None.






|         |                        
|-------- | -----------------------
|Item 9a. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures

An evaluation of the effectiveness of our
disclosure controls and procedures as of the end of the fiscal
year covered by this annual report on Form 10-K was carried
out under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief
Financial Officer. Based on and as of the date of that
evaluation, the CEO and CFO concluded that our disclosure
controls and procedures are sufficient to provide reasonable
assurance that information required to be disclosed by us in
reports that we file or submit under the Securities Exchange Act
of 1934 is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange
Commission rules and forms.

Changes in Internal Controls

Our management has assessed our internal controls
in each of the regions in which we operate as of the end of the
fiscal year covered by this annual report on Form 10-K.
Management continues to seek opportunities to improve our
internal controls and has assigned the highest priority to
implementing improvements to our internal controls.
Specifically, since September 27, 2003, we have implemented
the following improvements and additional procedures:

1. Development and implementation of
additional financial, accounting and other policies and
procedures and publication of these policies on our internal
website;

2. Expanded review of accounting practices
by our Disclosure Committee, and enhanced reporting of
accounting estimates to our Audit Committee;

3. Implementation of our ERP system in our
EMEA and Asia Pacific operations as of January 4, 2004, the
implementation of a dedicated budgeting and forecasting system
and upgrades to our financial reporting systems in Latin America;

4. Continued enhancement to system controls
and reporting; and

5. Continued expansion of internal audit
processes and procedures, including additional regional
financial statement reviews, and a company wide business risk
assessment.

We continue to evaluate the effectiveness of our
internal controls and procedures on an ongoing basis and will
take further action as appropriate.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

The information required under this item may be
found under the sections captioned Proposal I:
Election of Class II Directors, Executive
Officers, and Section 16(a) Beneficial
Ownership Reporting and Compliance in our 2004 Proxy
Statement and is incorporated herein by reference.

45



---



##### Table of Contents








|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required under this item may be
found under the sections captioned Summary Compensation
Table, Option Grants in the Last Fiscal Year,
and Option Exercises and Fiscal Year-End Values in
our 2004 Proxy Statement, and is incorporated herein by
reference.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information required under this item may be
found under the section captioned Securities Ownership of
Certain Beneficial Owners and Management in our 2004 Proxy
Statement, and is incorporated herein by reference.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required under this item may be
found under the section captioned Certain Relationships
and Related Transactions in our 2004 Proxy Statement, and
is incorporated herein by reference.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The information required under this item may be
found under the section captioned Principal
Accountants Fees and Service in our 2004 Proxy
Statement, and is incorporated herein by reference.

46



---



##### Table of Contents






PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(a) Documents filed as part of this
report:



| |                                                          
| | ---------------------------------------------------------
| | 1.     Consolidated
    Financial Statements (See Item 8)

|                                                                                                                                                                                                                            |  |      |     | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|Statement                                                                                                                                                                                                                   |  | Page
|                                                                                                                                                                                                                            |  |     
|Independent Auditors
    Report                                                                                                                                                                                            |  |      | F-1 | 
|Consolidated Balance Sheets
    at January 3, 2004 and December 28, 2002                                                                                                                                                    |  |      | F-2 | 
|Consolidated Statements of
    Operations for the year ended January 3, 2004, the year
    ended December 28, 2002, and the ten months ended
    December 29, 2001                                                          |  |      | F-3 | 
|Consolidated Statements of
    Redeemable Convertible Preferred Stock and Stockholders
    Equity for the year ended January 3, 2004, the year ended
    December 28, 2002, and the ten months ended
    December 29, 2001 |  |      | F-4 | 
|Consolidated Statements of
    Cash Flows for the year ended January 3, 2004, the year
    ended December 28, 2002, and the ten months ended
    December 29, 2001                                                          |  |      | F-6 | 
|Notes to Consolidated
    Financial Statements                                                                                                                                                                              |  |      | F-7 | 



| |                                                      
| | -----------------------------------------------------
| | 2.     Consolidated
    Financial Statement Schedules

|                                                                 |  |      |     | 
|---------------------------------------------------------------- |  | ---- | --- | 
|Schedule                                                         |  | Page
|                                                                 |  |     
|Schedule II 
    Valuation and Qualifying Accounts              |  |      | S-1 | 
|Independent Auditors
    Report on Financial Statement Schedule |  |      | S-2 | 

All other schedules have been omitted since they
are not required, not applicable or the information has been
included in the consolidated financial statements or the notes
thereto.



| |                
| | ---------------
| | 3.     Exhibits

(a) Exhibits:

| |     |  |  |   |  |                                                                                                                                                                                                                                                                                                                    
| | --- |  |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3.1 |  |  |  |  | Restated Certificate of Incorporation of the
    Registrant, a Delaware corporation, incorporated by reference to
    Exhibit 3.1 to the Registrants Registration Statement
    on Form S-1, No. 33-28055.                                                                                                        
| | 3.2 |  |  |  |  | Certificate of Correction of the
    Registrants Restated Certificate of Incorporation,
    incorporated by reference to Exhibit 3.1.2 to the
    Registrants Registration Statement on Form S-1,
    No. 33-42534.                                                                                              
| | 3.3 |  |  |  |  | Certificate of Amendment of the Restated
    Certificate of Incorporation of the Registrant, incorporated by
    reference to Exhibit 4.3 to the Registrants
    Registration Statement on Form S-3, No. 33-544666.                                                                                               
| | 3.4 |  |  |  |  | Certificate of Amendment of the Restated
    Certificate of Incorporation of the Registrant, incorporated by
    reference to Exhibit 3.5 to the Registrants annual
    report on Form 10-K filed on May 30, 2000.                                                                                                
| | 3.5 |  |  |  |  | Certificate of Designations, Preferences and
    Rights for Series F Convertible Preferred Stock of the
    Registrant, incorporated by reference to Exhibit 4.2 to the
    Registrants current report on Form 8-K filed
    May 31, 2002.                                                                        
| | 3.6 |  |  |  |  | Amended and Restated By-laws of the Registrant.                                                                                                                                                                                                                                                                    
| | 4.1 |  |  |  |  | Specimen stock certificate of the
    Registrants Common Stock, incorporated by reference to
    Exhibit 4.1 to the Registrants transition report on
    Form 10-K, filed on November 26, 2002 (the
    November 2002 10-K).                                                                                   
| | 4.2 |  |  |  |  | Form of Common Stock Purchase Warrant issued to
    certain Investors in connection with the merger of a subsidiary
    into the Registrant, incorporated by reference to
    Exhibit 4.2 to the Registrants quarterly report on
    Form 10-Q for the period ended September 1, 2001,
    filed October 16, 2001.
| | 4.3 |  |  |  |  | Rights Agreement, dated May 28, 2002,
    between the Registrant and EquiServe Trust Company, N.A., as
    Rights Agent, incorporated by reference to Exhibit 4.1 to
    the Registrants current report on Form 8-K, filed
    May 31, 2002.                                                                       

47



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##### Table of Contents



| |       |  |  |   |  |                                                                                                                                                                                                                                                                                                           
| | ----- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 4.4   |  |  |  |  | Form of Rights Certificate, incorporated by
    reference to Exhibit 4.3 to the Registrants current
    report on Form 8-K, filed May 31, 2002.                                                                                                                                                          
| | 10.1  |  |  |  |  | Amended and Restated Transformation Agreement,
    effective as of June 3, 2000, among Cabletron, Aprisma,
    Enterasys, GNTS and Riverstone, incorporated by reference to
    Exhibit 2.1 to the Registrants quarterly report on
    Form 10-Q filed on January 16, 2001 (the January
    2001 10-Q).
| | 10.2  |  |  |  |  | Amended and Restated Asset Contribution
    Agreement, effective as of June 3, 2000, between Cabletron
    and Enterasys, incorporated by reference to Exhibit 2.3 to
    the January 2001 10-Q.                                                                                                          
| | 10.3  |  |  |  |  | Amended and Restated Asset Contribution
    Agreement, effective as of June 3, 2000, between Cabletron
    and Riverstone, incorporated by reference to Exhibit 2.5 of
    the January 2001 10-Q.                                                                                                         
| | 10.4  |  |  |  |  | Tax Sharing Agreement, dated as of June 3,
    2000, among Cabletron, Aprisma, Enterasys, GNTS and Riverstone,
    incorporated by reference to Exhibit 2.6 of
    Cabletrons quarterly report on Form 10-Q, filed on
    October 18, 2000 (the October 2000 10-Q).                                    
| | 10.5  |  |  |  |  | Letter Sublease Agreement, dated June 4,
    1998, between the Registrant and Picturetel Corporation,
    together with related documents, incorporated by reference to
    Exhibit 10.8 to the Registrants Annual report on
    Form 10-K, filed on June 4, 2001.                                       
| | 10.6  |  |  |  |  | Registration Rights Agreement, dated as of
    August 29, 2000, among the Registrant and the Investors,
    incorporated by reference to Exhibit 2.7 to the Silver Lake
    8-K.                                                                                                                          
| | 10.7  |  |  |  |  | Manufacturing Services Agreement, dated as of
    March 1, 2000, between the Registrant and Flextronics
    International USA, Inc., incorporated by reference to
    Exhibit 10.6 to the February 2001 10-Q/ A.                                                                                          
| | 10.8  |  |  |  |  | 2002 Employee Stock Purchase Plan, incorporated
    by reference to Exhibit 4.1 to the Registrants
    registration statement on Form S-8, No. 333-103587.                                                                                                                                               
| | 10.9  |  |  |  |  | 2002 Stock Option Plan for Eligible Executives,
    incorporated by reference to Exhibit 10.8 to the
    Registrants Quarterly Report on Form 10-Q for the
    three-month period ended June 29, 2002, filed with the
    Commission on January 30, 2003 (the January 2003
    10-Q).                  
| | 10.10 |  |  |  |  | 2001 Equity Incentive Plan, incorporated by
    reference to Exhibit 4.1 to the Registrants
    registration statement on Form S-8, No. 333-66774.                                                                                                                                                       
| | 10.11 |  |  |  |  | 1998 Equity Incentive Plan, as amended,
    incorporated by reference to Exhibit 4.2 to the
    Registrants registration statement on Form S-8,
    No. 333-103587.                                                                                                                                      
| | 10.12 |  |  |  |  | Amended and Restated Change-in-Control Severance
    Benefit Plan for Key Employees.                                                                                                                                                                                                                      
| | 10.13 |  |  |  |  | Amended and Restated Executive Severance Pay Plan.                                                                                                                                                                                                                                                        
| | 10.14 |  |  |  |  | Deferral Plan for Directors, incorporated by
    reference to Exhibit 10.4 to the November 2002 10-K.                                                                                                                                                                                                     
| | 21.1  |  |  |  |  | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                           
| | 23.1  |  |  |  |  | Consent of Independent Auditors.                                                                                                                                                                                                                                                                          
| | 31.1  |  |  |  |  | Certification of William K. OBrien under
    Section 302 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                      
| | 31.2  |  |  |  |  | Certification of Richard S. Haak, Jr. under
    Section 302 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                    
| | 32.1  |  |  |  |  | Certification of William K. OBrien under
    Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                                                                                                     
| | 32.2  |  |  |  |  | Certification of Richard S. Haak, Jr. under
    Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                                                                                                   



---



|  |                                                                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | The certifications under Section 906 are
    being furnished hereunder and shall not be deemed
    filed for purposes of Section 18 of the
    Securities Exchange Act of 1934.

(b) Reports on Form 8-K:

We furnished a current report on Form 8-K on
October 9, 2003 to report our preliminary revenue estimate
for the third quarter of fiscal year 2003.

We filed a current report on Form 8-K on
October 17, 2003 to announce that we had reached agreements
to settle all outstanding shareholder litigation against us, our
directors and our former officers, filed in connection with our
restatement of financial results for the 2001 fiscal and
transition years.

We furnished a current report on Form 8-K on
October 23, 2003 to report our financial results for the
third quarter of fiscal year 2003.

48



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##### Table of Contents



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



| |                         
| | ------------------------
| | ENTERASYS NETWORKS, INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ WILLIAM K. OBRIEN

| |                                     
| | ------------------------------------
| |                                     
| | William K. OBrien                  
| | Chief Executive Officer and Director

Date: March 18, 2004

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|                                             |  |                                                                          |  |                |  | 
|-------------------------------------------- |  | ------------------------------------------------------------------------ |  | -------------- |  | 
|                                             |  |                                                                          |  |               
|Signature                                    |  | Title(s)                                                                 |  | Date          
|                                             |  |                                                                          |  |               
|                                            
|/s/ WILLIAM K. OBRIENWilliam K. OBrien     |  | Chief Executive Officer and Director
    (Principal Executive Officer)   |  | March 18, 2004
|                                            
|/s/ RICHARD S. HAAK, JR.Richard S. Haak, Jr. |  | Chief Financial Officer
    (Principal Financial and Accounting Officer) |  | March 18, 2004
|                                            
|/s/ PAUL R. DUNCANPaul R. Duncan             |  | Director                                                                 |  | March 18, 2004
|                                            
|/s/ MICHAEL GALLAGHERMichael Gallagher       |  | Director                                                                 |  | March 18, 2004
|                                            
|/s/ EDWIN A. HUSTONEdwin A. Huston           |  | Director                                                                 |  | March 18, 2004
|                                            
|/s/ RONALD T. MAHEURonald T. Maheu           |  | Director                                                                 |  | March 18, 2004

49



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##### Table of Contents



EXHIBIT INDEX

| |    |     |  |   |  |                                                                                                                                                                                                                                                                                                                    
| | -- | --- |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3  | .1  |  |  |  | Restated Certificate of Incorporation of the
    Registrant, a Delaware corporation, incorporated by reference to
    Exhibit 3.1 to the Registrants Registration Statement
    on Form S-1, No. 33-28055.                                                                                                        
| | 3  | .2  |  |  |  | Certificate of Correction of the
    Registrants Restated Certificate of Incorporation,
    incorporated by reference to Exhibit 3.1.2 to the
    Registrants Registration Statement on Form S-1,
    No. 33-42534.                                                                                              
| | 3  | .3  |  |  |  | Certificate of Amendment of the Restated
    Certificate of Incorporation of the Registrant, incorporated by
    reference to Exhibit 4.3 to the Registrants
    Registration Statement on Form S-3, No. 33-544666.                                                                                               
| | 3  | .4  |  |  |  | Certificate of Amendment of the Restated
    Certificate of Incorporation of the Registrant, incorporated by
    reference to Exhibit 3.5 to the Registrants annual
    report on Form 10-K filed on May 30, 2000.                                                                                                
| | 3  | .5  |  |  |  | Certificate of Designations, Preferences and
    Rights for Series F Convertible Preferred Stock of the
    Registrant, incorporated by reference to Exhibit 4.2 to the
    Registrants current report on Form 8-K filed
    May 31, 2002.                                                                        
| | 3  | .6  |  |  |  | Amended and Restated By-laws of the Registrant.                                                                                                                                                                                                                                                                    
| | 4  | .1  |  |  |  | Specimen stock certificate of the
    Registrants Common Stock, incorporated by reference to
    Exhibit 4.1 to the Registrants transition report on
    Form 10-K, filed on November 26, 2002 (the
    November 2002 10-K).                                                                                   
| | 4  | .2  |  |  |  | Form of Common Stock Purchase Warrant issued to
    certain Investors in connection with the merger of a subsidiary
    into the Registrant, incorporated by reference to
    Exhibit 4.2 to the Registrants quarterly report on
    Form 10-Q for the period ended September 1, 2001,
    filed October 16, 2001.
| | 4  | .3  |  |  |  | Rights Agreement, dated May 28, 2002,
    between the Registrant and EquiServe Trust Company, N.A., as
    Rights Agent, incorporated by reference to Exhibit 4.1 to
    the Registrants current report on Form 8-K, filed
    May 31, 2002.                                                                       
| | 4  | .4  |  |  |  | Form of Rights Certificate, incorporated by
    reference to Exhibit 4.3 to the Registrants current
    report on Form 8-K, filed May 31, 2002.                                                                                                                                                                   
| | 10 | .1  |  |  |  | Amended and Restated Transformation Agreement,
    effective as of June 3, 2000, among Cabletron, Aprisma,
    Enterasys, GNTS and Riverstone, incorporated by reference to
    Exhibit 2.1 to the Registrants quarterly report on
    Form 10-Q filed on January 16, 2001 (the January
    2001 10-Q).         
| | 10 | .2  |  |  |  | Amended and Restated Asset Contribution
    Agreement, effective as of June 3, 2000, between Cabletron
    and Enterasys, incorporated by reference to Exhibit 2.3 to
    the January 2001 10-Q.                                                                                                                   
| | 10 | .3  |  |  |  | Amended and Restated Asset Contribution
    Agreement, effective as of June 3, 2000, between Cabletron
    and Riverstone, incorporated by reference to Exhibit 2.5 of
    the January 2001 10-Q.                                                                                                                  
| | 10 | .4  |  |  |  | Tax Sharing Agreement, dated as of June 3,
    2000, among Cabletron, Aprisma, Enterasys, GNTS and Riverstone,
    incorporated by reference to Exhibit 2.6 of
    Cabletrons quarterly report on Form 10-Q, filed on
    October 18, 2000 (the October 2000 10-Q).                                             
| | 10 | .5  |  |  |  | Letter Sublease Agreement, dated June 4,
    1998, between the Registrant and Picturetel Corporation,
    together with related documents, incorporated by reference to
    Exhibit 10.8 to the Registrants Annual report on
    Form 10-K, filed on June 4, 2001.                                                
| | 10 | .6  |  |  |  | Registration Rights Agreement, dated as of
    August 29, 2000, among the Registrant and the Investors,
    incorporated by reference to Exhibit 2.7 to the Silver
    Lake 8-K.                                                                                                                                   
| | 10 | .7  |  |  |  | Manufacturing Services Agreement, dated as of
    March 1, 2000, between the Registrant and Flextronics
    International USA, Inc., incorporated by reference to
    Exhibit 10.6 to the February 2001 10-Q/A.                                                                                                    
| | 10 | .8  |  |  |  | 2002 Employee Stock Purchase Plan,
    incorporated by reference to Exhibit 4.1 to the
    Registrants registration statement on Form S-8,
    No. 333-103587.                                                                                                                                                    
| | 10 | .9  |  |  |  | 2002 Stock Option Plan for Eligible
    Executives, incorporated by reference to Exhibit 10.8 to
    the Registrants Quarterly Report on Form 10-Q for the
    three-month period ended June 29, 2002, filed with the
    Commission on January 30, 2003 (the January
    2003 10-Q).                           
| | 10 | .10 |  |  |  | 2001 Equity Incentive Plan, incorporated by
    reference to Exhibit 4.1 to the Registrants
    registration statement on Form S-8, No. 333-66774.                                                                                                                                                                
| | 10 | .11 |  |  |  | 1998 Equity Incentive Plan, as amended,
    incorporated by reference to Exhibit 4.2 to the
    Registrants registration statement on Form S-8,
    No. 333-103587.                                                                                                                                               



---



##### Table of Contents



| |    |     |  |   |  |                                                                                                      
| | -- | --- |  | - |  | -----------------------------------------------------------------------------------------------------
| | 10 | .12 |  |  |  | Amended and Restated Change-in-Control Severance
    Benefit Plan for Key Employees.                 
| | 10 | .13 |  |  |  | Amended and Restated Executive Severance Pay Plan.                                                   
| | 10 | .14 |  |  |  | Deferral Plan for Directors, incorporated by
    reference to Exhibit 10.4 to the November 2002 10-K.
| | 21 | .1  |  |  |  | Subsidiaries of the Registrant.                                                                      
| | 23 | .1  |  |  |  | Consent of Independent Auditors.                                                                     
| | 31 | .1  |  |  |  | Certification of William K. OBrien
    under Section 302 of the Sarbanes-Oxley Act.                 
| | 31 | .2  |  |  |  | Certification of Richard S. Haak, Jr.
    under Section 302 of the Sarbanes-Oxley Act.               
| | 32 | .1  |  |  |  | Certification of William K. OBrien
    under Section 906 of the Sarbanes-Oxley Act.*                
| | 32 | .2  |  |  |  | Certification of Richard S. Haak, Jr.
    under Section 906 of the Sarbanes-Oxley Act.*              



---



|  |                                                                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | The certifications under Section 906 are
    being furnished hereunder and shall not be deemed
    filed for purposes of Section 18 of the
    Securities Exchange Act of 1934.



---



##### Table of Contents






INDEPENDENT AUDITORS REPORT

The Board of Directors and Stockholders of
Enterasys Networks, Inc.:

We have audited the accompanying consolidated
balance sheets of Enterasys Networks, Inc. and subsidiaries
(the Company) as of January 3, 2004 and
December 28, 2002, and the related consolidated statements
of operations, redeemable convertible preferred stock and
stockholders equity, and cash flows for the years ended
January 3, 2004 and December 28, 2002, and the
ten-months ended December 29, 2001. These consolidated
financial statements are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit also
includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the financial position of the Company as of
January 3, 2004 and December 28, 2002, and the results
of their operations and their cash flows for the years ended
January 3, 2004 and December 28, 2002, and the
ten-months ended December 29, 2001, in conformity with
accounting principles generally accepted in the United States of
America.

As discussed in Note 2 to the consolidated
financial statements, effective December 30, 2001, the
Company changed its method of accounting for goodwill and other
intangible assets. In addition, also as discussed in Note 2
to the consolidated financial statements, effective
March 4, 2001, the Company changed its method of accounting
for derivative financial instruments and hedging activities.

/s/ KPMG LLP

Boston, Massachusetts

February 10, 2004


F-1



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##### Table of Contents



ENTERASYS NETWORKS, INC.



CONSOLIDATED BALANCE SHEETS


|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |           |         | 
|-------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ------- | ------------ | ------- |  | ------- | --------- | ------- | 
|                                                                                 |                                                                                                                                                                            | January 3,                                                                             |         | December 28,
|                                                                                 |                                                                                                                                                                            | 2004                                                                                   |         | 2002        
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |             
|                                                                                 |                                                                                                                                                                            |                                                                                       
|                                                                                 |                                                                                                                                                                            | (In thousands, except share                                                           
|                                                                                 |                                                                                                                                                                            | and per share amounts)                                                                
|ASSETS                                                                          
|Current assets:                                                                  |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 | Cash and cash equivalents                                                                                                                                                  |                                                                                        | $       | 136,801      |         |  | $       | 136,193   |        
|                                                                                 | Marketable securities                                                                                                                                                      |                                                                                        |         | 29,851       |         |  |         | 82,853    |        
|                                                                                 | Accounts receivable, net                                                                                                                                                   |                                                                                        |         | 37,541       |         |  |         | 41,683    |        
|                                                                                 | Inventories, net                                                                                                                                                           |                                                                                        |         | 29,049       |         |  |         | 44,552    |        
|                                                                                 | Income tax receivable                                                                                                                                                      |                                                                                        |         | 595          |         |  |         | 38,695    |        
|                                                                                 | Notes receivable                                                                                                                                                           |                                                                                        |         |             |         |  |         | 2,500     |        
|                                                                                 | Prepaid expenses and other current assets                                                                                                                                  |                                                                                        |         | 18,497       |         |  |         | 17,220    |        
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 |                                                                                                                                                                            | Total current assets                                                                   |         |              | 252,334 |  |         |           | 363,696 | 
|Restricted cash, cash equivalents and marketable
    securities                  |                                                                                                                                                                            |                                                                                        | 18,693  |              |         |  | 24,450  |          
|Long-term marketable securities                                                  |                                                                                                                                                                            |                                                                                        | 35,803  |              |         |  | 69,766  |          
|Investments                                                                      |                                                                                                                                                                            |                                                                                        | 11,417  |              |         |  | 39,135  |          
|Property, plant and equipment, net                                               |                                                                                                                                                                            |                                                                                        | 37,881  |              |         |  | 47,407  |          
|Goodwill                                                                         |                                                                                                                                                                            |                                                                                        | 15,129  |              |         |  | 15,129  |          
|Intangible assets, net                                                           |                                                                                                                                                                            |                                                                                        | 17,353  |              |         |  | 21,764  |          
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 |                                                                                                                                                                            | Total assets                                                                           |         | $            | 388,610 |  |         | $         | 581,347 | 
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
    STOCK AND STOCKHOLDERS EQUITY
|Current liabilities:                                                             |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 | Accounts payable                                                                                                                                                           |                                                                                        | $       | 39,738       |         |  | $       | 47,589    |        
|                                                                                 | Accrued compensation and benefits                                                                                                                                          |                                                                                        |         | 26,832       |         |  |         | 31,138    |        
|                                                                                 | Accrued legal and litigation costs                                                                                                                                         |                                                                                        |         | 8,338        |         |  |         | 10,297    |        
|                                                                                 | Accrued restructuring charges                                                                                                                                              |                                                                                        |         | 6,407        |         |  |         | 3,994     |        
|                                                                                 | Other accrued expenses                                                                                                                                                     |                                                                                        |         | 24,114       |         |  |         | 32,269    |        
|                                                                                 | Deferred revenue                                                                                                                                                           |                                                                                        |         | 41,187       |         |  |         | 49,720    |        
|                                                                                 | Customer advances and billings in excess of
    revenues                                                                                                                   |                                                                                        |         | 7,323        |         |  |         | 7,398     |        
|                                                                                 | Income taxes payable                                                                                                                                                       |                                                                                        |         | 44,275       |         |  |         | 48,242    |        
|                                                                                 | Redeemable convertible preferred stock                                                                                                                                     |                                                                                        |         |             |         |  |         | 94,800    |        
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 |                                                                                                                                                                            | Total current liabilities                                                              |         |              | 198,214 |  |         |           | 325,447 | 
|Deferred revenue                                                                 |                                                                                                                                                                            |                                                                                        | 6,217   |              |         |  | 6,262   |          
|Accrued restructuring charges                                                    |                                                                                                                                                                            |                                                                                        | 4,118   |              |         |  | 3,688   |          
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|Total liabilities                                                                |                                                                                                                                                                            |                                                                                        | 208,549 |              |         |  | 335,397 |          
|                                                                                 | Commitments and contingencies
    (Note 20)                                                                                                                                |                                                                                        |         |              |         |  |         |           |        
|Stockholders equity:                                                            |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 | Series F preferred stock, $1.00 par
    value; 300,000 shares authorized; none outstanding                                                                                 |                                                                                        |         |             |         |  |         |          |        
|                                                                                 | Undesignated preferred stock, $1.00 par
    value; 1,700,000 shares authorized; none outstanding                                                                           |                                                                                        |         |             |         |  |         |          |        
|                                                                                 | Common stock, $0.01 par value;
    450,000,000 shares authorized; 210,805,013 and
    204,940,728 shares issued at January 3, 2004 and
    December 28, 2002, respectively |                                                                                        |         | 2,108        |         |  |         | 2,049     |        
|                                                                                 | Additional paid-in capital                                                                                                                                                 |                                                                                        |         | 1,187,449    |         |  |         | 1,176,843 |        
|                                                                                 | Accumulated deficit                                                                                                                                                        |                                                                                        |         | (990,250     | )       |  |         | (875,407  | )      
|                                                                                 | Unearned stock-based compensation                                                                                                                                          |                                                                                        |         |             |         |  |         | (158      | )      
|                                                                                 | Treasury stock, at cost; 1,748,861 and 3,053,201
    common shares at January 3, 2004 and December 28,
    2002, respectively                                              |                                                                                        |         | (30,119      | )       |  |         | (64,890   | )      
|                                                                                 | Accumulated other comprehensive income                                                                                                                                     |                                                                                        |         | 10,873       |         |  |         | 7,513     |        
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 |                                                                                                                                                                            | Total stockholders equity                                                             |         |              | 180,061 |  |         |           | 245,950 | 
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          
|                                                                                 |                                                                                                                                                                            | Total liabilities, redeemable convertible
    preferred stock and stockholders equity |         | $            | 388,610 |  |         | $         | 581,347 | 
|                                                                                 |                                                                                                                                                                            |                                                                                        |         |              |         |  |         |          

See accompanying notes to consolidated financial
statements.

F-2



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##### Table of Contents



ENTERASYS NETWORKS, INC.



CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |         |          |          |  
|------------------------------------------------------------------------------------ | -------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------- | ----------------------------------------- | ----------------- | -------- | ----------------- | ------- | ------- | -------- | -------- | ------- | ------- | -------- | -------- | -
|                                                                                     |                                                                      | Year Ended                                                                                                        |                                           | Year Ended        |          | Ten Months Ended 
|                                                                                     |                                                                      | January 3, 2004                                                                                                   |                                           | December 28, 2002 |          | December 29, 2001
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                  
|                                                                                     |                                                                      |                                                                                                                  
|                                                                                     |                                                                      | (In thousands, except per share amounts)                                                                         
|Net revenue:                                                                         |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     | Product                                                              |                                                                                                                   | $                                         | 300,119           |          |                   | $       | 346,610 |          |          | $       | 257,947 |         
|                                                                                     | Services                                                             |                                                                                                                   |                                           | 114,419           |          |                   |         | 138,187 |          |          |         | 136,598 |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Total revenue                                                                                                     |                                           |                   | 414,538  |                   |         |         | 484,797  |          |         |         | 394,545  |         
|Cost of revenue:                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     | Product                                                              |                                                                                                                   |                                           | 159,186           |          |                   |         | 231,359 |          |          |         | 302,820 |         
|                                                                                     | Services(a)                                                          |                                                                                                                   |                                           | 46,977            |          |                   |         | 43,643  |          |          |         | 47,556  |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Total cost of revenue                                                                                             |                                           |                   | 206,163  |                   |         |         | 275,002  |          |         |         | 350,376  |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Gross margin                              |                   |          | 208,375           |         |         |          | 209,795  |         |         |          | 44,169   |  
|Operating expenses:                                                                  |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     | Research and development(a)                                          |                                                                                                                   |                                           | 84,029            |          |                   |         | 85,019  |          |          |         | 76,471  |         
|                                                                                     | Selling, general and administrative(a)                               |                                                                                                                   |                                           | 173,933           |          |                   |         | 234,960 |          |          |         | 284,735 |         
|                                                                                     | Amortization of intangible assets                                    |                                                                                                                   |                                           | 6,503             |          |                   |         | 8,708   |          |          |         | 32,366  |         
|                                                                                     | Stock-based compensation                                             |                                                                                                                   |                                           | 158               |          |                   |         | 2,644   |          |          |         | 30,572  |         
|                                                                                     | Shareholder litigation expense                                       |                                                                                                                   |                                           | 15,900            |          |                   |         |        |          |          |         |        |         
|                                                                                     | Special charges                                                      |                                                                                                                   |                                           | 17,532            |          |                   |         | 31,978  |          |          |         | 47,168  |         
|                                                                                     | Impairment of intangible assets                                      |                                                                                                                   |                                           |                  |          |                   |         |        |          |          |         | 104,147 |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Total operating expenses                                                                                          |                                           |                   | 298,055  |                   |         |         | 363,309  |          |         |         | 575,459  |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Loss from operations                      |                   |          | (89,680           | )       |         |          | (153,514 | )       |         |          | (531,290 | )
|Interest income, net                                                                 |                                                                      |                                                                                                                   | 5,132                                     |                   |          |                   | 8,347   |         |          |          | 17,672  |        
|Other expense, net                                                                   |                                                                      |                                                                                                                   | (27,354                                   | )                 |          |                   | (42,625 | )       |          |          | (41,209 | )      
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Loss from continuing operations before income
    taxes and cumulative effect of a change in accounting principle |                                           |                   | (111,902 | )                 |         |         | (187,792 | )        |         |         | (554,827 | )       
|Income tax expense (benefit)                                                         |                                                                      |                                                                                                                   | 749                                       |                   |          |                   | (85,247 | )       |          |          | 60,242  |        
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Loss from continuing operations before cumulative
    effect of a change in accounting principle                  |                                           |                   | (112,651 | )                 |         |         | (102,545 | )        |         |         | (615,069 | )       
|Discontinued operations:                                                             |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Operating loss (net of tax expense of $346)                                                                       |                                           |                   |         |                   |         |         |         |          |         |         | (59,124  | )       
|                                                                                     |                                                                      | Loss on disposal (net of tax expense of $0)                                                                       |                                           |                   |         |                   |         |         | (11,700  | )        |         |         | (42,782  | )       
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Loss from discontinued operations         |                   |          |                  |         |         |          | (11,700  | )       |         |          | (101,906 | )
|Cumulative effect of a change in accounting
    principle (net of tax expense of $0) |                                                                      |                                                                                                                   |                                          |                   |          |                   |        |         |          |          | 12,691  |        
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Net loss                                  |                   |          | (112,651          | )       |         |          | (114,245 | )       |         |          | (704,284 | )
|Accretive dividend and accretion of discount on
    preferred shares                 |                                                                      |                                                                                                                   | (2,192                                    | )                 |          |                   | (12,963 | )       |          |          | (10,347 | )      
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Net loss available to common shareholders |                   | $        | (114,843          | )       |         | $        | (127,208 | )       |         | $        | (714,631 | )
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|Basic and diluted loss per common share:                                             |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     | Loss from continuing operations available to
    common shareholders |                                                                                                                   | $                                         | (0.56             | )        |                   | $       | (0.57   | )        |          | $       | (3.24   | )       
|                                                                                     | Discontinued operations:                                             |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |         |         
|                                                                                     |                                                                      | Operating loss                                                                                                    |                                           |                   |         |                   |         |         |         |          |         |         | (0.31    | )       
|                                                                                     |                                                                      | Loss on disposal                                                                                                  |                                           |                   |         |                   |         |         | (0.06    | )        |         |         | (0.22    | )       
|                                                                                     | Cumulative effect of a change in accounting
    principle            |                                                                                                                   |                                           |                  |          |                   |         |        |          |          |         | 0.06    |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      |                                                                                                                   | Net loss available to common shareholders |                   | $        | (0.56             | )       |         | $        | (0.63    | )       |         | $        | (3.71    | )
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|Weighted average number of basic and diluted
    common shares outstanding           |                                                                      |                                                                                                                   | 205,009                                   |                   |          |                   | 201,562 |         |          |          | 192,743 |        
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|(a) Excludes non-cash, stock-based
    compensation expense as follows:              |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     | Services cost of revenue                                             |                                                                                                                   | $                                         |                  |          |                   | $       |        |          |          | $       | 2,292   |         
|                                                                                     | Research and development                                             |                                                                                                                   |                                           | 158               |          |                   |         | 2,644   |          |          |         | 13,356  |         
|                                                                                     | Selling, general and administrative                                  |                                                                                                                   |                                           |                  |          |                   |         |        |          |          |         | 14,924  |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        
|                                                                                     |                                                                      | Total stock-based compensation                                                                                    |                                           | $                 | 158      |                   |         | $       | 2,644    |          |         | $       | 30,572   |         
|                                                                                     |                                                                      |                                                                                                                   |                                           |                   |          |                   |         |         |          |          |         |        

See accompanying notes to consolidated financial
statements.

F-3



---



##### Table of Contents



ENTERASYS NETWORKS, INC.



CONSOLIDATED STATEMENTS OF REDEEMABLE
CONVERTIBLE PREFERRED STOCK


AND STOCKHOLDERS EQUITY


|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |          |       |          |  
|------------------------------------------------------------------ | ---------------------------------- | ----------------------------------------------------------------------------------- | ------------------------ | -------------------- | - | ---------- | ------- | ----- | - | ----------- | ----------- | -------------- | - | ------------ | ----- | ------ | - | ------------- | --------- | ------------- | - | ------ | -------- | -------- | - | - | ------- | - | - | - | ---------- | - | - | - | ------- | - | - | - | ----- | - | ----- | - | --------- | -------- | ----- | -------- | -
|                                                                   |                                    |                                                                                     |                          |                      |   |           
|                                                                   |                                    |                                                                                     |                          | Stockholders Equity
|                                                                   |                                    | Redeemable                                                                          |                          |                     
|                                                                   |                                    | Convertible                                                                         |                          |                      |   |           
|                                                                   |                                    | Preferred Stock                                                                     |                          | Common Stock         |   |           
|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   | Accumulated |             |               
|                                                                   |                                    |                                                                                     |                          |                      |   | Additional |         |       |   | Unearned    |             | Treasury Stock |   | Other        |       | Total 
|                                                                   |                                    |                                                                                     |                          | Carrying             |   |            |         | Par   |   | Paid-in     |             | Retained       |   | Stock-based  |       |        |   | Comprehensive |           | Stockholders
|                                                                   |                                    | Shares                                                                              |                          | Value                |   | Shares     |         | Value |   | Capital     |             | Earnings       |   | Compensation |       | Shares |   | Cost          |           | Income (Loss) |   | Equity
|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |       
|                                                                   |                                    |                                                                                    
|                                                                   |                                    | (In thousands, except number of shares)                                            
|Balance at March 3, 2001                                           |                                    |                                                                                     | 135,471                  |                      |   | $          | 109,589 |       |   |             | 190,611,576 |                |   | $            | 1,906 |        |   | $             | 990,157   |               |   | $      | 296,032  |          |   | $ | (16,673 | ) |   |   | (2,100,000 | ) |   | $ | (56,479 | ) |   | $ | (624  | ) |       | $ | 1,214,319 |         
|Comprehensive loss:                                                |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |         
|                                                                   | Net loss                           |                                                                                     |                          |                     |   |            |         |      |   |             |             |               |   |              |       |       |   |               |           |              |   |        |          | (704,284 | ) |   |         |  |   |   |            |  |   |   |         |  |   |   |       |  |       |   |           | (704,284 | )    
|                                                                   | Other comprehensive income (loss): |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |          |      
|                                                                   |                                    | Unrealized gain on available-for-sale securities
    (net of tax expense of $1,490) |                          |                      |  |            |         |       |  |             |             |                |  |              |       |        |  |               |           |               |  |        |          |          |  |   |         |   |  |   |            |   |  |   |         |   |  |   |       |   | 2,235 |   |           |          | 2,235 |         
|                                                                   |                                    | Effect of foreign currency translation                                              |                          |                      |  |            |         |       |  |             |             |                |  |              |       |        |  |               |           |               |  |        |          |          |  |   |         |   |  |   |            |   |  |   |         |   |  |   |       |   | 866   |   |           |          | 866   |         
|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |         
|                                                                   |                                    |                                                                                     | Total comprehensive loss |                      |   |           |         |       |   |            |             |                |   |             |       |        |   |              |           |               |   |       |          |          |   |  |         |   |   |  |            |   |   |  |         |   |   |  |       |   |       |  |           |          |       | (701,183 | )
|Riverstone spin-off                                                |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (329,600 | )        |   |   | 9,022   |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (320,578  | )       
|Exercise of options and warrants for shares of
    common stock    |                                    |                                                                                     |                         |                      |   |            |        |       |   |             | 10,477,337  |                |   |              | 105   |        |   |               | 48,296    |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 48,401    |         
|Acceleration of stock options                                      |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | 42,274    |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 42,274    |         
|Proceeds from sale of put options                                  |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | 135       |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 135       |         
|Issuance of shares under employee share purchase
    plan          |                                    |                                                                                     |                         |                      |   |            |        |       |   |             | 778,752     |                |   |              | 7     |        |   |               | 7,561     |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 7,568     |         
|Issuance of Riverstone stock at spin-off                           |                                    |                                                                                     |                         |                      |   |            | (18,582 | )     |   |             |            |                |   |              |      |        |   |               | 18,582    |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 18,582    |         
|Adjustment to Riverstone stock derivative                          |                                    |                                                                                     |                         |                      |   |            | (4,020  | )     |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   |          |         
|Accretive dividend of Series A and B
    preferred stock           |                                    |                                                                                     |                         |                      |   |            | 1,443   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (1,443   | )        |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (1,443    | )       
|Accretion of Series D and E preferred stock
    discount(a)        |                                    |                                                                                     |                         |                      |   |            | 7,251   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (7,251   | )        |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (7,251    | )       
|Accretive dividend of Series D and E
    preferred stock(a)        |                                    |                                                                                     |                         |                      |   |            | 1,653   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (1,653   | )        |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (1,653    | )       
|Conversion of Series C preferred stock                             |                                    |                                                                                     | (45,471                  | )                    |   |            | (31,875 | )     |   |             | 955,253     |                |   |              | 9     |        |   |               | 31,866    |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 31,875    |         
|Conversion of options and warrants on
    Series C preferred stock |                                    |                                                                                     |                         |                      |   |            | (3,670  | )     |   |             |            |                |   |              |      |        |   |               | 3,670     |               |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 3,670     |         
|Contingent redemption value of common stock put
    options        |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | (842      | )             |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (842      | )       
|Purchase of treasury stock                                         |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   |        |   |   |   | (953,201   | ) |   |   | (8,411  | ) |   |   |      |   |       |   | (8,411    | )       
|Exercise of warrants                                               |                                    |                                                                                     |                         |                      |   |            |        |       |   |             | 118,626     |                |   |              | 2     |        |   |               | (2        | )             |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   |          |         
|Amortization of unearned stock-based compensation                  |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   | 4,849   |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | 4,849     |         
|Effect of minority interests                                       |                                    |                                                                                     |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | (608      | )             |   |        |         |          |   |   |        |   |   |   |           |   |   |   |        |   |   |   |      |   |       |   | (608      | )       
|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |         
|Balance at December 29, 2001                                       |                                    |                                                                                     | 90,000                   |                      |   | $          | 61,789  |       |   |             | 202,941,544 |                |   | $            | 2,029 |        |   | $             | 1,141,089 |               |   | $      | (748,199 | )        |   | $ | (2,802  | ) |   |   | (3,053,201 | ) |   | $ | (64,890 | ) |   | $ | 2,477 |   |       | $ | 329,704   |         
|                                                                   |                                    |                                                                                     |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |         |   |   |   |            |   |   |   |         |   |   |   |       |   |       |   |           |         



---



|    |  |                                                                                                                                                            
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Series A and Series B redeemable
    preferred stock were exchanged for Series D and
    Series E redeemable preferred stock in July 2001 (see
    Note 18)

See accompanying notes to consolidated financial
statements.

F-4



---



##### Table of Contents



ENTERASYS NETWORKS, INC.


CONSOLIDATED STATEMENTS OF REDEEMABLE
CONVERTIBLE PREFERRED STOCK

AND STOCKHOLDERS EQUITY 
(Continued)


|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |          |          |          |  
|--------------------------------------------------------------- | ------------------------------------------------ | ------------------------------------------------------------------------------- | ------------------------ | -------------------- | - | ---------- | ------- | ----- | - | ----------- | ----------- | -------------- | - | ------------ | ----- | ------ | - | ------------- | --------- | ------------- | - | ------ | -------- | -------- | - | - | ------ | - | - | - | ---------- | - | - | - | ------- | - | - | - | ------ | ------ | ----- | - | ------- | -------- | -------- | -------- | -
|                                                                |                                                  |                                                                                 |                          |                      |   |           
|                                                                |                                                  |                                                                                 |                          | Stockholders Equity
|                                                                |                                                  | Redeemable                                                                      |                          |                     
|                                                                |                                                  | Convertible                                                                     |                          |                      |   |           
|                                                                |                                                  | Preferred Stock                                                                 |                          | Common Stock         |   |           
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   | Accumulated |             |               
|                                                                |                                                  |                                                                                 |                          |                      |   | Additional |         |       |   | Unearned    |             | Treasury Stock |   | Other        |       | Total 
|                                                                |                                                  |                                                                                 |                          | Carrying             |   |            |         | Par   |   | Paid-in     |             | Retained       |   | Stock-based  |       |        |   | Comprehensive |           | Stockholders
|                                                                |                                                  | Shares                                                                          |                          | Value                |   | Shares     |         | Value |   | Capital     |             | Earnings       |   | Compensation |       | Shares |   | Cost          |           | Income        |   | Equity
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |       
|                                                                |                                                  |                                                                                
|                                                                |                                                  | (In thousands, except number of shares)                                        
|Balance at December 29, 2001                                    |                                                  |                                                                                 | 90,000                   |                      |   | $          | 61,789  |       |   |             | 202,941,544 |                |   | $            | 2,029 |        |   | $             | 1,141,089 |               |   | $      | (748,199 | )        |   | $ | (2,802 | ) |   |   | (3,053,201 | ) |   | $ | (64,890 | ) |   | $ | 2,477  |        |       | $ | 329,704 |         
|Comprehensive loss:                                             |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|                                                                | Net loss                                         |                                                                                 |                          |                     |   |            |         |      |   |             |             |               |   |              |       |       |   |               |           |              |   |        |          | (114,245 | ) |   |        |  |   |   |            |  |   |   |         |  |   |   |        |       |       |   |         | (114,245 | )       
|                                                                | Other comprehensive income (loss):               |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |          |         
|                                                                |                                                  | Unrealized gain on available-for-sale securities
    (net of tax expense of $0) |                          |                      |  |            |         |       |  |             |             |                |  |              |       |        |  |               |           |               |  |        |          |          |  |   |        |   |  |   |            |   |  |   |         |   |  |   |        |        | 930   |   |         |          | 930      |         
|                                                                |                                                  | Effect of foreign currency translation                                          |                          |                      |  |            |         |       |  |             |             |                |  |              |       |        |  |               |           |               |  |        |          |          |  |   |        |   |  |   |            |   |  |   |         |   |  |   |        |        | 4,106 |   |         |          | 4,106    |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|                                                                |                                                  |                                                                                 | Total comprehensive loss |                      |   |           |         |       |   |            |             |                |   |             |       |        |   |              |           |               |   |       |          |          |   |  |        |   |   |  |            |   |   |  |         |   |   |  |        |        |       |  |         |          |          | (109,209 | )
|Exercise of options and warrants for shares of
    common stock |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             | 1,333,995   |                |   |              | 13    |        |   |               | 3,833     |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 3,846   |         
|Tax adjustment for options exercised                            |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | 30,266    |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 30,266  |         
|Issuance of shares under employee share purchase
    plan       |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             | 665,189     |                |   |              | 7     |        |   |               | 813       |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 820     |         
|Adjustment to Riverstone stock derivative                       |                                                  |                                                                                 |                         |                      |   |            | 20,048  |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   |        |         
|Accretion of Series D and E preferred stock
    discount        |                                                  |                                                                                 |                         |                      |   |            | 9,019   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (9,019   | )        |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | (9,019  | )       
|Accretive dividend of Series D and E
    preferred stock        |                                                  |                                                                                 |                         |                      |   |            | 3,944   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (3,944   | )        |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | (3,944  | )       
|Expiration of put options                                       |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | 842       |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 842     |         
|Amortization of unearned stock- based compensation              |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   | 2,644  |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 2,644   |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|Balance at December 28, 2002                                    |                                                  |                                                                                 | 90,000                   |                      |   | $          | 94,800  |       |   |             | 204,940,728 |                |   | $            | 2,049 |        |   | $             | 1,176,843 |               |   | $      | (875,407 | )        |   | $ | (158   | ) |   |   | (3,053,201 | ) |   | $ | (64,890 | ) |   | $ | 7,513  |        |       | $ | 245,950 |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|Comprehensive loss:                                             |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|                                                                | Net loss                                         |                                                                                 |                          |                     |   |            |         |      |   |             |             |               |   |              |       |       |   |               |           |              |   |        |          | (112,651 | ) |   |        |  |   |   |            |  |   |   |         |  |   |   |        |       |       |   |         | (112,651 | )       
|Other comprehensive income (loss):                              |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|                                                                | Unrealized loss on available-for-sale securities |                                                                                 |                          |                     |   |            |         |      |   |             |             |               |   |              |       |       |   |               |           |              |   |        |          |         |   |   |        |  |   |   |            |  |   |   |         |  |   |   |        | (1,676 | )     |   |         | (1,676   | )       
|                                                                | Effect of foreign currency translation           |                                                                                 |                          |                     |   |            |         |      |   |             |             |               |   |              |       |       |   |               |           |              |   |        |          |         |   |   |        |  |   |   |            |  |   |   |         |  |   |   |        | 5,036  |       |   |         | 5,036    |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|                                                                |                                                  | Total comprehensive loss                                                        |                          |                      |  |            |         |       |  |             |             |                |  |              |       |        |  |               |           |               |  |        |          |          |  |   |        |   |  |   |            |   |  |   |         |   |  |   |        |        |      |   |         |          | (109,291 | )       
|Exercise of options and warrants for shares of
    common stock |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             | 4,693,445   |                |   |              | 47    |        |   |               | 10,940    |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 10,987  |         
|Issuance of shares under employee share purchase
    plan       |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             | 1,170,840   |                |   |              | 12    |        |   |               | 1,437     |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 1,449   |         
|Adjustment to Riverstone stock derivative                       |                                                  |                                                                                 |                         |                      |   |            | (178    | )     |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   |        |         
|Accretion of Series D and E preferred stock
    discount        |                                                  |                                                                                 |                         |                      |   |            | 1,536   |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (1,536   | )        |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | (1,536  | )       
|Accretive dividend of Series D and E
    preferred stock        |                                                  |                                                                                 |                         |                      |   |            | 656     |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        | (656     | )        |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | (656    | )       
|Redemption of Series D and E
    preferred stock                |                                                  |                                                                                 | (90,000                  | )                    |   |            | (96,814 | )     |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   |        |         
|Treasury stock issued for litigation settlement                 |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | (34,771   | )             |   |        |         |          |   |   |       |   |   |   | 1,304,340  |   |   |   | 34,771  |   |   |   |       |        |       |   |        |         
|Litigation settlement                                           |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               | 33,000    |               |   |        |         |          |   |   |       |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 33,000  |         
|Amortization of unearned stock- based compensation              |                                                  |                                                                                 |                         |                      |   |            |        |       |   |             |            |                |   |              |      |        |   |               |          |               |   |        |         |          |   |   | 158    |   |   |   |           |   |   |   |        |   |   |   |       |        |       |   | 158     |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         
|Balance at January 3, 2004                                      |                                                  |                                                                                 |                         |                      |   | $          |        |       |   |             | 210,805,013 |                |   | $            | 2,108 |        |   | $             | 1,187,449 |               |   | $      | (990,250 | )        |   | $ |       |   |   |   | (1,748,861 | ) |   | $ | (30,119 | ) |   | $ | 10,873 |        |       | $ | 180,061 |         
|                                                                |                                                  |                                                                                 |                          |                      |   |            |         |       |   |             |             |                |   |              |       |        |   |               |           |               |   |        |          |          |   |   |        |   |   |   |            |   |   |   |         |   |   |   |        |        |       |   |         |         

See accompanying notes to consolidated financial
statements.

F-5



---



##### Table of Contents



ENTERASYS NETWORKS, INC.



CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |          |          |  
|---------------------------------------------- | --------------------------------------------------------------------------------------------- | --------------------------------------------------------------------- | ------- | ----------------- | ------- | ----------------- | ------- | -------- | ------- | - | ------- | -------- | -------- | -
|                                               |                                                                                               | Year Ended                                                            |         | Year Ended        |         | Ten Months Ended 
|                                               |                                                                                               | January 3, 2004                                                       |         | December 28, 2002 |         | December 29, 2001
|                                               |                                                                                               |                                                                       |         |                   |         |                  
|                                               |                                                                                               |                                                                      
|                                               |                                                                                               | (In thousands)                                                       
|Cash flows from operating activities:          |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               | Net loss                                                                                      |                                                                       | $       | (112,651          | )       |                   | $       | (114,245 | )       |   | $       | (704,284 | )       
|                                               | Adjustments to reconcile net loss to net cash
    provided by (used in) operating activities: |                                                                       |         |                   |         |                   |         |          |         |   |         |          |         
|                                               |                                                                                               | Loss from discontinued operations                                     |         |                   |        |                   |         |          | 11,700  |   |         |          | 101,906  |  
|                                               |                                                                                               | Depreciation and amortization                                         |         |                   | 31,257  |                   |         |          | 42,833  |   |         |          | 59,106   |  
|                                               |                                                                                               | (Recoveries) provision for losses on accounts
    receivable          |         |                   | (7,852  | )                 |         |          | 1,630   |   |         |          | 12,523   |  
|                                               |                                                                                               | Provision for inventory write-downs                                   |         |                   | 12,246  |                   |         |          | 17,885  |   |         |          | 72,888   |  
|                                               |                                                                                               | (Recovery) write-down of note receivable                              |         |                   | (2,450  | )                 |         |          | (2,500  | ) |         |          | 6,125    |  
|                                               |                                                                                               | Deferred income taxes                                                 |         |                   |        |                   |         |          |        |   |         |          | 82,275   |  
|                                               |                                                                                               | Impairment of intangible assets                                       |         |                   |        |                   |         |          |        |   |         |          | 104,147  |  
|                                               |                                                                                               | Loss on disposals and impairment of property,
    plant and equipment |         |                   |        |                   |         |          |        |   |         |          | 4,671    |  
|                                               |                                                                                               | Stock-based compensation                                              |         |                   | 158     |                   |         |          | 2,644   |   |         |          | 30,572   |  
|                                               |                                                                                               | Net realized gain on sale of securities                               |         |                   | (838    | )                 |         |          | (1,121  | ) |         |          | (1,712   | )
|                                               |                                                                                               | Loss on investment write-downs                                        |         |                   | 27,775  |                   |         |          | 22,119  |   |         |          | 65,901   |  
|                                               |                                                                                               | Unrealized (gain) loss on Riverstone stock
    derivative             |         |                   | (178    | )                 |         |          | 20,048  |   |         |          | (4,020   | )
|                                               |                                                                                               | Unrealized loss on foreign currency                                   |         |                   | 5,644   |                   |         |          | 2,937   |   |         |          | 691      |  
|                                               |                                                                                               | Common stock commitment relating to shareholder
    litigation        |         |                   | 33,000  |                   |         |          |        |   |         |          |         |  
|                                               |                                                                                               | Other, net                                                            |         |                   |        |                   |         |          |        |   |         |          | (60,107  | )
|                                               | Changes in operating assets and liabilities:                                                  |                                                                       |         |                   |         |                   |         |          |         |   |         |          |         
|                                               |                                                                                               | Accounts receivable                                                   |         |                   | 14,117  |                   |         |          | 24,385  |   |         |          | 57,494   |  
|                                               |                                                                                               | Inventories                                                           |         |                   | 5,145   |                   |         |          | 55,777  |   |         |          | (106,067 | )
|                                               |                                                                                               | Prepaid expenses and other assets                                     |         |                   | 3,208   |                   |         |          | 4,676   |   |         |          | 35,565   |  
|                                               |                                                                                               | Accounts payable and accrued expenses                                 |         |                   | (23,130 | )                 |         |          | (34,422 | ) |         |          | 3,128    |  
|                                               |                                                                                               | Customer advances and billings in excess of
    revenues              |         |                   | (75     | )                 |         |          | (48,717 | ) |         |          | 56,115   |  
|                                               |                                                                                               | Deferred revenue                                                      |         |                   | (10,343 | )                 |         |          | (21,394 | ) |         |          | (11,066  | )
|                                               |                                                                                               | Income taxes payable                                                  |         |                   | 30,400  |                   |         |          | 7,458   |   |         |          | (13,424  | )
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               |                                                                                               | Net cash provided by (used in) operating
    activities               |         |                   | 5,433   |                   |         |          | (8,307  | ) |         |          | (207,573 | )
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|Cash flows from investing activities:          |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               | Capital expenditures and purchases of intangible
    assets                                   |                                                                       |         | (18,589           | )       |                   |         | (24,608  | )       |   |         | (21,115  | )       
|                                               | Cash paid for investments                                                                     |                                                                       |         | (1,750            | )       |                   |         | (1,677   | )       |   |         | (20,538  | )       
|                                               | Proceeds from sales of investments                                                            |                                                                       |         | 1,923             |         |                   |         | 4,107    |         |   |         | 427      |         
|                                               | Proceeds from sale of fixed assets                                                            |                                                                       |         | 1,250             |         |                   |         |         |         |   |         | 2,000    |         
|                                               | Purchase of marketable securities                                                             |                                                                       |         | (67,628           | )       |                   |         | (142,151 | )       |   |         | (259,193 | )       
|                                               | Sales and maturities of marketable securities                                                 |                                                                       |         | 159,281           |         |                   |         | 143,685  |         |   |         | 689,336  |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               | Net cash provided by (used in) investing
    activities                                       |                                                                       |         | 74,487            |         |                   |         | (20,644  | )       |   |         | 390,917  |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|Cash flows from financing activities:          |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               | Proceeds from common stock issued pursuant to
    employee stock purchase plans               |                                                                       |         | 1,449             |         |                   |         | 820      |         |   |         | 7,568    |         
|                                               | Proceeds from sale of common stock put options                                                |                                                                       |         |                  |         |                   |         |         |         |   |         | 135      |         
|                                               | Cash flows related to discontinued operations                                                 |                                                                       |         |                  |         |                   |         | 29,509   |         |   |         | (169,665 | )       
|                                               | Proceeds from notes receivable                                                                |                                                                       |         | 4,950             |         |                   |         | 15,000   |         |   |         | 1,875    |         
|                                               | Issuance of notes receivable                                                                  |                                                                       |         |                  |         |                   |         |         |         |   |         | (13,000  | )       
|                                               | Repurchase of common stock                                                                    |                                                                       |         |                  |         |                   |         |         |         |   |         | (8,411   | )       
|                                               | Net payments for redemption of Series D and
    E preferred stock                             |                                                                       |         | (96,814           | )       |                   |         |         |         |   |         |         |         
|                                               | Proceeds from exercise of stock options                                                       |                                                                       |         | 10,987            |         |                   |         | 3,846    |         |   |         | 48,401   |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|                                               | Net cash (used in) provided by financing
    activities                                       |                                                                       |         | (79,428           | )       |                   |         | 49,175   |         |   |         | (133,097 | )       
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|Effect of exchange rate changes on cash        |                                                                                               |                                                                       | 116     |                   |         |                   | 1,169   |          |         |   | 175     |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|Net increase in cash and cash equivalents      |                                                                                               |                                                                       | 608     |                   |         |                   | 21,393  |          |         |   | 50,422  |         
|Cash and cash equivalents at beginning of year |                                                                                               |                                                                       | 136,193 |                   |         |                   | 114,800 |          |         |   | 64,378  |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         
|Cash and cash equivalents at end of year       |                                                                                               | $                                                                     | 136,801 |                   |         | $                 | 136,193 |          |         | $ | 114,800 |         
|                                               |                                                                                               |                                                                       |         |                   |         |                   |         |          |         |   |         |         

Supplemental disclosures of cash flow information
(see Note 17).

See accompanying notes to consolidated financial
statements.

F-6



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##### Table of Contents



ENTERASYS NETWORKS, INC.



NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS




|   |                    
|-- | -------------------
|1. | Business Operations

Enterasys Networks, Inc. and its
subsidiaries (the Company) design, develop, market,
and support comprehensive networking solutions architected to
address the networking requirements facing global enterprises.
The Company believes its solutions offer customers the secure,
high-capacity, cost-effective, network connectivity required to
facilitate the exchange of information among employees,
customers, suppliers, business partners and other network users.
The Company is focused on delivering networking solutions that
include security features within the network architecture. The
Company believes its solutions enable customers to meet their
network requirements for continuity, context, control,
compliance and consolidation through an architecture and
management interface designed for ease of use. The
Companys installed base of customers consists of
commercial enterprises; governmental entities; healthcare,
financial, educational and non-profit institutions; and various
other organizations.

The Company does not have internal manufacturing
capabilities. It outsources substantially all of its
manufacturing to two companies, Flextronics International
USA, Inc. (Flextronics) and Accton Technology
Corporation (Accton), which procure material on the
Companys behalf and provide comprehensive manufacturing
services, including assembly, test and quality control.
Flextronics, which accounted for approximately 63% of the
Companys outsourced manufacturing during fiscal year 2003,
manufactures the Companys products primarily in
Cork, Ireland as well as Portsmouth, New Hampshire. Accton,
which accounted for 21% of the Companys outsourced
manufacturing during fiscal year 2003, manufactures the
Companys products in Taiwan.



|   |                                               
|-- | ----------------------------------------------
|2. | Summary of Significant Accounting
    Policies



| |                            
| | ---------------------------
| | Principles of Consolidation

The consolidated financial statements include the
accounts of Enterasys Networks, Inc. and its subsidiaries. All
significant intercompany balances and transactions have been
eliminated in consolidation.



| |                       
| | ----------------------
| | Fiscal Year-End Change

On September 28, 2001, the Companys
Board of Directors amended the by-laws to change the
Companys fiscal year-end from the Saturday closest to the
last day in February of each year to the Saturday closest to the
last day in December of each year. References to fiscal year
2003 represent the twelve-month period ended January 3,
2004. The twelve-month period ended December 28, 2002, is
noted as such or as fiscal year 2002 and the
ten-month transition period ended December 29, 2001 is
noted as such or as transition year 2001.



| |                  
| | -----------------
| | Reclassifications

Certain prior period balances have been
reclassified to conform to the current period presentation.



| |                 
| | ----------------
| | Use of Estimates

The preparation of consolidated financial
statements in conformity with accounting principles generally
accepted in the United States of America requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
period. These estimates include assessing the fair value of
acquired assets, the amount and timing of revenue recognition,
the collectibility of accounts and notes receivable, the
valuation of investments, the use and recoverability of
inventory and tangible and intangible assets, the amounts of
incentive compensation liabilities, accrued restructuring
charges, and litigation liabilities and contingencies, among
others. The Company bases its estimates on historical
experience, current conditions and various other

F-7



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

assumptions that are believed to be reasonable
under the circumstances. The markets for the Companys
products are characterized by rapid technological development,
intense competition and frequent new product introductions, any
of which could affect the future realizability of the
Companys assets. Estimates and assumptions are reviewed on
an ongoing basis and the effects of revisions are reflected in
the consolidated financial statements in the period they are
determined to be necessary. Actual results could differ from
those estimates under different assumptions or conditions.



| |                    
| | -------------------
| | Revenue Recognition

The Companys revenue is comprised of
product revenue, which includes revenue from sales of its
switches, routers, and other network equipment and software, and
services revenue, which includes maintenance, installation,
system integration services and the Companys Smart Source
managed network offering. The Companys revenue recognition
policy follows SEC Staff Accounting Bulletin (SAB)
No. 101, Revenue Recognition in Financial
Statements, SAB No. 104 Revenue
Recognition,Statement of Position (SOP)
No. 97-2, Software Revenue Recognition,
as amended by SOP No. 98-9, Modification of SOP
No. 97-2, Software Recognition, With Respect to Certain
Transactions, and Financial Accounting Standards Board
(FASB) Emerging Issues Task Force (EITF)
No. 00-21 Revenue Arrangements with Multiple
Deliverables.The Company generally recognizes product
revenue from its end-user and reseller customers at the time of
shipment, provided that persuasive evidence of an arrangement
exists, the price is fixed or determinable and collectibility of
sales proceeds is reasonably assured. When significant
obligations remain after products are delivered, such as for
system integration or customer acceptance, revenue and related
costs are deferred until such obligations are fulfilled.
Software and equipment revenue is deferred in instances when
vendor specific objective evidence, or VSOE, of fair value of
undelivered elements is not determinable. Revenue from service
obligations under maintenance contracts is deferred and
recognized on a straight-line basis over the contractual period,
which is typically twelve months.

The Company recognizes revenue from stocking
distributors when the distributors ship the Companys
products to their customers. The Company records revenue from
certain distributors and resellers located in Asia Pacific and
Latin America upon cash receipt. During the third quarter of
fiscal year 2003, the Company converted one of its larger
distributors in Asia Pacific from revenue recognition upon cash
receipt to revenue recognition when the distributor ships the
Companys products to their customers. This change is a
result of improved distributor practices including consistent
timely payment, adherence to standard contract terms, and
independent relationships with end-users. This conversion did
not have a material impact on the Companys consolidated
results of operations.

The Company provides for pricing allowances in
the period when granted. The Company also provides an allowance
for sales returns based on specific return rights granted to a
customer.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

Cash and cash equivalents consist of all highly
liquid investments with an original or remaining maturity of
90 days or less. Cash and cash equivalents are carried at
cost, which approximates fair value.



| |                      
| | ---------------------
| | Marketable Securities

Available-for-sale securities are recorded at
fair value. Unrealized gains and losses, net of the related tax
effect, on available-for-sale securities are reported in
accumulated other comprehensive income (loss) until realized.
The estimated market values of investments are based on quoted
market prices as of the end of the reporting period.

F-8



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Investments described below under the heading
Investments are not included in marketable
securities.



| |                                    
| | -----------------------------------
| | Allowance for Doubtful
    Accounts

The Company estimates the collectibility of its
accounts receivable and the related amount of bad debts that may
be incurred in the future. The allowance for doubtful accounts
results from an analysis of specific customer accounts,
historical experience, customer concentrations, credit ratings
and current economic trends.



| |                                                           
| | ----------------------------------------------------------
| | Financial Instruments and Concentration of
    Credit Risk

Financial instruments that potentially subject
the Company to a concentration of credit risk principally
consist of cash equivalents, marketable securities, long-term
investments, notes and accounts receivable. The Company seeks to
reduce credit risk on financial instruments by investing in high
credit quality issuers and, by policy, limiting the amount of
credit exposure to any one issuer or fund. Exposure to customer
credit risk is controlled through credit approvals, credit
limits, continuous monitoring procedures and establishment of an
allowance for doubtful accounts when deemed necessary.

The carrying amounts of cash, cash equivalents,
trade receivables, accounts payable and accrued expenses
approximate the fair value because of the short maturity of
these financial instruments.

Several major international financial
institutions are counterparties to the Companys financial
instruments. It is Company practice to monitor the financial
standing of these counterparties and limit the amount of
exposure with any one institution. The Company may be exposed to
credit loss in the event of nonperformance by the counterparties
to these contracts, but believes any such loss is unlikely and
would not be material to its financial position and results of
operations.

At January 3, 2004, one customer accounted
for approximately 15% of the Companys net accounts
receivable balance. At December 28, 2002, no customers
accounted for more than 10% of the Companys net accounts
receivable balance.

During fiscal year 2003, one distributor
accounted for approximately 23% of net revenue; for fiscal year
2002, two distributors accounted for approximately 17% and 12%,
respectively, of net revenue; and for transition year 2001, two
distributors accounted for approximately 14% and 10%,
respectively, of net revenue. No single direct sales customer
accounted for more than 10% of the Companys net revenue in
any of the periods presented. Effective March 31, 2003, two
of the Companys distributors merged. Combined revenue from
these merged distributors accounted for 27%, 26% and 24% of net
revenue for the fiscal year 2003, fiscal year 2002 and
transition year 2001, respectively.

During fiscal year 2003, fiscal year 2002, and
transition year 2001, the U.S. federal government and its
various agencies accounted for approximately 8%, 11% and 13% of
total net revenue, respectively. The Companys sales to the
U.S. federal government are distributed across a wide
variety of government agencies; therefore, the Company does not
believe its revenue would be materially impacted by fluctuations
in federal government spending by any one agency.



| |            
| | -----------
| | Inventories

Inventories are reported at the lower of cost or
market. Costs are determined at standard, which approximates
actual cost on a first-in, first-out (FIFO) method.
The Company records a provision for excess and obsolete raw
materials and finished goods inventory using a reserve
methodology based primarily on forecasts of future demand.
Finished goods inventory includes customer evaluation units as
well as products shipped to stocking distributors where revenue
is not recognized until the products are

F-9



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

shipped to their customers. Service spares
represent inventory used by the Company as replacement parts for
customers covered by service contracts. The Company records a
provision for excess service spares inventory based on estimated
usage. Service spares are periodically adjusted to net
realizable value.



| |                              
| | -----------------------------
| | Property, Plant and Equipment

Property, plant and equipment are reported at
cost. Depreciation is provided on a straight-line method over
the estimated useful lives of the assets. Leasehold improvements
are amortized over the shorter of the lives of the related
assets or the term of the lease. Repairs and maintenance costs
are expensed as incurred.



| |         
| | --------
| | Goodwill

Goodwill is the excess of the purchase price over
the fair value of identifiable net assets acquired in business
combinations accounted for as purchases. Existing and future
acquired goodwill is subject to an impairment test on an annual
basis using a fair-value-based approach or when an event or
circumstances indicate that it is more likely than not that an
impairment loss has occurred. The Company has designated the end
of the third quarter of the fiscal year as the date of the
annual impairment test for goodwill.

There were no impairments of recorded goodwill
for the years ended January 3, 2004 and December 28,
2002. The Company recorded a charge of $104.1 million in
the fourth quarter of transition year 2001 relating to the
impairment of goodwill recorded in connection with the
acquisition of Indus River Networks. This impairment was
primarily due to the complex, proprietary nature of the Indus
River VPN technology, which had to be substantially redesigned
in order to conform with emerging industry standards; the
introduction of new, low cost VPN products and technologies by a
leading provider of network security products who captured a
market leadership position in 2001; and abandonment of the
Companys development efforts in conjunction with a
significant reduction in the acquired workforce in the fourth
quarter of transition year 2001. These factors led to
significantly lower projections for future sales of products
using the Indus River VPN technology.



| |                                                          
| | ---------------------------------------------------------
| | Impairment of Intangible Assets and
    Long-Lived Assets

Long-lived assets are comprised of property,
plant and equipment and intangible assets with finite lives.
Intangible assets consist of customer relations, patents, and
technology acquired in business combinations and are reported at
cost less accumulated amortization. The Company assesses the
impairment of long-lived assets whenever events or changes in
circumstances indicate that the carrying value may not be
recoverable through projected undiscounted cash flows expected
to be generated by the asset. When the Company determines that
the carrying value of intangible assets and fixed assets may not
be recoverable, the Company measures impairment by the amount by
which the carrying value of the long-lived asset exceeds the
related fair value. Estimated fair value is generally based on a
projected discounted cash flow method using a discount rate
determined by management to be commensurate with the risk
inherent in the business underlying the asset in question.

Long-lived assets to be disposed of by sale are
to be measured at the lower of carrying amount or fair value
less cost to sell.



| |                                                          
| | ---------------------------------------------------------
| | Cumulative Effect of a Change in Accounting
    Principle

The Company accounts for derivatives in
accordance with SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities,as
amended by FASB Statement of Financial Accounting Standards
(SFAS) No. 149, Amendment of Statement
133 on Derivative Instruments and Hedging Activitiesand recognizes derivatives on the balance sheet at fair
value. The accounting for changes in the fair value

F-10



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

of a derivative depends on the intended use of
the derivative and the resulting designation. The Company had no
foreign exchange or option contracts outstanding at
January 3, 2004 and December 28, 2002.

Upon adoption of SFAS No. 133 in the
first quarter of transition year 2001, the Company recorded a
transition adjustment, which resulted in an after-tax increase
in net income of $12.7 million related to the
Companys written call options on Efficient
Networks, Inc. (Efficient) common stock held as
of March 4, 2001. The call options expired, in accordance
with their terms during the quarter ended June 2, 2001, as
part of the acquisition of Efficient by Siemens A.G. This
transition adjustment is reflected in the Companys results
of operations for transition year 2001 as the cumulative effect
of a change in accounting principle.



| |                     
| | --------------------
| | Comprehensive Income

The Company presents comprehensive income (loss)
in its consolidated statement of redeemable convertible
preferred stock and stockholders equity. Accumulated other
comprehensive income, net of tax, as of January 3, 2004
consisted of unrealized gains on available-for-sale securities
of $0.9 million and foreign currency translation
adjustments of $10.0 million. Accumulated other
comprehensive income, net of tax, as of December 28, 2002
consisted of unrealized gains on available-for-sale securities
of $2.5 million and foreign currency translation
adjustments of $5.0 million.



| |            
| | -----------
| | Investments

Investments in which the Companys interest
is less than 20% and which are not classified as
available-for-sale securities are carried at the lower of cost
or net realizable value unless it is determined that the Company
exercises significant influence over the investee company, in
which case the equity method of accounting is used. For those
investments in affiliates in which the Companys voting
interest is between 20% and 50%, the equity method of accounting
is generally used. Under this method, the investment balance,
originally recorded at cost, is adjusted to recognize the
Companys share of net earnings or losses of the affiliates
as they occur, limited to the extent of the Companys
investment in, advances to and commitments for the investee. The
Company had no investments accounted for under the equity method
during fiscal year 2003, or fiscal year 2002. Prior to fiscal
year 2002, the Company accounted for certain investments in
technology focused venture capital funds under the equity method
of accounting.

The Company maintains certain minority
investments in debt and equity securities of companies that were
acquired for cash and in non-monetary transactions whereby the
Company exchanged inventory or product credits for preferred or
common stock or convertible notes. The Company records cash
investments at cost and non-monetary transactions generally at
the fair value of the instrument received using the most
objectively determinable basis from among a variety of methods
and data sources. Methods and data sources used to value
non-monetary transactions include quoted market prices for
publicly traded securities, cash financing rounds with outside
investors completed near the date of the Companys
investment, and third party valuations or appraisals. These
investments are accounted for under the cost method and are
included in investments on the Companys balance sheet. The
carrying value of investments approximates fair value.

The Company reviews investments for potential
impairment whenever events or changes in circumstances indicate
that the carrying value may not be recoverable. Many factors are
considered in assessing potential impairments. Such events or
factors include declines in the investees stock price in
new rounds of financing, market capitalization relative to book
value, deteriorating financial condition or results of
operations and bankruptcy or insolvency. From time to time the
Company may engage third party experts to estimate the
recoverable value of investments management may consider
selling. Appropriate

F-11



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

reductions in carrying value are recognized in
other expense, net in the consolidated statements of operations.



| |                                                      
| | -----------------------------------------------------
| | Research and Development Costs and Software
    Costs

Expenditures related to the development of new
products, including significant improvements and refinements to
existing products and the development of software, are expensed
as incurred, unless they are required to be capitalized.
Software development costs are required to be capitalized
beginning when the technological feasibility of a product has
been established and ending when a product is available for
general release to customers. The Companys current process
for developing software is essentially completed concurrent with
the establishment of technological feasibility; accordingly, no
costs have been capitalized to date.



| |                                   
| | ----------------------------------
| | Stock-Based Compensation
    Plans

At January 3, 2004, the Company had four
stock-based employee compensation plans, which are described
more fully in Note 19. The Company accounts for those plans
using the intrinsic method under the recognition and measurement
principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees,and related
interpretations. The following table illustrates the effect on
net loss and net loss per share if the Company had applied the
fair value recognition provisions of SFAS No. 123,
Accounting for Stock-Based Compensation,as
amended by SFAS No. 148, Accounting for
Stock-Based Compensation  Disclosure,to
stock-based employee compensation:

|                                                                                                                                                                                                                  |             |                                          |          |                   |   |                   |          |       |   |   |          |       |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------- | ---------------------------------------- | -------- | ----------------- | - | ----------------- | -------- | ----- | - | - | -------- | ----- | -
|                                                                                                                                                                                                                  |             | Year Ended                               |          | Year Ended        |   | Ten Months Ended 
|                                                                                                                                                                                                                  |             | January 3, 2004                          |          | December 28, 2002 |   | December 29, 2001
|                                                                                                                                                                                                                  |             |                                          |          |                   |   |                  
|                                                                                                                                                                                                                  |             |                                         
|                                                                                                                                                                                                                  |             | (In thousands, except per share amounts)
|Net loss available to common shareholders, as
    reported                                                                                                                                                        |             | $                                        | (114,843 | )                 |   | $                 | (127,208 | )     |   | $ | (714,631 | )    
|Add: Total stock-based employee compensation
    expense determined under fair-value-based method for the
    employee stock option awards and the employee stock purchase
    plans, net of related tax benefits |             |                                          | (21,573  | )                 |   |                   | (25,704  | )     |   |   | (32,137  | )    
|                                                                                                                                                                                                                  |             |                                          |          |                   |   |                   |          |       |   |   |          |      
|Pro forma net loss available to common
    shareholders                                                                                                                                                           |             | $                                        | (136,416 | )                 |   | $                 | (152,912 | )     |   | $ | (746,768 | )    
|                                                                                                                                                                                                                  |             |                                          |          |                   |   |                   |          |       |   |   |          |      
|Basic and diluted loss per share:                                                                                                                                                                                 |             |                                          |          |                   |   |                   |          |       |   |   |          |      
|                                                                                                                                                                                                                  | As reported |                                          | $        | (0.56             | ) |                   | $        | (0.63 | ) |   | $        | (3.71 | )
|                                                                                                                                                                                                                  | Pro forma   |                                          | $        | (0.67             | ) |                   | $        | (0.76 | ) |   | $        | (3.87 | )

F-12



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

The fair value of each Company option grant was
estimated on the date of grant using the Black-Scholes option
pricing model, with the following weighted-average assumptions
used for grants in fiscal year 2003, fiscal year 2002 and
transition year 2001:

|                                     |  |                 |                   |                   |  |                   |           |  |  |  |           | 
|------------------------------------ |  | --------------- | ----------------- | ----------------- |  | ----------------- | --------- |  |  |  | --------- | 
|                                     |  | January 3, 2004 |                   | December 28, 2002 |  | December 29, 2001
|                                     |  |                 |                   |                   |  |                  
|Employee stock options:              |  |                 |                   |                   |  |                   |           |  |  |  |           | 
|Risk-free interest rate              |  |                 | 2.52 - 3.25%      |                   |  |                   | 2.79%     |  |  |  | 3.86%     | 
|Expected option life                 |  |                 | 5.37 - 6.14 years |                   |  |                   | 5.4 years |  |  |  | 2.7 years | 
|Expected volatility                  |  |                 | 110.16 - 113.02%  |                   |  |                   | 113.28%   |  |  |  | 92.11%    | 
|Expected dividend yield              |  |                 | 0.0%              |                   |  |                   | 0.0%      |  |  |  | 0.0%      | 
|Employee stock purchase plan shares: |  |                 |                   |                   |  |                   |           |  |  |  |           | 
|Risk-free interest rate              |  |                 | 0.95 - 1.02%      |                   |  |                   | 1.23%     |  |  |  | 1.83%     | 
|Expected option life                 |  |                 | 6 months          |                   |  |                   | 11 months |  |  |  | 6 months  | 
|Expected volatility                  |  |                 | 70.64 - 112.23%   |                   |  |                   | 98.11%    |  |  |  | 92.11%    | 
|Expected dividend yield              |  |                 | 0.0%              |                   |  |                   | 0.0%      |  |  |  | 0.0%      | 

The weighted average estimated fair values of
stock options granted during fiscal year 2003, fiscal year 2002,
and transition year 2001 were $3.09, $0.97, and $8.68 per
share, respectively. The weighted average estimated fair values
of employee stock purchase plan shares during fiscal year 2003,
fiscal year 2002, and transition year 2001 were $0.88, $1.05,
and $7.32, per share, respectively.

The Black-Scholes option valuation model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price
volatility. Because the Company options held by employees and
directors have characteristics significantly different from
those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate,
in the opinion of management the existing models do not
necessarily provide a reliable single measure of the fair value
of these options.

Equity instruments issued to non-employees are
accounted for in accordance with the provisions of
SFAS No. 123 and EITF No. 96-18,
Accounting for Equity Instruments That Are Issued to
Other Than Employees for Acquiring or in Conjunction with
Selling Goods or Services.

Income
Taxes

The Company accounts for income taxes under the
asset and liability method. Under this method, deferred tax
assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities
and their respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income
during the period that includes the enactment date. The Company
recognizes a valuation allowance if it anticipates that it may
not realize some or all of a deferred tax asset.

Net Loss Per
Share

The Company computes basic earnings per common
share by dividing net loss available to common shareholders by
the weighted average number of common shares outstanding for the
period. The dilutive effect of common stock equivalents is
included in the calculation of diluted earnings per share only
when the effect of their inclusion would be dilutive.

F-13



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Foreign
Currency Translation and Transaction Gains and
Losses

The Companys international revenues are
denominated in either U.S. dollars or local currencies. For
those international subsidiaries that use their local currency
as their functional currency, assets and liabilities are
translated at period-end exchange rates in effect at the balance
sheet date, and income and expense items are translated at the
average exchange rate for the period. Resulting translation
adjustments are reported in accumulated other comprehensive
income, a component of stockholders equity.

Where the U.S. dollar is the functional
currency, non-monetary assets are translated at historical
exchange rates, and all other assets and liabilities are
translated at exchange rates in effect at the end of the period.
Depreciation is translated at historical exchange rates, and all
other income and expense items are translated at the average
exchange rate for the period. Gains and losses that result from
translation are included in other expense, net, in the
consolidated statement of operations.

Restructuring
Reserves

The Company has periodically recorded
restructuring charges in connection with its plans to reduce the
cost structure of its business. These restructuring charges,
which reflect managements commitment to a termination or
exit plan that will be completed within twelve months, require
managements judgment and may include severance benefits
and costs for future lease commitments on excess facilities, net
of estimated future sublease income. In determining the amount
of the facility exit costs, the Company is required to estimate
such factors as future vacancy rates, the time required to
sublet properties and sublease rates. These estimates are
reviewed and potentially revised on a quarterly basis based on
known real estate market conditions and the credit worthiness of
subtenants, resulting in revisions to established facility
reserves. If the actual cost incurred exceeds the estimated
cost, an additional charge to earnings will result. If the
actual cost is less than the estimated cost, a reduction to
restructuring charges will be recognized.

New
Accounting Pronouncements

In July 2002, the FASB issued
SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities,which requires
companies to recognize costs associated with exit or disposal
activities when a liability is incurred rather than at the date
of a commitment to an exit or disposal plan. This statement is
effective for exit or disposal activities initiated after
December 31, 2002. The Company recorded restructuring
charges of $17.5 million in fiscal year 2003 in accordance
with the new requirements.

In November 2002, the FASB issued EITF
No. 00-21, Revenue Arrangements with Multiple
Deliverables,which provides guidance on how to
account for revenue arrangements that involve the delivery or
performance of multiple products, services and/or rights to use
assets. The provisions of this pronouncement were effective for
revenue arrangements entered into beginning in the
Companys third quarter of fiscal year 2003. The adoption
of EITF No. 00-21 did not have a material effect on the
Companys consolidated financial statements.

In January 2003, FASB interpretation No. 46,
Consolidation of Variable Interest Entities,or VIEs, was issued and in December 2003, a revision
of FIN No. 46 was issued. FIN No. 46 requires
identification of the Companys participation in
VIEs, which are defined as entities with a level of
invested equity that is not sufficient to fund future activities
to permit them to operate on a stand-alone basis, or whose
equity holders lack certain characteristics of a controlling
financial interest. For entities identified as VIEs, FIN
No. 46 sets forth a model to evaluate potential
consolidation based on an assessment of which party to a VIE, if
any, bears a majority of the risk of the VIEs expected
losses, or stands to gain from a majority of the VIEs
expected returns. FIN No. 46 also sets forth certain
disclosures regarding

F-14



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

interests in VIEs that are deemed
significant, even if consolidation is not required. This
interpretation is effective for all VIEs created after
January 31, 2003. The Company is not the primary
beneficiary of any minority investment that would be considered
a variable interest entity and, as such, the adoption of FIN
No. 46 did not have an effect on the consolidated financial
statements.

In April 2003, the FASB issued
SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities,which amends and clarifies financial accounting and
reporting for derivative instruments, including certain
derivative instruments embedded in other contracts and for
hedging activities under SFAS No. 133
Accounting for Derivative Instruments and Hedging
Activities.This statement was effective for contracts
entered into or modified after June 30, 2003 and for
hedging relationships designated after June 30, 2003 and is
to be applied prospectively. The Company has no derivatives
imbedded in other contracts and no hedging relationships at this
time and, as such, the adoption of SFAS No. 149 did
not have an effect on the consolidated financial statements.

In May 2003, the FASB issued
SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities
and Equity,which establishes standards for how an
issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity.
SFAS No. 150 requires that an issuer classify a
financial instrument that is within its scope as a liability (or
an asset in some circumstances). This statement is effective for
financial instruments entered into or modified after
May 31, 2003 and otherwise is effective at the beginning of
the first interim period beginning after June 15, 2003. The
adoption of SFAS No. 150 did not have a material
impact on the Companys consolidated financial statements.

In May 2003, the consensus on EITF Issue
No. 01-08, Determining Whether an Arrangement
Contains a Lease,was issued. The guidance in the
consensus applies to the purchase or sale of goods and services
under various types of contracts, including outsourcing
arrangements. Based on the criteria in the consensus, both
parties to an arrangement are required to determine whether the
arrangement includes a lease within the scope of
SFAS No. 13, Accounting for Leases.The new requirement applies prospectively to new or modified
arrangements for reporting periods beginning after May 28,
2003. The Company did not enter into or modify any arrangements
covered by EITF 01-08 during fiscal year 2003 and, as such,
the adoption of EITF No. 01-08 did not have an effect on
the Companys consolidated financial statements.

In May 2003, the FASB issued EITF No. 03-5,
Applicability of AICPA Statement of Position 97-2,
Software Revenue Recognition, to Non-Software Deliverables in an
Arrangement Containing More-Than-Incidental Software,which provides guidance on how to account for non-software
deliverables included in an arrangement that contains software
that is more than incidental to the products or services as a
whole. The provisions of this pronouncement are effective for
revenue arrangements entered into beginning in the
Companys third quarter of fiscal year 2003. The adoption
of EITF No. 03-5 did not have a material effect on the
Companys consolidated financial statements.

In December 2003, the Securities and Exchange
Commission issued Staff Accounting Bulletin No. 104
(SAB No. 104), Revenue
Recognitionwhich revises or rescinds portions of the
interpretative guidance included in Topic 13 of the
codification of staff accounting bulletins in order to provide
consistent guidance with respect to selected revenue recognition
issues. The adoption of SAB No. 104 did not have a material
effect on the Companys consolidated financial statements.

F-15



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



|   |                      
|-- | ---------------------
|3. | Marketable Securities

Marketable securities are summarized as follows
at January 3, 2004 and December 28, 2002:

|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |         | 
|----------------------------------------------------------------------------------- | --------------------------- | -------------- | ------- | ---------- |  | ---------- | ----- | ----- |  | - | ---- | ---- | - | - | ------- | ------- | 
|                                                                                    |                             |                |         | Gross      |  | Gross      |       |      
|                                                                                    |                             | Amortized      |         | Unrealized |  | Unrealized |       | Fair 
|                                                                                    |                             | Cost           |         | Gains      |  | Losses     |       | Value
|                                                                                    |                             |                |         |            |  |            |       |      
|                                                                                    |                             |               
|                                                                                    |                             | (In thousands)
|January 3, 2004                                                                     |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|U.S. government and agency obligations                                              |                             | $              | 81,561  |            |  | $          | 444   |       |  | $ | (14  | )    |   | $ | 81,991  |        
|U.S. corporate obligations                                                          |                             |                | 20,597  |            |  |            | 153   |       |  |   | (4   | )    |   |   | 20,746  |        
|Asset-backed securities                                                             |                             |                | 1,009   |            |  |            | 10    |       |  |   |     |      |   |   | 1,019   |        
|State, municipal and county government notes and
    bonds                          |                             |                | 9,826   |            |  |            | 143   |       |  |   |     |      |   |   | 9,969   |        
|Repurchase agreements                                                               |                             |                | 12,425  |            |  |            |      |       |  |   |     |      |   |   | 12,425  |        
|Corporate equity securities                                                         |                             |                | 318     |            |  |            | 132   |       |  |   |     |      |   |   | 450     |        
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|                                                                                    | Total marketable securities |                | $       | 125,736    |  |            | $     | 882   |  |   | $    | (18  | ) |   | $       | 126,600 | 
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|Amounts included in cash and cash equivalents                                       |                             | $              | 49,423  |            |  | $          |      |       |  | $ |     |      |   | $ | 49,423  |        
|Amounts included in short-term marketable
    securities                            |                             |                | 29,471  |            |  |            | 380   |       |  |   |     |      |   |   | 29,851  |        
|Amounts included in long-term marketable
    securities                             |                             |                | 35,373  |            |  |            | 447   |       |  |   | (17  | )    |   |   | 35,803  |        
|Amounts included in restricted cash, cash
    equivalents and marketable securities |                             |                | 11,469  |            |  |            | 55    |       |  |   | (1   | )    |   |   | 11,523  |        
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|                                                                                    | Total marketable securities |                | $       | 125,736    |  |            | $     | 882   |  |   | $    | (18  | ) |   | $       | 126,600 | 
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|December 28, 2002                                                                   |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|U.S. government and agency obligations                                              |                             | $              | 131,192 |            |  | $          | 1,945 |       |  | $ | (3   | )    |   | $ | 133,134 |        
|U.S. corporate obligations                                                          |                             |                | 25,029  |            |  |            | 465   |       |  |   |     |      |   |   | 25,494  |        
|Asset-backed securities                                                             |                             |                | 14,047  |            |  |            | 57    |       |  |   |     |      |   |   | 14,104  |        
|State, municipal and county government notes and
    bonds                          |                             |                | 18,914  |            |  |            | 441   |       |  |   |     |      |   |   | 19,355  |        
|Corporate equity securities                                                         |                             |                | 403     |            |  |            |      |       |  |   | (365 | )    |   |   | 38      |        
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|                                                                                    | Total marketable securities |                | $       | 189,585    |  |            | $     | 2,908 |  |   | $    | (368 | ) |   | $       | 192,125 | 
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|Amounts included in cash and cash equivalents                                       |                             | $              | 22,810  |            |  | $          | 47    |       |  | $ |     |      |   | $ | 22,857  |        
|Amounts included in short-term marketable
    securities                            |                             |                | 81,740  |            |  |            | 1,113 |       |  |   |     |      |   |   | 82,853  |        
|Amounts included in long-term marketable
    securities                             |                             |                | 68,574  |            |  |            | 1,560 |       |  |   | (368 | )    |   |   | 69,766  |        
|Amounts included in restricted cash, cash
    equivalents and marketable securities |                             |                | 16,461  |            |  |            | 188   |       |  |   |     |      |   |   | 16,649  |        
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        
|                                                                                    | Total marketable securities |                | $       | 189,585    |  |            | $     | 2,908 |  |   | $    | (368 | ) |   | $       | 192,125 | 
|                                                                                    |                             |                |         |            |  |            |       |       |  |   |      |      |   |   |         |        

F-16



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

The contractual maturities of debt securities at
January 3, 2004 were as follows. Actual maturities may
differ from contractual maturities because some borrowers have
the right to call or prepay obligations.

|                   |       |                |        |         |  |   |        |         | 
|------------------ | ----- | -------------- | ------ | ------- |  | - | ------ | ------- | 
|                   |       | Amortized      |        | Fair   
|                   |       | Cost           |        | Value  
|                   |       |                |        |        
|                   |       |               
|                   |       | (In thousands)
|Less than one year |       | $              | 78,893 |         |  | $ | 79,274 |        
|Due in 1-2 years   |       |                | 38,516 |         |  |   | 38,997 |        
|Due in 2-3 years   |       |                | 8,327  |         |  |   | 8,329  |        
|                   |       |                |        |         |  |   |        |        
|                   | Total |                | $      | 125,736 |  |   | $      | 126,600 | 
|                   |       |                |        |         |  |   |        |        

The fair value of marketable securities
categorized by purpose of investment was as follows:

|                   |  |                |         |           |  |       |        |  |  |   |         | 
|------------------ |  | -------------- | ------- | --------- |  | ----- | ------ |  |  | - | ------- | 
|                   |  | Current        |         | Long-Term |  | Total
|                   |  |                |         |           |  |      
|                   |  |               
|                   |  | (In thousands)
|January 3, 2004    |  |                |         |           |  |       |        |  |  |   |         | 
|Available-for-sale |  | $              | 79,274  |           |  | $     | 47,326 |  |  | $ | 126,600 | 
|                   |  |                |         |           |  |       |        |  |  |   |         | 
|December 28, 2002  |  |                |         |           |  |       |        |  |  |   |         | 
|Available-for-sale |  | $              | 105,710 |           |  | $     | 86,415 |  |  | $ | 192,125 | 
|                   |  |                |         |           |  |       |        |  |  |   |         | 

The temporary loss on investments recorded at
January 3, 2004 categorized by type of investment is as
follows:

|                                       |                                     |                |        |               |  |       |     |            |   |       |   |            |  |   |   |   |  |   |        |        |  |   |     |     |  
|-------------------------------------- | ----------------------------------- | -------------- | ------ | ------------- |  | ----- | --- | ---------- | - | ----- | - | ---------- |  | - | - | - |  | - | ------ | ------ |  | - | --- | --- | -
|                                       |                                     |                |        |               |  |       |     |           
|                                       |                                     | Maturity of    |        | Maturity of   |  |       |     |           
|                                       |                                     | Less than      |        | Twelve Months |  |      
|                                       |                                     | Twelve Months  |        | or Longer     |  | Total
|                                       |                                     |                |        |               |  |      
|                                       |                                     | Fair           |        | Unrealized    |  | Fair  |     | Unrealized |   | Fair  |   | Unrealized
|Description of Securities              |                                     | Value          |        | Losses        |  | Value |     | Value      |   | Value |   | Value     
|                                       |                                     |                |        |               |  |       |     |            |   |       |   |           
|                                       |                                     |               
|                                       |                                     | (In thousands)
|U.S. government and agency obligations |                                     | $              | 13,487 |               |  | $     | (14 | )          |   | $     |  |            |  | $ |  |   |  | $ | 13,487 |        |  | $ | (14 | )  
|U.S. corporate obligations             |                                     |                | 1,190  |               |  |       | (4  | )          |   |       |  |            |  |   |  |   |  |   | 1,190  |        |  |   | (4  | )  
|                                       |                                     |                |        |               |  |       |     |            |   |       |   |            |  |   |   |   |  |   |        |        |  |   |     |    
|                                       | Total temporary impaired securities |                | $      | 14,677        |  |       | $   | (18        | ) |       | $ |           |  |   | $ |  |  |   | $      | 14,677 |  |   | $   | (18 | )
|                                       |                                     |                |        |               |  |       |     |            |   |       |   |            |  |   |   |   |  |   |        |        |  |   |     |    



|   |                                                                
|-- | ---------------------------------------------------------------
|4. | Restricted Cash, Cash Equivalents and
    Marketable Securities

At January 3, 2004, the Company had
restricted cash, cash equivalents and marketable securities of
$18.7 million, which included $11.5 million of
marketable securities. At December 28, 2002, the Company
had restricted cash of $24.5 million, which included
marketable securities of $16.6 million. Pledged assets at
January 3, 2004, included $0.3 million to secure
letters of credit for equipment leases associated with sales by
discontinued operations. The underlying obligations decrease
over time and terminate in 2004. In addition, the Company had
$4.8 million pledged to secure a real estate lease
associated with the sale of a discontinued operation. The
underlying obligation decreases $1.0 million each year
beginning in 2009 and terminates in 2012. See Note 20 for
further discussion of the underlying obligation. The remaining
balance of restricted cash,cash equivalents and marketable
securities is primarily collateral for operations-related
performance obligations that are required by various parties,
since the Company does not have an existing credit facility.

F-17



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



|   |                    
|-- | -------------------
|5. | Accounts Receivable

Accounts receivable were as follows:

|                                |  |                |        |              |  |   |         |  
|------------------------------- |  | -------------- | ------ | ------------ |  | - | ------- | -
|                                |  | January 3,     |        | December 28,
|                                |  | 2004           |        | 2002        
|                                |  |                |        |             
|                                |  |               
|                                |  | (In thousands)
|Gross accounts receivable       |  | $              | 40,938 |              |  | $ | 60,933  |  
|Allowance for doubtful accounts |  |                | (3,397 | )            |  |   | (19,250 | )
|                                |  |                |        |              |  |   |         |  
|Accounts receivable, net        |  | $              | 37,541 |              |  | $ | 41,683  |  
|                                |  |                |        |              |  |   |         |  

Beginning in September 2001, the Company defers
revenue on product shipments to certain stocking distributors
until those distributors have sold the product to their
customer. At January 3, 2004 and December 28, 2002,
$19.1 million and $21.4 million, respectively, of
product shipments had been billed and revenue has not been
recognized, of which $6.2 million and $3.8 million,
respectively, was paid and is included in customer advances and
billings in excess of revenues. The balance of
$12.9 million and $17.6 million, respectively, was
unpaid and is recorded as an offset to accounts receivable.



|   |                 
|-- | ----------------
|6. | Notes Receivable

Notes receivable consisted of the following:

|                      |                           |                |        |              |   |   |        |         |  
|--------------------- | ------------------------- | -------------- | ------ | ------------ | - | - | ------ | ------- | -
|                      |                           | January 3,     |        | December 28,
|                      |                           | 2004           |        | 2002        
|                      |                           |                |        |             
|                      |                           |               
|                      |                           | (In thousands)
|Note receivable       |                           | $              | 30,000 |              |   | $ | 30,000 |        
|Credit agreement      |                           |                | 1,175  |              |   |   | 6,125  |        
|                      | Less: valuation allowance |                |        | (31,175      | ) |   |        | (33,625 | )
|                      |                           |                |        |              |   |   |        |        
|Notes receivable, net |                           | $              |       |              |   | $ | 2,500  |        
|                      |                           |                |        |              |   |   |        |        



| |                                     
| | ------------------------------------
| | Note Receivable From
    Distributor

During transition year 2001, the Company entered
into a promissory note with a distributor in which the Company
loaned the distributor $13.0 million. Principal and
interest were due in full on March 9, 2002. In the second
quarter of fiscal year 2002, the Company reached a settlement in
which the note was extinguished in connection with product
returns by the distributor.



| |                                         
| | ----------------------------------------
| | Note Receivable and Credit
    Agreement

A note receivable and credit agreement were
entered into in connection with the sale of the Companys
DNPG division during fiscal year 2001. Commencing on
May 31, 2002 through February 28, 2006, principal
amounts of the note receivable are due in quarterly installments
of approximately $1.9 million. The buyer has the ability
under certain circumstances to defer principal payments when
due, potentially extending the final maturity of the note to
February 28, 2010. All scheduled payments to date have been
deferred. Interest accrues and is due quarterly at a rate of
4.0% per annum. At January 3, 2004 and
December 28, 2002, the Company had a valuation allowance
for the total amount of the note receivable of
$30.0 million due to significant uncertainty regarding the
likelihood that the Company will receive payments under the note.

In addition, as part of the sale the Company
entered into a credit agreement for up to $10.0 million
with the buyer. Interest under the credit agreement accrues at a
rate of 6.5% per annum. The Company recorded a valuation
allowance of $6.1 million in transition year 2001 on the
balance of the credit

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

agreement due to significant uncertainty
regarding the likelihood that the Company would receive the
balance remaining. The Company has subsequently received
principal payments of $5.0 million in fiscal year 2003, of
which $2.5 million was recorded as a recovery in fiscal
year 2002 due to a subsequent receipt of a principal payment on
December 31, 2002. The remaining principal payments of
$1.2 million on the credit agreement are outstanding at
January 3, 2004.

Given the significant uncertainty regarding
collection of these notes receivable, no interest income has
been accrued. Instead, the Company records interest income on
these obligations when the Company is paid.



|   |                 
|-- | ----------------
|7. | Inventories, Net

Inventories, net, consisted of the following:

|               |                  |                |        |              |  |   |        |        | 
|-------------- | ---------------- | -------------- | ------ | ------------ |  | - | ------ | ------ | 
|               |                  | January 3,     |        | December 28,
|               |                  | 2004           |        | 2002        
|               |                  |                |        |             
|               |                  |               
|               |                  | (In thousands)
|Raw materials  |                  | $              | 4,170  |              |  | $ | 2,454  |       
|Service spares |                  |                | 2,184  |              |  |   | 7,522  |       
|Finished goods |                  |                | 22,695 |              |  |   | 34,576 |       
|               |                  |                |        |              |  |   |        |       
|               | Inventories, net |                | $      | 29,049       |  |   | $      | 44,552 | 
|               |                  |                |        |              |  |   |        |       



|   |                                   
|-- | ----------------------------------
|8. | Property, Plant and Equipment, Net

Property, plant and equipment, net, consisted of
the following:

|                                               |                                          |                |          |              |  |             |          |         |  |  |             |  | 
|---------------------------------------------- | ---------------------------------------- | -------------- | -------- | ------------ |  | ----------- | -------- | ------- |  |  | ----------- |  | 
|                                               |                                          | January 3,     |          | December 28, |  | Estimated  
|                                               |                                          | 2004           |          | 2002         |  | Useful Life
|                                               |                                          |                |          |              |  |            
|                                               |                                          |               
|                                               |                                          | (In thousands)
|Land and improvements                          |                                          | $              | 1,045    |              |  | $           | 1,045    |         |  |  | 15 years    | 
|Buildings and improvements                     |                                          |                | 14,396   |              |  |             | 15,752   |         |  |  | 15-40 years | 
|Equipment                                      |                                          |                | 119,620  |              |  |             | 143,206  |         |  |  | 1.5-7 years | 
|Furniture and fixtures                         |                                          |                | 6,018    |              |  |             | 6,400    |         |  |  | 5 years     | 
|Software                                       |                                          |                | 24,939   |              |  |             | 14,066   |         |  |  | 3 years     | 
|Leasehold improvements                         |                                          |                | 7,879    |              |  |             | 7,781    |         |  |  | 5 years     | 
|                                               |                                          |                |          |              |  |             |          |         |  |  |             | 
|                                               | Total property, plant and equipment      |                |          | 173,897      |  |             |          | 188,250 |  |  |             |  | 
|Less accumulated depreciation and amortization |                                          |                | (136,016 | )            |  |             | (140,843 | )       |  |  |             | 
|                                               |                                          |                |          |              |  |             |          |         |  |  |             | 
|                                               | Total property, plant and equipment, net |                | $        | 37,881       |  |             | $        | 47,407  |  |  |             |  | 
|                                               |                                          |                |          |              |  |             |          |         |  |  |             | 

For fiscal year 2003, fiscal year 2002 and
transition year 2001 depreciation and amortization expense was
$24.8 million, $34.1 million, and $26.7 million,
respectively. Buildings and improvements at December 28,
2002 included $1.3 million associated with a building held
for sale. In March 2003, the Company completed the sale of the
building to a third party for $1.3 million.

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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



|   |                                     
|-- | ------------------------------------
|9. | Goodwill and Other Intangible Assets

A reconciliation of net loss and loss per share
adjusted for the discontinuation of the amortization of
goodwill, net of the related income tax effect, was as follows:

|                                                   |  |                                          |          |                   |  |                   |          |   |  |   |          |  
|-------------------------------------------------- |  | ---------------------------------------- | -------- | ----------------- |  | ----------------- | -------- | - |  | - | -------- | -
|                                                   |  | Year Ended                               |          | Year Ended        |  | Ten Months Ended 
|                                                   |  | January 3, 2004                          |          | December 28, 2002 |  | December 29, 2001
|                                                   |  |                                          |          |                   |  |                  
|                                                   |  |                                         
|                                                   |  | (In thousands, except per share amounts)
|Net loss available to common shareholders          |  | $                                        | (114,843 | )                 |  | $                 | (127,208 | ) |  | $ | (714,631 | )
|Add back: Goodwill amortization expense            |  |                                          |         |                   |  |                   |         |   |  |   | 24,826   |  
|                                                   |  |                                          |          |                   |  |                   |          |   |  |   |          |  
|Adjusted net loss available to common shareholders |  | $                                        | (114,843 | )                 |  | $                 | (127,208 | ) |  | $ | (689,805 | )
|                                                   |  |                                          |          |                   |  |                   |          |   |  |   |          |  
|Basic and diluted loss per share:                  |  |                                          |          |                   |  |                   |          |   |  |   |          |  
|Net loss available to common shareholders          |  | $                                        | (0.56    | )                 |  | $                 | (0.63    | ) |  | $ | (3.71    | )
|Add back: Goodwill amortization expense            |  |                                          |         |                   |  |                   |         |   |  |   | 0.13     |  
|                                                   |  |                                          |          |                   |  |                   |          |   |  |   |          |  
|Adjusted net loss available to common shareholders |  | $                                        | (0.56    | )                 |  | $                 | (0.63    | ) |  | $ | (3.58    | )
|                                                   |  |                                          |          |                   |  |                   |          |   |  |   |          |  

Identifiable intangible assets at January 3,
2004 consisted of the following:

|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            |  | 
|---------------------- | ------------------------------------ | -------------- | ------ | ------------ |  | ----------------- | ------ | ----------- |  | - | ------ | ------ |  |  | ---------- |  | 
|                       |                                      | Gross          |        |              |  | Net Carrying      |        |            
|                       |                                      | Carrying       |        | Accumulated  |  | Value of          |        | Estimated  
|                       |                                      | Amount         |        | Amortization |  | Intangible Assets |        | Useful Life
|                       |                                      |                |        |              |  |                   |        |            
|                       |                                      |               
|                       |                                      | (In thousands)
|Customer relations     |                                      | $              | 28,600 |              |  | $                 | 22,246 |             |  | $ | 6,354  |        |  |  | 8 years    | 
|Patents and technology |                                      |                | 34,300 |              |  |                   | 23,301 |             |  |   | 10,999 |        |  |  | 3-10 years | 
|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            | 
|                       | Total identifiable intangible assets |                | $      | 62,900       |  |                   | $      | 45,547      |  |   | $      | 17,353 |  |  |            |  | 
|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            | 

The Company acquired certain fixed assets and
intellectual property from Tenor Networks in fiscal year 2003.
The Company allocated the purchase price between the fixed
assets and intellectual property acquired. The amount allocated
to the patents and technology intangibles was $2.1 million,
and this amount will be amortized over the estimated useful life
of the intangibles, or three years.

Identifiable intangible assets at
December 28, 2002 consisted of the following:

|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            |  | 
|---------------------- | ------------------------------------ | -------------- | ------ | ------------ |  | ----------------- | ------ | ----------- |  | - | ------ | ------ |  |  | ---------- |  | 
|                       |                                      | Gross          |        |              |  | Net Carrying      |        |            
|                       |                                      | Carrying       |        | Accumulated  |  | Value of          |        | Estimated  
|                       |                                      | Amount         |        | Amortization |  | Intangible Assets |        | Useful Life
|                       |                                      |                |        |              |  |                   |        |            
|                       |                                      |               
|                       |                                      | (In thousands)
|Customer relations     |                                      | $              | 28,600 |              |  | $                 | 19,226 |             |  | $ | 9,374  |        |  |  | 8 years    | 
|Patents and technology |                                      |                | 32,200 |              |  |                   | 19,810 |             |  |   | 12,390 |        |  |  | 3-10 years | 
|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            | 
|                       | Total identifiable intangible assets |                | $      | 60,800       |  |                   | $      | 39,036      |  |   | $      | 21,764 |  |  |            |  | 
|                       |                                      |                |        |              |  |                   |        |             |  |   |        |        |  |  |            | 

All of the Companys identifiable intangible
assets are subject to amortization. Total amortization was
$6.5 million for fiscal year 2003, $8.7 million for
fiscal year 2002 and $7.5 million for transition year 2001.
Based on intangible assets recorded at January 3, 2004, the
estimated amortization expense is $6.4 million for fiscal
years 2004 and 2005; $3.2 million for fiscal year 2006;
$0.5 million for fiscal year 2007; $0.3 million for
fiscal year 2008 and $0.6 million thereafter.

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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



|    |                       
|--- | ----------------------
|10. | Other Accrued Expenses

Other accrued expenses consisted of the following:

|                                      |                              |                 |       |                   |  |   |        |        | 
|------------------------------------- | ---------------------------- | --------------- | ----- | ----------------- |  | - | ------ | ------ | 
|                                      |                              | January 3, 2004 |       | December 28, 2002
|                                      |                              |                 |       |                  
|                                      |                              |                
|                                      |                              | (In thousands) 
|Accrued audit expense                 |                              | $               | 2,285 |                   |  | $ | 4,729  |       
|Accrued marketing and selling costs   |                              |                 | 7,180 |                   |  |   | 11,663 |       
|Accrued liability on lease guarantees |                              |                 | 48    |                   |  |   | 4,324  |       
|Accrued sales tax and VAT expense     |                              |                 | 4,462 |                   |  |   | 1,792  |       
|Accrued utilities                     |                              |                 | 822   |                   |  |   | 277    |       
|Other                                 |                              |                 | 9,317 |                   |  |   | 9,484  |       
|                                      |                              |                 |       |                   |  |   |        |       
|                                      | Total other accrued expenses |                 | $     | 24,114            |  |   | $      | 32,269 | 
|                                      |                              |                 |       |                   |  |   |        |       



|    |             
|--- | ------------
|11. | Income Taxes

Loss from continuing operations before income
taxes was summarized as follows:

|                         |                                |                 |         |                   |   |                   |          |          |   |   |          |          |  
|------------------------ | ------------------------------ | --------------- | ------- | ----------------- | - | ----------------- | -------- | -------- | - | - | -------- | -------- | -
|                         |                                | Year Ended      |         | Year Ended        |   | Ten Months Ended 
|                         |                                | January 3, 2004 |         | December 28, 2002 |   | December 29, 2001
|                         |                                |                 |         |                   |   |                  
|                         |                                |                
|                         |                                | (In thousands) 
|Total U.S. domestic loss |                                | $               | (52,839 | )                 |   | $                 | (152,686 | )        |   | $ | (508,217 | )       
|Total foreign loss       |                                |                 | (59,063 | )                 |   |                   | (35,106  | )        |   |   | (46,610  | )       
|                         |                                |                 |         |                   |   |                   |          |          |   |   |          |         
|                         | Total loss before income taxes |                 | $       | (111,902          | ) |                   | $        | (187,792 | ) |   | $        | (554,827 | )
|                         |                                |                 |         |                   |   |                   |          |          |   |   |          |         

The provision (benefit) for income taxes
consisted of the following items:

|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |         |         |        | 
|--------- | ------- | --------------- | ---------------------------------- | ----------------- | --- | ----------------- | - | ------- | ------- | ------- | - | ------- | ------- | ------ | 
|          |         | Year Ended      |                                    | Year Ended        |     | Ten Months Ended 
|          |         | January 3, 2004 |                                    | December 28, 2002 |     | December 29, 2001
|          |         |                 |                                    |                   |     |                  
|          |         |                
|          |         | (In thousands) 
|Current:  |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|          | Federal |                 | $                                  | (4,487            | )   |                   | $ | (90,127 | )       |         | $ | (30,251 | )      
|          | State   |                 |                                    | 625               |     |                   |   | 650     |         |         |   | 4,935   |        
|          | Foreign |                 |                                    | 4,611             |     |                   |   | 4,230   |         |         |   | 3,283   |        
|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|          |         | Total current   |                                    |                   | 749 |                   |   |         | (85,247 | )       |   |         | (22,033 | )     
|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|Deferred: |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|          | Federal |                 |                                    |                  |     |                   |   | (237    | )       |         |   | 82,227  |        
|          | State   |                 |                                    |                  |     |                   |   |        |         |         |   |        |        
|          | Foreign |                 |                                    |                  |     |                   |   | 237     |         |         |   | 48      |        
|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|          |         | Total deferred  |                                    |                   |    |                   |   |         |        |         |   |         | 82,275  |       
|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |        
|          |         |                 | Total income tax expense (benefit) |                   | $   | 749               |   |         | $       | (85,247 | ) |         | $       | 60,242 | 
|          |         |                 |                                    |                   |     |                   |   |         |         |         |   |        

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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

The differences between the U.S. statutory
federal tax rate and the Companys effective tax expense
(benefit) rate for continuing operations were as follows:

|                                                 |                                      |                 |       |                   |   |                   |       |       |    |  |       |      |  
|------------------------------------------------ | ------------------------------------ | --------------- | ----- | ----------------- | - | ----------------- | ----- | ----- | -- |  | ----- | ---- | -
|                                                 |                                      | Year Ended      |       | Year Ended        |   | Ten Months Ended 
|                                                 |                                      | January 3, 2004 |       | December 28, 2002 |   | December 29, 2001
|                                                 |                                      |                 |       |                   |   |                  
|Statutory federal income tax (benefit) rate      |                                      |                 | (35.0 | )%                |   |                   | (35.0 | )%    |    |  | (35.0 | )%  
|State income tax, net of federal tax benefit     |                                      |                 | 0.4   |                   |   |                   | 0.2   |       |    |  | 0.6   |     
|Research and experimentation credit              |                                      |                 | (3.3  | )                 |   |                   | (1.7  | )     |    |  | (0.5  | )   
|Rate differential on foreign operations          |                                      |                 | 4.7   |                   |   |                   | 6.8   |       |    |  | 2.8   |     
|Nondeductible goodwill and intangibles           |                                      |                 |      |                   |   |                   |      |       |    |  | 8.9   |     
|Unbenefited losses/change in valuation allowance |                                      |                 | 34.7  |                   |   |                   | (31.0 | )     |    |  | 39.6  |     
|Change in estimate for tax contingencies         |                                      |                 | (0.9  | )                 |   |                   | 10.9  |       |    |  | (5.5  | )   
|Other                                            |                                      |                 | 0.1   |                   |   |                   | 4.4   |       |    |  |      |     
|                                                 |                                      |                 |       |                   |   |                   |       |       |    |  |       |     
|                                                 | Effective tax expense (benefit) rate |                 |       | 0.7               | % |                   |       | (45.4 | )% |  |       | 10.9 | %
|                                                 |                                      |                 |       |                   |   |                   |       |       |    |  |       |     

The tax effects of temporary differences that
give rise to significant portions of deferred tax assets and
deferred tax liabilities were as follows:

|                     |                                           |                           |   |                   |         |  |   |          |         | 
|-------------------- | ----------------------------------------- | ------------------------- | - | ----------------- | ------- |  | - | -------- | ------- | 
|                     |                                           | January 3, 2004           |   | December 28, 2002
|                     |                                           |                           |   |                  
|                     |                                           |                          
|                     |                                           | (In thousands)           
|Deferred tax assets: |                                           |                           |   |                   |         |  |   |         
|                     | Accounts receivable                       |                           | $ | 1,572             |         |  | $ | 3,432    |        
|                     | Inventories                               |                           |   | 12,451            |         |  |   | 9,724    |        
|                     | Deferred revenue                          |                           |   | 1,849             |         |  |   | 11,696   |        
|                     | Property, plant and equipment             |                           |   | 4,331             |         |  |   | 6,906    |        
|                     | Other reserves and accruals               |                           |   | 38,709            |         |  |   | 28,942   |        
|                     | Acquired research and development         |                           |   | 148,796           |         |  |   | 167,116  |        
|                     | Domestic net operating loss carryforwards |                           |   | 141,360           |         |  |   | 93,141   |        
|                     | Foreign net operating loss carryforwards  |                           |   | 39,687            |         |  |   | 37,522   |        
|                     |                                           |                           |   |                   |         |  |   |         
|                     |                                           | Gross deferred tax assets |   |                   | 388,755 |  |   |          | 358,479 | 
|                     | Valuation allowance                       |                           |   | (388,755          | )       |  |   | (358,479 | )      
|                     |                                           |                           |   |                   |         |  |   |         
|                     |                                           | Total deferred tax assets |   | $                 |        |  |   | $        |        | 
|                     |                                           |                           |   |                   |         |  |   |         

On March 9, 2002, the President of the
United States signed into law the Job Creation and Worker
Assistance Act of 2002, which extended the net operating loss
carryback period from two to five years for losses generated in
tax years ending in 2001 and 2002. As a result, the Company was
able to utilize the benefit of $110.7 million,
$201.8 million and $116.8 million in net operating
losses from fiscal year 2002, transition year 2001 and fiscal
year 2001, respectively. During fiscal years 2003 and 2002, the
Company received domestic net refunds of $31.9 million and
$102.2 million, respectively, which consisted of a tax
benefit of $31.9 million and $71.9 million for the net
operating losses and $30.3 million attributable to the
exercise of employee stock options which was recorded as an
increase to additional paid-in capital during fiscal year 2002.

At January 3, 2004, the Company had domestic
net operating loss (NOL) carryforwards for tax
purposes of $296.2 million expiring in fiscal years 2005
through 2023. Approximately $53.3 million of this NOL is
attributable to the pre-acquisition periods of acquired
subsidiaries. The utilization of these

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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

acquired NOLs is limited pursuant to Internal
Revenue Code (IRC) Section 382 as a result of
these prior ownership changes. In addition, the Company has
$30.1 million of U.S. income tax credit carryforwards
as of January 3, 2004, which expire in fiscal years 2019
through 2023. The future utilization of the losses during fiscal
years 2003 and 2002, respectively, and credits may be limited in
the event of an ownership change under IRC Section 382.

The Company has recorded a valuation allowance
against its remaining foreign, federal and state deferred tax
assets at January 3, 2004 and December 28, 2002 since
management believes that, after considering all the available
objective evidence, both positive and negative, historical and
prospective, with greater weight given to historical evidence,
it is more likely than not that these assets will not be
realized. In addition, the calculation of the Companys tax
liabilities involves dealing with uncertainties in the
application of complex tax regulations in a multitude of
jurisdictions. The Company recognizes the potential liabilities
for anticipated tax audit issues in the U.S and other tax
jurisdictions based on its estimate of whether, and the extent
to which, additional taxes will be due. If payment of these
amounts ultimately proves to be unnecessary, the reversal of the
liabilities would result in tax benefits being recognized in the
period when the Company determines the liabilities are no longer
necessary. If the Companys estimate of tax liabilities
proves to be less than the ultimate assessment, a further charge
to expense would result.

During fiscal years 2003 and 2002, the Company
received a refund of $3.6 million and made a payment of
$12.2 million, respectively, related to settlements of
federal income tax audits covering tax years through fiscal year
1998. Management believes that adequate provision has been made
for any adjustments that may result from future tax examinations.

The net change in the total valuation allowance
for fiscal years 2003 and 2002 was an increase of
$30.3 million and a decrease of $93.6 million,
respectively. The decrease in fiscal year 2002 related primarily
to the ability to carry back the net operating losses as a
result of the 2002 tax legislation. Subsequently recognized tax
benefits relating to valuation allowances for deferred tax
assets (if any) will be allocated as follows: $20.0 million
to additional paid-in capital which is attributable to the
exercise of employee stock options, $5.2 million to
goodwill, and $363.6 million to the consolidated statement
of operations.

The Company has permanently reinvested earnings
of its foreign subsidiaries and therefore, has not provided for
U.S. income taxes that could result from the remittance of
such earnings. The unremitted earnings at January 3, 2004,
and December 28, 2002 amounted to approximately
$155.6 million and $207.4 million, respectively.
Furthermore, any taxes paid to foreign governments on those
earnings may be used, in whole or in part, as credits against
U.S. tax on any dividends distributed from such earnings.
It is not practicable to estimate the amount of unrecognized
deferred U.S. taxes on these undistributed earnings.

F-23



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



|    |                
|--- | ---------------
|12. | Special Charges

The components of special charges were as follows:

|                       |                               |                             |                       |                   |        |                   |   |        |        |        |        |        |        |        | 
|---------------------- | ----------------------------- | --------------------------- | --------------------- | ----------------- | ------ | ----------------- | - | ------ | ------ | ------ | ------ | ------ | ------ | ------ | 
|                       |                               | Year Ended                  |                       | Year Ended        |        | Ten Months Ended 
|                       |                               | January 3, 2004             |                       | December 28, 2002 |        | December 29, 2001
|                       |                               |                             |                       |                   |        |                  
|                       |                               |                            
|                       |                               | (In thousands)             
|Transformation charges |                               | $                           |                      |                   |        | $                 |  |        |        | $      | 24,461 |       
|Restructuring charges: |                               |                             |                       |                   |        |                   |   |        |        |        |        |       
|                       | Fixed assets                  |                             |                       |                  |        |                   |   | 129    |        |        |        | 2,170  |       
|                       | Severance benefits            |                             |                       | 14,704            |        |                   |   | 25,974 |        |        |        | 17,874 |       
|                       | Facility exit costs           |                             |                       | 2,828             |        |                   |   | 6,079  |        |        |        | 2,663  |       
|                       | Reversal of prior year charge |                             |                       |                  |        |                   |   | (204   | )      |        |        |       |       
|                       |                               |                             |                       |                   |        |                   |   |        |        |        |        |       
|                       |                               | Total restructuring charges |                       |                   | 17,532 |                   |   |        | 31,978 |        |        |        | 22,707 |       
|                       |                               |                             |                       |                   |        |                   |   |        |        |        |        |       
|                       |                               |                             | Total special charges |                   | $      | 17,532            |   |        | $      | 31,978 |        |        | $      | 47,168 | 
|                       |                               |                             |                       |                   |        |                   |   |        |        |        |        |       

In the last several years, the Company has
implemented a number of cost reduction initiatives designed to
improve gross margins and reduce fixed operating costs. Since
the beginning of fiscal year 2002, the Company has closed or
reduced the size of eleven facilities. The workforce reductions
during fiscal year 2003 were the result of an evaluation of the
Companys workforce and the skill levels necessary to
satisfy expected future requirements of the business. The
Company recorded restructuring charges of $17.5 million in
fiscal year 2003, which included $14.7 million in employee
severance related costs for approximately 405 individuals, plus
$2.8 million in facility exit costs primarily as a result
of consolidation of a North American distribution center into an
owned facility with excess space. The fiscal year 2003
reductions in the global workforce involved most functions
within the Company.

During the fourth quarter of fiscal year 2002,
the Company recorded a restructuring charge of $1.2 million
primarily for facilities exit costs related to the closure of
two facilities. During the third quarter of fiscal year 2002,
the Company recorded a restructuring charge of
$10.7 million which consisted of exit costs of
$5.1 million related to the closure or reduction in size of
seven facilities and employee severance costs of
$5.6 million. The employee severance costs were associated
with the reduction of approximately 130 individuals or 8% of the
Companys global workforce at the time. During the second
quarter of fiscal year 2002, the Company recorded a
restructuring charge of $20.2 million. These restructuring
costs consisted of employee severance costs associated with the
reduction of approximately 600 individuals or 26% of the
Companys global workforce at the time. The reduction in
the global workforce involved most functions within the Company.

In transition year 2001, the Company recorded
special charges of $24.5 million related to the
transformation of Cabletrons business. The
transformation-related charges include investment banking, legal
and accounting fees related to the establishment of four
Operating Subsidiaries as stand-alone entities and the
Riverstone spin-off. Also, during the fourth quarter of
transition year 2001, the Company recorded a restructuring
charge of $12.4 million for employee severance costs
associated with the reduction of approximately 400 individuals
from the Companys global workforce. The reduction in the
global workforce involved principally sales, engineering and
administrative personnel and also included targeted reductions
impacting most functions within the Company. In addition, during
the second quarter of transition year 2001, the Company recorded
restructuring charges of $10.3 million to reduce the
expense structure of the Company. These charges reflected a
write-down of $2.2 million for a vacant office building in
Rochester, New Hampshire, to its estimated fair value, exit
costs of $2.6 million associated with the planned closure
of eight sales offices worldwide and executive severance costs
of $5.5 million.

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

The activity for accrued restructuring costs for
the three years ended January 3, 2004 was as follows:

|                           |                               |                               |       |               |   |       |       |        |   |   |        |         |  
|-------------------------- | ----------------------------- | ----------------------------- | ----- | ------------- | - | ----- | ----- | ------ | - | - | ------ | ------- | -
|                           |                               |                              
|                           |                               | Accrued Restructuring Charges
|                           |                               |                              
|                           |                               | Severance                     |       | Facility Exit |   |      
|                           |                               | Benefits                      |       | Costs         |   | Total
|                           |                               |                               |       |               |   |      
|                           |                               |                              
|                           |                               | (In thousands)               
|Balance, March 3, 2001     |                               | $                             | 940   |               |   | $     | 139   |        |   | $ | 1,079  |        
|                           | Second quarter charges        |                               |       | 5,471         |   |       |       | 2,663  |   |   |        | 8,134   |  
|                           | Fourth quarter charges        |                               |       | 12,403        |   |       |       |       |   |   |        | 12,403  |  
|                           | Cash payments                 |                               |       | (14,862       | ) |       |       | (572   | ) |   |        | (15,434 | )
|                           |                               |                               |       |               |   |       |       |        |   |   |        |        
|Balance, December 29, 2001 |                               |                               | 3,952 |               |   |       | 2,230 |        |   |   | 6,182  |        
|                           | Reclassification              |                               |       | (572          | ) |       |       | 572    |   |   |        |        |  
|                           | Second quarter charges        |                               |       | 20,239        |   |       |       |       |   |   |        | 20,239  |  
|                           | Third quarter charges         |                               |       | 5,646         |   |       |       | 5,089  |   |   |        | 10,735  |  
|                           | Fourth quarter charges        |                               |       | 89            |   |       |       | 1,120  |   |   |        | 1,209   |  
|                           | Cash payments                 |                               |       | (27,534       | ) |       |       | (2,945 | ) |   |        | (30,479 | )
|                           | Reversal of prior year charge |                               |       | (204          | ) |       |       |       |   |   |        | (204    | )
|                           |                               |                               |       |               |   |       |       |        |   |   |        |        
|Balance, December 28, 2002 |                               |                               | 1,616 |               |   |       | 6,066 |        |   |   | 7,682  |        
|                           | Second quarter charges        |                               |       | 7,431         |   |       |       | 772    |   |   |        | 8,203   |  
|                           | Third quarter charges         |                               |       | 6,282         |   |       |       | 2,056  |   |   |        | 8,338   |  
|                           | Fourth quarter charges        |                               |       | 990           |   |       |       |       |   |   |        | 990     |  
|                           | Cash payments                 |                               |       | (12,477       | ) |       |       | (2,211 | ) |   |        | (14,688 | )
|                           |                               |                               |       |               |   |       |       |        |   |   |        |        
|Balance, January 3, 2004   |                               | $                             | 3,842 |               |   | $     | 6,683 |        |   | $ | 10,525 |        
|                           |                               |                               |       |               |   |       |       |        |   |   |        |        

The remaining accrued severance costs of
$3.8 million as of January 3, 2004 will be paid out
during fiscal year 2004; and the remaining accrued exit costs of
$6.7 million, which consisted of long-term lease
commitments, will be paid out as follows: $2.6 million in
fiscal year 2004, $1.0 million in fiscal year 2005,
$0.8 million in fiscal year 2006, $0.7 million in
fiscal year 2007, and $1.6 million thereafter.

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

13.     Other
Expense, Net

The components of other expense, net, were as
follows:

|                                                                  |                          |                 |         |                   |   |                   |         |         |   |   |         |         |  
|----------------------------------------------------------------- | ------------------------ | --------------- | ------- | ----------------- | - | ----------------- | ------- | ------- | - | - | ------- | ------- | -
|                                                                  |                          |                 |         |                   |   | Ten Months       
|                                                                  |                          | Year Ended      |         | Year Ended        |   | Ended            
|                                                                  |                          | January 3, 2004 |         | December 28, 2002 |   | December 29, 2001
|                                                                  |                          |                 |         |                   |   |                  
|                                                                  |                          |                
|                                                                  |                          | (In thousands) 
|Loss on investment write-downs                                    |                          | $               | (27,775 | )                 |   | $                 | (22,119 | )       |   | $ | (65,901 | )      
|Loss on exchange of products for investments                      |                          |                 |        |                   |   |                   |        |         |   |   | (17,086 | )      
|Recognition of deferred gain on Efficient
    investment          |                          |                 |        |                   |   |                   |        |         |   |   | 46,778  |        
|Other than temporary decline in
    available-for-sale securities |                          |                 |        |                   |   |                   |        |         |   |   | (1,712  | )      
|Unrealized gain (loss) on Riverstone stock
    derivative         |                          |                 | 178     |                   |   |                   | (20,048 | )       |   |   | 4,020   |        
|Net realized gain on sale of marketable securities                |                          |                 | 838     |                   |   |                   | 1,121   |         |   |   | 4,062   |        
|Recovery (write-down) of note receivable                          |                          |                 | 2,450   |                   |   |                   | 2,500   |         |   |   | (6,125  | )      
|Foreign currency loss                                             |                          |                 | (4,119  | )                 |   |                   | (2,711  | )       |   |   | (4,850  | )      
|Other, net                                                        |                          |                 | 1,074   |                   |   |                   | (1,368  | )       |   |   | (395    | )      
|                                                                  |                          |                 |         |                   |   |                   |         |         |   |   |         |        
|                                                                  | Total other expense, net |                 | $       | (27,354           | ) |                   | $       | (42,625 | ) |   | $       | (41,209 | )
|                                                                  |                          |                 |         |                   |   |                   |         |         |   |   |         |        

The Company reviews its minority investments in
debt and equity securities of primarily privately held companies
for potential impairment whenever events or changes in
circumstances indicate that the carrying value may not be
recoverable. Many factors are considered for assessing potential
impairments. Such events or factors include declines in the
investees stock price in new rounds of financing, market
capitalization relative to book value, deteriorating financial
condition or results of operations, and bankruptcy or
insolvency. From time to time, the Company may also engage third
party experts to estimate the recoverable value of investments
management may consider selling. The Company is currently
considering selling its interests in several private venture
funds.

A portion of the Companys Series D and
E convertible preferred stock redemption liability was offset by
the value of 1.3 million shares of Riverstone stock
received by the holders of the Series D and E redeemable
convertible preferred stock in connection with the
Companys spin-off of its Riverstone subsidiary in August
2001 (see Note 18). This offset created a derivative
instrument as the Companys liability was related to the
Riverstone stock price. The value of the Riverstone shares
increased by $0.2 million during the fiscal year 2003,
decreased by $20.0 million in fiscal year 2002 and
increased by $4.0 million in transition year 2001. The
changes in the redemption liability were recorded in other
expense, net. The Company redeemed all of the Series D and
E convertible preferred stock in the first quarter of fiscal
year 2003.

During transition year 2001 the Company entered
into a number of transactions in which it made an investment in
a customer in exchange for cash and/or products and services. In
certain of these transactions, the Company recorded the
difference between the cost of the consideration given and the
fair value of the investment received as other expense. These
transactions resulted in losses of $17.1 million for
transition year 2001.

In December 1999, the Company sold its Flow
Point, Inc. subsidiary to Efficient. On the transaction date,
the Company held a portion of the outstanding common stock of
Efficient on an as-converted basis.

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Accordingly, the Company deferred
$235.9 million of its pre-tax gain, since through its
ownership percentage of Efficient, it effectively still had an
ownership interest in Flow Point. As the Company sold the
Efficient shares, this deferred gain was recognized into income
in proportion to the Companys reduction in its percentage
ownership of Efficient. During the ten months ended
December 29, 2001, the Company sold its remaining shares of
Efficient for net proceeds of approximately $242.7 million
and recognized approximately $46.8 million of deferred gain
to other income.



|    |                   
|--- | ------------------
|14. | Net Loss Per Share

The reconciliation of the numerator for basic and
diluted loss per common share computations for the
Companys reported net loss was as follows:

|                                                                     |                                           |                 |          |                   |   |                   |          |          |   |   |          |          |  
|-------------------------------------------------------------------- | ----------------------------------------- | --------------- | -------- | ----------------- | - | ----------------- | -------- | -------- | - | - | -------- | -------- | -
|                                                                     |                                           | Year Ended      |          | Year Ended        |   | Ten Months Ended 
|                                                                     |                                           | January 3, 2004 |          | December 28, 2002 |   | December 29, 2001
|                                                                     |                                           |                 |          |                   |   |                  
|                                                                     |                                           |                
|                                                                     |                                           | (In thousands) 
|Loss from continuing operations                                      |                                           | $               | (112,651 | )                 |   | $                 | (102,545 | )        |   | $ | (615,069 | )       
|Effect of preferred shares                                           |                                           |                 | (2,192   | )                 |   |                   | (12,963  | )        |   |   | (10,347  | )       
|                                                                     |                                           |                 |          |                   |   |                   |          |          |   |   |          |         
|Loss from continuing operations available to
    common shareholders |                                           |                 | (114,843 | )                 |   |                   | (115,508 | )        |   |   | (625,416 | )       
|Discontinued operations:                                             |                                           |                 |          |                   |   |                   |          |          |   |   |          |         
|                                                                     | Operating loss                            |                 |          |                  |   |                   |          |         |   |   |          | (59,124  | )
|                                                                     | Loss on disposal                          |                 |          |                  |   |                   |          | (11,700  | ) |   |          | (42,782  | )
|Cumulative effect of a change in accounting
    principle            |                                           |                 |         |                   |   |                   |         |          |   |   | 12,691   |         
|                                                                     |                                           |                 |          |                   |   |                   |          |          |   |   |          |         
|                                                                     | Net loss available to common shareholders |                 | $        | (114,843          | ) |                   | $        | (127,208 | ) |   | $        | (714,631 | )
|                                                                     |                                           |                 |          |                   |   |                   |          |          |   |   |          |         

In fiscal year 2003, fiscal year 2002, and
transition year 2001, options to purchase 27.4 million,
29.8 million, and 36.4 million, respectively, shares
of the Companys common stock were outstanding but excluded
from the calculation of diluted loss per common share since the
effect would have been anti-dilutive. Additionally, in fiscal
year 2003, fiscal year 2002 and transition year 2001, warrants
to purchase 7.4 million of shares of the Companys
common stock were outstanding but excluded from the calculation
of diluted loss per common share.

During the fourth quarter of fiscal 2003, the
Company agreed to distribute shares of its common stock with a
value of $33.0 million to settle outstanding shareholder
litigation. During the fourth quarter of fiscal year 2003, the
Company distributed 1,304,340 shares of common stock and
expects to distribute the remaining 7,423,511 shares of its
stock during fiscal year 2004. See Note 20 for further
discussion of this transaction. In accordance with
SFAS No. 128, Earnings Per Share,
the Company considers these shares to have no contingencies and
accordingly included these shares of common stock in its
calculation of weighted common stock outstanding at
January 3, 2004.



|    |                        
|--- | -----------------------
|15. | Discontinued Operations

On July 17, 2001, the Companys Board
of Directors declared a special dividend of its shares of a
wholly owned subsidiary, Riverstone Networks Inc.
(Riverstone), common stock to the Companys
shareholders of record on July 27, 2001, payable on
August 6, 2001; and on August 6, 2001, the Company
distributed its shares of Riverstone common stock to its
shareholders. The distribution ratio was 0.5131 shares of
Riverstone common stock for each outstanding share of its common
stock. The Company did not recognize any gain or loss as a
result of this transaction. As a result of the distribution of
the

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Companys Riverstone shares, the Company
recorded a non-cash charge to retained earnings of approximately
$329.6 million, which reflected the distribution of the net
assets and liabilities of Riverstone to its shareholders.

The Company finalized the sale of a portion of a
wholly owned subsidiary, GlobalNetwork Technology
Service, Inc. (GNTS), to a third party during
September 2001. The remainder of GNTS was either absorbed into
the Company or its Aprisma subsidiary or discontinued. During
transition year 2001, the Company recognized a loss on disposal
of GNTS of approximately $41.5 million primarily related to
severance, office closings and asset write-offs associated with
the discontinuation and sale of GNTS. Approximately
$23.1 million of these expenses were non-cash charges.

In August 2001, the Companys Board of
Directors made a determination to distribute a wholly owned
subsidiarys, Aprisma Management Technologies Inc.
(Aprisma), shares to its stockholders or to
otherwise dispose of Aprisma. The Company recorded in
discontinued operations a provision for the loss on sale of
Aprisma of $1.3 million for transition year 2001. This
included Aprismas estimated loss from operations of
$14.8 million from December 29, 2001 to the disposal
date. During the first quarter of fiscal year 2002, the Company
recorded an additional charge of $11.7 million due to a
change in estimate of the loss on disposal of Aprisma and
received approximately $62.0 million of cash and marketable
securities from Aprisma. On August 9, 2002, the Company
completed the sale of Aprisma to a third party for proceeds, net
of expenses, of approximately $7.6 million.

As a result of the above dispositions, the
Company has presented Aprisma as discontinued operations for
fiscal year 2002 and transition year 2001 and GNTS and
Riverstone as discontinued operations for transition year 2001.

The Companys discontinued operations
included sales to customers in which it had investments in debt
and equity securities accounted for under the cost method of
accounting. This revenue is disclosed separately in the
following table as Revenue from related
parties  minority investees. See Note 22
for further discussion of these transactions. The following
revenue was recorded in the consolidated statements of
operations in loss from discontinued operations:

|                                                                   |                                       |                   |         |         | 
|------------------------------------------------------------------ | ------------------------------------- | ----------------- | ------- | ------- | 
|                                                                   |                                       | Ten Months Ended 
|                                                                   |                                       | December 29, 2001
|                                                                   |                                       |                  
|                                                                   |                                       | (In thousands)   
|Revenue from discontinued operations                               |                                       | $                 | 91,888  |        
|Intercompany revenue  Enterasys,
    Aprisma, GNTS and Riverstone |                                       |                   | 11,836  |        
|Revenue from related parties  minority
    investees              |                                       |                   | 22,940  |        
|                                                                   |                                       |                   |         |        
|                                                                   | Subtotal                              |                   |         | 126,664 | 
|Eliminations                                                       |                                       |                   | (11,836 | )      
|                                                                   |                                       |                   |         |        
|                                                                   | Total discontinued operations revenue |                   | $       | 114,828 | 
|                                                                   |                                       |                   |         |        



|    |                                     
|--- | ------------------------------------
|16. | Segment and Geographical Information

The Company operates its business as one segment,
which is the business of designing, developing, marketing and
supporting comprehensive standards-based networking solutions.

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Geographic revenue information for the three
years ended January 3, 2004, was based on the location of
the customer. Net revenue from unaffiliated customers by
geographic region was as follows:

|                                   |                   |                 |         |                   |  |                   |       |         |  |         |         |         |  |  |       |        |  |   |         |         |  |  |       |        | 
|---------------------------------- | ----------------- | --------------- | ------- | ----------------- |  | ----------------- | ----- | ------- |  | ------- | ------- | ------- |  |  | ----- | ------ |  | - | ------- | ------- |  |  | ----- | ------ | 
|                                   |                   |                 |         |                   |  |                  
|                                   |                   | Year Ended      |         | Year Ended        |  | Ten Months Ended 
|                                   |                   | January 3, 2004 |         | December 28, 2002 |  | December 29, 2001
|                                   |                   |                 |         |                   |  |                  
|                                   |                   | Revenue         |         | Percent           |  | Revenue           |       | Percent |  | Revenue |         | Percent
|                                   |                   |                 |         |                   |  |                   |       |         |  |         |         |        
|                                   |                   |                
|                                   |                   | (In thousands) 
|North America                      |                   | $               | 204,510 |                   |  |                   | 49.3% |         |  | $       | 273,218 |         |  |  | 56.4% |        |  | $ | 196,616 |         |  |  | 49.9% |       
|Europe, the Middle East and Africa |                   |                 | 136,674 |                   |  |                   | 33.0% |         |  |         | 142,934 |         |  |  | 29.5% |        |  |   | 132,218 |         |  |  | 33.5% |       
|Asia Pacific                       |                   |                 | 47,479  |                   |  |                   | 11.5% |         |  |         | 36,267  |         |  |  | 7.5%  |        |  |   | 44,336  |         |  |  | 11.2% |       
|Latin America                      |                   |                 | 25,875  |                   |  |                   | 6.2%  |         |  |         | 32,378  |         |  |  | 6.6%  |        |  |   | 21,375  |         |  |  | 5.4%  |       
|                                   |                   |                 |         |                   |  |                   |       |         |  |         |         |         |  |  |       |        |  |   |         |         |  |  |       |       
|                                   | Total net revenue |                 | $       | 414,538           |  |                   |       | 100.0%  |  |         | $       | 484,797 |  |  |       | 100.0% |  |   | $       | 394,545 |  |  |       | 100.0% | 
|                                   |                   |                 |         |                   |  |                   |       |         |  |         |         |         |  |  |       |        |  |   |         |         |  |  |       |       

In fiscal year 2003, the U.S. accounted for 49%
of net revenues and the United Kingdom (U.K.)
accounted for 16%; in fiscal year 2002, the U.S. accounted for
56% of net revenues and the U.K. accounted for 16%; and in
transition year 2001, the U.S. accounted for 50% of net revenues
and the U.K. accounted for 19%.

Long-lived assets consist of the net book value
of property, plant, and equipment, goodwill and intangible
assets. Long-lived assets by location were as follows:

|                    |                         |                |        |              |  |   |        |        | 
|------------------- | ----------------------- | -------------- | ------ | ------------ |  | - | ------ | ------ | 
|                    |                         | January 3,     |        | December 28,
|                    |                         | 2004           |        | 2002        
|                    |                         |                |        |             
|                    |                         |               
|                    |                         | (In thousands)
|U.S.                |                         | $              | 66,735 |              |  | $ | 77,551 |       
|All other countries |                         |                | 3,628  |              |  |   | 6,749  |       
|                    |                         |                |        |              |  |   |        |       
|                    | Total long-lived assets |                | $      | 70,363       |  |   | $      | 84,300 | 
|                    |                         |                |        |              |  |   |        |       



|    |                                   
|--- | ----------------------------------
|17. | Supplemental Cash Flow Information

Supplemental disclosure of cash flow information
was as follows:

|                                                                                 |  |                 |        |                   |  |                   |        |  |  |   |        | 
|-------------------------------------------------------------------------------- |  | --------------- | ------ | ----------------- |  | ----------------- | ------ |  |  | - | ------ | 
|                                                                                 |  | Year Ended      |        | Year Ended        |  | Ten Months Ended 
|                                                                                 |  | January 3, 2004 |        | December 28, 2002 |  | December 29, 2001
|                                                                                 |  |                 |        |                   |  |                  
|                                                                                 |  |                
|                                                                                 |  | (In thousands) 
|Refunds received for income taxes, net                                           |  | $               | 34,602 |                   |  | $                 | 96,656 |  |  | $ | 7,188  | 
|Non-cash transactions:                                                           |  |                 |        |                   |  |                   |        |  |  |   |        | 
|Accretive dividend and accretion of discount on
    preferred shares             |  | $               | 2,192  |                   |  | $                 | 12,963 |  |  | $ | 10,347 | 
|Conversion of Series C preferred stock,
    options and warrants to common stock |  | $               |       |                   |  | $                 |       |  |  | $ | 35,545 | 
|Product and services exchanged for investments                                   |  | $               |       |                   |  | $                 |       |  |  | $ | 12,771 | 



|    |                     
|--- | --------------------
|18. | Stockholders Equity



| |                        
| | -----------------------
| | Common Stock Commitment

During the fourth quarter of fiscal year 2003,
the Company finalized its agreements to settle the outstanding
shareholder litigation against the Company, and certain of its
former directors and officers filed in connection with the
financial restatements for the 2001 fiscal and transition years.
Under the financial

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

terms of the settlements, the Company has agreed
to pay $17.4 million in cash and to distribute
8,727,851 shares of its stock with a settlement date value
of $33.0 million. During the fourth quarter of fiscal year
2003, the Company paid $17.0 million of its cash
obligation, and distributed 1,304,340 shares of its
treasury stock with a value of $4.9 million. The Company
paid the remaining cash obligation of $0.4 million in
January of fiscal year 2004 and expects to distribute the
remaining stock obligation of 7,423,511 shares of its stock
during fiscal year 2004.



| |                                            
| | -------------------------------------------
| | Stock Repurchase and Put Option
    Program

On April 24, 2000, the Companys Board
of Directors authorized the Company to repurchase up to
$400 million of the Companys outstanding shares of
common stock. During fiscal year 2003 and fiscal year 2002, the
Company did not make any repurchases. During transition year
2001, the Company repurchased 953,201 shares for
approximately $8.4 million. During fiscal year 2003, the
Company distributed 1,304,340 shares of treasury stock as
part of an agreement to settle all outstanding shareholder
litigation in connection with the financial restatements for the
2001 fiscal and transition years. Approximately
$335.1 million of the original repurchase authorization had
not been used as of January 3, 2004. The Company has no
current plans to make additional repurchases of common shares.

The Company previously sold equity put options as
an enhancement to its share repurchase program. Each put option
entitled its holder to sell one share of the Companys
common stock to the Company at a specified price. During
transition year 2001, the Company received $0.1 million in
premiums from the sale of put options covering
150,000 shares of the Companys common stock and
recorded this amount as additional paid-in capital. The put
options outstanding at December 29, 2001 had an average
exercise price of $5.61 per share and a total contingent
redemption amount of approximately $0.8 million which was
recorded as temporary equity and a reduction to additional
paid-in capital. These options expired unexercised in fiscal
year 2002, and the Company recorded an increase of
$0.8 million to additional paid-in capital and an offset to
the contingent redemption liability.



| |                        
| | -----------------------
| | Stockholder Rights Plan

In April 2002, the Companys Board of
Directors adopted a stockholder rights plan pursuant to which
the Company issued one right for each share of common stock held
by stockholders of record on June 11, 2002. Under the plan,
each right initially represents the right, under certain
circumstances, to purchase 1/1,000 of a share of the
Companys Series F Preferred Stock, par value
$1.00 per share (the Series F Preferred
Stock), at an exercise price of $20 per share.
Initially the rights will not be exercisable and will trade with
the shares of the Companys common stock. Generally, if a
person or group acquires beneficial ownership of 15 percent
or more of the then outstanding shares of the Companys
common stock or announces a tender or exchange offer that would
result in such person or group owning 15 percent or more of
the Companys then outstanding common stock, each right
would entitle its holder (other than the holder or group which
acquired 15 percent or more of our common stock) to
purchase shares of the Companys common stock having a
market value of two times the exercise price of the right. The
Companys Board of Directors may redeem the rights at the
redemption price of $.01 per right, subject to adjustment,
at any time prior to the earlier of June 11, 2012, which is
the expiration date of the rights, or the date of distribution
of the rights, as determined under the plan.



| |                             
| | ----------------------------
| | Preferred Stock and Warrants



| |                                         
| | ----------------------------------------
| | Series A, B, D and E Preferred
    Stock

On August 29, 2000, the Company and its
operating subsidiaries, Riverstone, Enterasys Subsidiary,
Aprisma and GNTS (collectively, the Operating
Subsidiaries), issued securities and granted rights for
the purchase of additional securities to an investor group led
by Silver Lake Partners, L.P. (collectively,

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

the Strategic Investors). The Company
and its Operating Subsidiaries received approximately
$87.8 million in cash from the Strategic Investors. The
Company issued to the Strategic Investors 65,000 shares of
4% Series A Participating Convertible Preferred Stock
(A Preferred Stock), par value $1.00 per
share, and 25,000 shares of 4% Series B
Participating Convertible Preferred Stock
(B Preferred Stock), par value $1.00 per
share, (the A&B Preferred Stock) as well as
Class A and Class B warrants to purchase the
Companys common stock.

The Company allocated $68.0 million of the
proceeds to the A&B Preferred Stock. In addition, the
Company recorded an accretive dividend of $22.0 million
through February 23, 2003, using the interest method, as a
result of the difference between the $90.0 million
redemption value of the A&B Preferred Stock and the
$68.0 million ascribed value.

On July 12, 2001, the Company amended its
securities purchase agreement (the
SPA Amendment) with the Strategic Investors and
entered into an exchange agreement with the Strategic Investors
whereby the Strategic Investors exchanged their shares of
A Preferred Stock for an equal number of shares of the
Companys 4% Series D Participating Convertible
Preferred Stock (D Preferred Stock) and
exchanged their shares of B Preferred Stock for an equal
number of shares of the Companys 4% Series E
Participating Convertible Preferred Stock
(E Preferred Stock and together with the
D Preferred Stock, D&E Preferred
Stock).

In accordance with certain distribution rights
for the Series D&E Preferred Stock, the Company
distributed approximately 1,300,000 shares of Riverstone
common stock to the Strategic Investors in connection with the
Riverstone Spin-off on August 6, 2001. This distribution
resulted in a net increase to the Companys equity of
$18.6 million. These shares were restricted from transfer
and any permitted sales of these shares reduce the liquidation
preference and redemption value of the D&E Preferred
Stock.

The Company redeemed the D&E Preferred
Stock during the first quarter of fiscal year 2003 for
$96.8 million, which was net of the value of the Riverstone
shares sold by the holders of the D&E Preferred Stock,
which partially offset the redemption liability.



| |         
| | --------
| | Warrants

The Company issued to the Strategic Investors
warrants to purchase 250,000 shares of common stock at an
initial exercise price of $45.00 per share, adjusted for
stock dividends, splits, combinations or similar events (the
Class A Warrants). In connection with the
Riverstone spin-off, the exercise price of these warrants was
adjusted to $28.424 per share. The Class A Warrants
are exercisable until August 2007 and otherwise contain
customary terms and conditions (including provisions with
respect to cashless exercise and customary
anti-dilutive provisions). In fiscal year 2003, approximately
228,000 of these warrants were cancelled.

The Company issued to the Strategic Investors
warrants to purchase 200,000 shares of common stock at an
initial exercise price of $35.00 per share, adjusted for
stock dividends, splits, combinations or similar events (the
Class B Warrants). In connection with the
Riverstone spin-off, the exercise price of these warrants was
adjusted to $22.108 per share. The Class B Warrants
are exercisable until August 2007 and otherwise contain
customary terms and conditions (including provisions with
respect to cashless exercise and customary
anti-dilutive provisions). In fiscal year 2003, approximately
183,000 of these warrants were cancelled.

In connection with the SPA Amendment, the
Company and the Strategic Investors agreed that the distribution
of the Companys shares of Riverstone common stock would be
deemed to have occurred prior to the merger of Enterasys
Subsidiary into the Company and, pursuant to the terms of the
SPA Amendment and as a consequence of the merger of
Enterasys Subsidiary into the Company, that the Company would
issue warrants to purchase an additional 7,400,000 shares
of its common stock for an

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

exercise price of $6.20 per share (the
Replacement Warrants) in replacement of all of the
Strategic Investors rights to purchase common stock of the
Enterasys Subsidiary. The Replacement Warrants are exercisable
until August 29, 2004, and other than the number of shares
subject to the warrants and the exercise price of the warrants,
the terms of these warrants are substantially the same as the
terms of the Class A Warrants and Class B Warrants.
All of the Replacement Warrants were outstanding at
January 3, 2004.



| |                         
| | ------------------------
| | Series C Preferred Stock

As part of the acquisition of Indus River,
completed on January 31, 2001, the Company issued
45,471 shares of Series C Preferred Stock
(C Preferred Stock) and options and warrants to
purchase 5,293 shares of C Preferred Stock. The merger
of Enterasys Subsidiary into the Company on August 6, 2001
represented an Enterasys Spin-off for purposes of
the C Preferred Stock. In accordance with the
C Preferred Stock conversion provisions, upon the merger
all outstanding shares of the C Preferred Stock and related
options and warrants converted into approximately
955,000 shares of the Companys common stock.



| |                         
| | ------------------------
| | Series F Preferred Stock

In connection with the stockholder rights plan,
the Company is authorized to issue up to 300,000 shares of
Series F Preferred Stock. The number of shares of
Series F Preferred Stock may be increased or decreased by
the Companys Board of Directors by a duly adopted
resolution of the Board. As of January 3, 2004, no shares
of Series F Preferred Stock were outstanding.

The terms of the Series F Preferred Stock
are as follows:

Voting

Each share of Series F Preferred Stock
entitles the holder to 1,000 votes on all matters submitted
to a vote of the stockholders of the Company. The holders of the
shares of Series F Preferred Stock and the holders of the
common stock shall vote together on all matters submitted to a
vote of stockholders, except as required by applicable law.

Seniority

The Series F Preferred Stock shall rank
equal to all other series of preferred stock of the Company as
to dividends and/or preference upon liquidation, dissolution or
winding up, unless otherwise resolved by the Board of Directors
in any vote establishing any other series of preferred stock.

Dividends

Beginning on the last day of the first March,
June, September or December after the issuance of shares of
Series F Preferred Stock, the holders of shares of
Series F Preferred Stock shall be entitled to receive a
quarterly dividend equal to the greater of (a) $1.00 per
share or (b) 1,000 times the aggregate per share amount of
all cash dividends and all non-cash dividends or other
distributions other than a dividend payable in shares of common
stock. In the event no dividend or distribution shall have been
declared on the common stock during any quarterly period in
which shares of Series F Preferred Stock are outstanding, a
dividend of $1.00 per share shall accrue and be cumulative.
Accrued but unpaid dividends do not bear interest.

Whenever quarterly dividends or other dividends
or distributions payable on the Series F Preferred Stock
are in arrears, the Company may not, in addition to certain
other similar restrictions, declare or pay

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

dividends on, make any other distributions on, or
redeem any shares of common stock or any other series of
preferred stock ranking junior to the Series F Preferred
Stock.

Liquidation
Preference

The Series F Preferred Stock has a
liquidation preference equal to the sum of $1,000 per share plus
an amount equal to all accrued and unpaid dividends and
distributions thereon, whether or not declared.



| |           
| | ----------
| | Redemption

Outstanding shares of Series F Preferred
Stock may be purchased by the Company at such times and on such
terms as the redeeming stockholder and the Company may agree,
subject to any limitations imposed by law or the Companys
charter. Promptly after such shares are reacquired by the
Company they shall be retired and canceled and shall become
authorized but unissued shares of the Companys
Undesignated Preferred Stock (defined below).



| |                             
| | ----------------------------
| | Undesignated Preferred Stock

At January 3, 2004, the Company was
authorized to issue up to 1,700,000 shares of preferred
stock (the Undesignated Preferred Stock). Issuances
of the Undesignated Preferred Stock may be made at the
discretion of the Board of Directors of the Company (without
stockholder approval) with designations, rights and preferences
as the Board of Directors may determine from time to time, which
may be more expansive than the rights of the current holders of
the Companys preferred stock and common stock.



|    |            
|--- | -----------
|19. | Stock Plans

Equity
Incentive Plans

The Companys 1998 Equity Incentive Plan, as
amended, was approved by the stockholders of the Company on
July 9, 1998 and provides for the availability of
19,500,000 shares of common stock for the granting of
various incentive awards to eligible employees. Options granted
under the plan are granted with exercise prices equal to the
fair market value on the date of grant, generally expire ten
years from the date of grant and vest as to 25 percent of
the shares one year from the date of grant with monthly vesting
of the remainder ratably over the following three years. As of
January 3, 2004, 3,709,752 shares remained available
for issuance under the 1998 Equity Incentive Plan and options to
purchase 12,617,182 shares were outstanding under the plan.

The Companys 2001 Equity Incentive Plan was
adopted by the Board of Directors of the Company on
July 30, 2001 and provided for the availability of
50,000,000 shares of common stock solely for the purpose of
granting options to purchase shares of the Companys common
stock (Replacement Options) to replace options to
purchase shares of the Enterasys Subsidiary (Prior
Options) in connection with the merger of the Enterasys
Subsidiary into the Company on August 6, 2001. Replacement
Options were granted to replace Prior Options held on the basis
of 1.39105 shares of the Companys common stock for
each share of common stock subject to the original Enterasys
Subsidiary options. The exercise price of each Replacement
Option is equal to the exercise price of the Prior Option
divided by 1.39105 to reflect the effect of the merger. The 2001
Equity Incentive Plan was not required to be, and has not been,
approved by the Companys stockholders. No additional
options may be granted under the 2001 Equity Incentive Plan and
as of January 3, 2004 options to purchase
14,309,748 shares were outstanding under the plan.

The Companys 2002 Stock Option Plan for
Eligible Executives was adopted by the Board of Directors on
April 5, 2002 and provides for the availability of
900,000 shares of common stock solely for the purpose of
granting options in connection with the acceptance by certain
executives of offers of

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

employment with the Company. The options vest
over a period of twelve months, or sooner if certain performance
targets outlined in the plan are met, and expire ten years from
the date of grant. No additional options may be granted under
the 2002 Stock Options Plan for Eligible Executives and options
to purchase 500,000 shares were outstanding under the 2002
Stock Option Plan for Eligible Executives at January 3,
2004.

A summary of option transactions under the
Companys Equity Incentive Plans for the three years ended
January 3, 2004 is as follows:

|                                         |                              |           |            |                |   |   |       |       | 
|---------------------------------------- | ---------------------------- | --------- | ---------- | -------------- | - | - | ----- | ----- | 
|                                         |                              |           |            | Weighted-     
|                                         |                              | Number of |            | Average       
|                                         |                              | Options   |            | Exercise Price
|                                         |                              |           |            |               
|Options outstanding at March 3, 2001     |                              |           | 11,767,580 |                |   | $ | 11.66 |      
|                                         | Granted                      |           |            | 1,042,299      |   |   |       | 13.86 | 
|                                         | Converted subsidiary options |           |            | 41,568,878     |   |   |       | 3.47  | 
|                                         | Exercised                    |           |            | (10,477,337    | ) |   |       | 4.62  | 
|                                         | Cancelled                    |           |            | (8,173,832     | ) |   |       | 9.83  | 
|                                         |                              |           |            |                |   |   |       |      
|Options outstanding at December 29, 2001 |                              |           | 35,727,588 |                |   |   | 3.91  |      
|                                         | Granted                      |           |            | 8,075,121      |   |   |       | 1.21  | 
|                                         | Exercised                    |           |            | (1,333,995     | ) |   |       | 2.88  | 
|                                         | Cancelled                    |           |            | (13,444,802    | ) |   |       | 3.98  | 
|                                         |                              |           |            |                |   |   |       |      
|Options outstanding at December 28, 2002 |                              |           | 29,023,912 |                |   |   | 3.18  |      
|                                         | Granted                      |           |            | 8,259,260      |   |   |       | 3.71  | 
|                                         | Exercised                    |           |            | (4,693,445     | ) |   |       | 2.34  | 
|                                         | Cancelled                    |           |            | (5,162,797     | ) |   |       | 4.13  | 
|                                         |                              |           |            |                |   |   |       |      
|Options outstanding at January 3, 2004   |                              |           | 27,426,930 |                |   | $ | 3.32  |      
|                                         |                              |           |            |                |   |   |       |      

|                                |  |                 |            |                   |  |                   |            |  |  |   |            | 
|------------------------------- |  | --------------- | ---------- | ----------------- |  | ----------------- | ---------- |  |  | - | ---------- | 
|                                |  | January 3, 2004 |            | December 28, 2002 |  | December 29, 2001
|                                |  |                 |            |                   |  |                  
|Options exercisable             |  |                 | 14,949,071 |                   |  |                   | 13,245,695 |  |  |   | 11,867,978 | 
|Weighted average exercise price |  | $               | 3.30       |                   |  | $                 | 3.60       |  |  | $ | 3.34       | 

The following table summarizes information
concerning outstanding and exercisable options as of
January 3, 2004:

|                |               |             |  |                  |            |                  |  |             |      |                  |  |   |       |  |  |  |            |  |  |   |       | 
|--------------- | ------------- | ----------- |  | ---------------- | ---------- | ---------------- |  | ----------- | ---- | ---------------- |  | - | ----- |  |  |  | ---------- |  |  | - | ----- | 
|                |               |             |  | Weighted Average |            |                  |  |             |      |                 
|Range of        |               | Options     |  | Remaining        |            | Weighted Average |  | Options     |      | Weighted Average
|Exercise Prices |               | Outstanding |  | Years Life       |            | Exercise Price   |  | Exercisable |      | Exercise Price  
|                |               |             |  |                  |            |                  |  |             |      |                 
|                | $ 0.90-$ 1.12 |             |  |                  | 3,620,364  |                  |  |             | 8.46 |                  |  | $ | 1.03  |  |  |  | 1,257,862  |  |  | $ | 1.03  | 
|                | $ 1.30-$ 2.40 |             |  |                  | 3,296,224  |                  |  |             | 9.05 |                  |  | $ | 1.86  |  |  |  | 662,705    |  |  | $ | 1.42  | 
|                | $ 2.41-$ 2.52 |             |  |                  | 10,237,932 |                  |  |             | 6.37 |                  |  | $ | 2.52  |  |  |  | 9,490,246  |  |  | $ | 2.52  | 
|                | $ 2.55-$ 3.59 |             |  |                  | 3,148,095  |                  |  |             | 7.45 |                  |  | $ | 3.33  |  |  |  | 1,855,930  |  |  | $ | 3.41  | 
|                | $ 3.87-$ 4.99 |             |  |                  | 4,851,674  |                  |  |             | 9.56 |                  |  | $ | 4.69  |  |  |  | 153,967    |  |  | $ | 4.47  | 
|                | $ 5.00-$ 8.88 |             |  |                  | 1,147,883  |                  |  |             | 7.65 |                  |  | $ | 6.19  |  |  |  | 655,952    |  |  | $ | 6.35  | 
|                | $ 9.06-$13.63 |             |  |                  | 746,502    |                  |  |             | 7.54 |                  |  | $ | 11.55 |  |  |  | 516,514    |  |  | $ | 11.69 | 
|                | $15.56-$24.31 |             |  |                  | 378,256    |                  |  |             | 6.01 |                  |  | $ | 16.64 |  |  |  | 355,895    |  |  | $ | 16.64 | 
|                |               |             |  |                  |            |                  |  |             |      |                  |  |   |       |  |  |  |            |  |  |   |       | 
|                |               |             |  |                  | 27,426,930 |                  |  |             | 7.74 |                  |  | $ | 3.32  |  |  |  | 14,949,071 |  |  | $ | 3.30  | 
|                |               |             |  |                  |            |                  |  |             |      |                  |  |   |       |  |  |  |            |  |  |   |       | 

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



| |                              
| | -----------------------------
| | Employee Stock Purchase Plans

In October 2002 the Board approved the Employee
Stock Purchase Plan (the 2002 ESPP) which was
approved by the stockholders in December 2002. It provides for
the availability of 5,000,000 shares of common stock to be
purchased by employees. Under this plan, eligible employees,
twice yearly through the accumulation of employee payroll
deductions from 2 to 10 percent of employee compensation as
defined in the plan (up to a maximum of $12,500 per six-month
plan period), may purchase stock at 85 percent of the fair
market value of the common stock at the beginning or end of the
applicable six-month period, whichever amount is lower. The
maximum number of shares that an employee may purchase during a
six-month plan period is limited to 1,200 shares. At
January 3, 2004, 423,776 shares had been issued under
the plan.

Prior to the adoption of the 2002 ESPP, the
Company had two Employee Stock Purchase Plans, the
1989 ESPP and the 1995 ESPP
which provided for the combined availability of up to
6,000,000 shares of common stock to be purchased by
employees. Under these plans, eligible employees twice yearly
through the accumulation of employee payroll deductions from 2
to 10 percent of employee compensation as defined in the
plan, up to a maximum of $25,000 annually (measured by reference
to share values at the dates of grant of the Purchase rights),
were able to purchase stock at 85 percent of the fair
market value of the common stock at the beginning or end of the
applicable six-month period, whichever amount was lower. In
fiscal year 2002, 665,189 shares were purchased at a price
of $1.23 per share. The Companys employees purchased
778,752 shares at a weighted-average purchase price of
$9.71 during transition year 2001; and 906,000 shares at a
weighted-average purchase price of $14.85 during fiscal year
2001. The remaining number of shares available for purchase by
employees under these plans at December 28, 2002 was
747,064 shares. These shares were purchased by employees in
February 2003. After that date, no further shares remained
available for purchase under the 1989 ESPP and the
1995 ESPP.

Stock-Based
Compensation

The Company incurred stock-based compensation as
a result of certain transactions during fiscal year 2001 and
transition year 2001. The total amount of compensation recorded,
and the charges to earnings for the respective fiscal years were
as follows:

|                                                  |                                                   |              |        |                                                       |  |              |     |              |  |          |       |   |  |   |        |         |   |   |       |        |  
|------------------------------------------------- | ------------------------------------------------- | ------------ | ------ | ----------------------------------------------------- |  | ------------ | --- | ------------ |  | -------- | ----- | - |  | - | ------ | ------- | - | - | ----- | ------ | -
|                                                  |                                                   |              |        |                                                      
|                                                  |                                                   | Unearned     |        | Stock-Based Compensation for the Fiscal Periods Ended
|                                                  |                                                   | Based        |        |                                                      
|                                                  |                                                   | Compensation |        | January 3,                                            |  | December 28, |     | December 29, |  | March 3,
|                                                  |                                                   | Recorded     |        | 2004                                                  |  | 2002         |     | 2001         |  | 2001    
|                                                  |                                                   |              |        |                                                       |  |              |     |              |  |         
|Acceleration of employee stock option(1)          |                                                   | $            | 42,274 |                                                       |  | $            |    |              |  | $        |      |   |  | $ | 42,274 |         |   | $ |      |       
|Options issued in connection with acquisitions(2) |                                                   |              | 8,454  |                                                       |  |              | 158 |              |  |          | 2,644 |   |  |   | 4,210  |         |   |   | 1,442 |       
|Riverstone stock option grants(3)                 |                                                   |              | 11,099 |                                                       |  |              |    |              |  |          |      |   |  |   | 639    |         |   |   | 1,438 |       
|Riverstone spinoff(3)                             |                                                   |              | (9,022 | )                                                     |  |              |    |              |  |          |      |   |  |   |       |         |   |   |      |       
|                                                  |                                                   |              |        |                                                       |  |              |     |              |  |          |       |   |  |   |        |         |   |   |       |       
|                                                  |                                                   |              | 52,805 |                                                       |  |              | 158 |              |  |          | 2,644 |   |  |   | 47,123 |         |   |   | 2,880 |       
|                                                  | Less: Amounts included in discontinued operations |              |        |                                                      |  |              |     |             |  |          |       |  |  |   |        | (16,551 | ) |   |       | (1,438 | )
|                                                  |                                                   |              |        |                                                       |  |              |     |              |  |          |       |   |  |   |        |         |   |   |       |       
|Total Stock-based Compensation                    |                                                   | $            | 52,805 |                                                       |  | $            | 158 |              |  | $        | 2,644 |   |  | $ | 30,572 |         |   | $ | 1,442 |       
|                                                  |                                                   |              |        |                                                       |  |              |     |              |  |          |       |   |  |   |        |         |   |   |       |       

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In connection with the transformation events of
    August 6, 2001, vesting was accelerated on approximately
    8.0 million options granted to three officers of the
    Company and certain other employees resulting in stock-based
    compensation charges of approximately $17.8 million for
    transition year 2001, of which $15.9 million relates to
    discontinued operations. Additionally, options to purchase
    common stock of Cabletron that was held by an employee (other
    than the employees of Aprisma and certain other individuals)
    that would have vested after February 28, 2002, were
    cancelled and the portion of the option that was scheduled to
    vest prior to that date was accelerated. The acceleration of
    Cabletron options resulted in stock-based compensation charges
    of $24.5 million in transition year 2001.        
|   
|(2) | In connection with the acquisition of Indus River
    in fiscal year 2001, the Company issued stock options to
    employees in respect of unvested stock options resulting in
    stock-based compensation of $3.0 million which was
    recognized over the vesting period as follows: $0.2 million
    in fiscal year 2003, $0.8 million in fiscal year 2002,
    $1.9 million in transition year 2001 and $0.1 million
    in fiscal year 2001. In connection with the acquisition of
    Network Security Wizards (NSW) in fiscal year 2001,
    the Company issued 157,714 shares of common stock to
    certain employees of NSW resulting in stock-based compensation
    of $5.5 million which was recognized over the service
    period as follows: $1.8 million in fiscal year 2002,
    $2.3 million in transition year 2001 and $1.4 million
    in fiscal year 2001.
|   
|(3) | In connection with certain Riverstone subsidiary
    stock option grants to employees, the Company recorded
    approximately $11.1 million of unearned stock-based
    compensation for the excess of the deemed fair market value over
    the exercise price at date of grant during fiscal year 2001. The
    stock-based compensation was recognized over the vesting period
    as follows: $0.7 million for transition year 2001 and
    $1.4 million for fiscal year 2001. These charges for
    stock-based compensation were included in discontinued
    operations for each respective fiscal period. The remaining
    unearned stock-based compensation of $9.0 million was
    assumed by Riverstone as a result of the transformation events
    of August 6, 2001.                                                                                                  



|    |                              
|--- | -----------------------------
|20. | Commitments and Contingencies



| |                                      
| | -------------------------------------
| | Shareholder Litigation
    Settlement

In October 2003, the Company reached agreements
to settle the various outstanding shareholder litigation against
the Company, and certain of its former directors and officers
filed in connection with the financial restatements for the 2001
fiscal and transition years. Under the financial terms of the
settlements, the Company agreed to pay $17.4 million in
cash of which $17.0 million was paid in December 2003, and
to distribute 8,727,851 shares of its stock with a
settlement date value of $33.0 million. The Company also
received approximately $34.5 million in cash proceeds from
certain of its insurers in the fourth quarter of fiscal year
2003. As a result, the Company recorded a net shareholder
litigation charge of $15.9 million in the third quarter of
fiscal year 2003 for the net settlement. The Company is
currently engaged in legal proceedings against certain other
insurers to recover a portion of the remaining expenses incurred
by it in connection with the shareholder litigation and other
related matters.



| |                  
| | -----------------
| | Legal Proceedings

In the normal course of the Companys
business, it is subject to proceedings, litigation and other
claims. Litigation in general, and securities and intellectual
property litigation in particular, can be expensive and
disruptive to normal business operations. Moreover, the results
of litigation are difficult to predict. The uncertainty
associated with these and other unresolved or threatened legal
actions could adversely affect the Companys relationships
with existing customers and impair the Companys ability to
attract new customers. In addition, the defense of these actions
may result in the diversion of

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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

managements resources from the operation of
the Companys business, which could impede the
Companys ability to achieve the Companys business
objectives. The unfavorable resolution of any specific action
could materially harm the Companys business, operating
results and financial condition, and could cause the price of
the Companys common stock to decline significantly.

Described below are the material legal
proceedings in which the Company is involved:

Securities Class Action in the District
of Rhode Island.Between
October 24, 1997 and March 2, 1998, nine shareholder
class action lawsuits were filed against the Company and certain
of its officers and directors in the United States District
Court for the District of New Hampshire. By order dated
March 3, 1998, these lawsuits, which are similar in
material respects, were consolidated into one class action
lawsuit, captioned In re Cabletron Systems, Inc. Securities
Litigation (C.A. No. 97-542-SD).The case was
transferred to the District of Rhode Island. The complaint
alleges that the Company and several of its officers and
directors disseminated materially false and misleading
information about the Companys operations and acted in
violation of Section 10(b) of the Exchange Act and
Rule 10b-5 thereunder during the period between
March 3, 1997 and December 2, 1997. The complaint
further alleges that certain officers and directors profited
from the dissemination of such misleading information by selling
shares of the Companys common stock during this period.
The complaint does not specify the amount of damages sought on
behalf of the class. The defendants have filed an answer denying
the allegations in all material respects, and the parties are
engaged in limited discovery. If the plaintiffs prevail on the
merits of this case, the Company could be required to pay
substantial damages.

Securities Class Action in the District
of New Hampshire.Between
February 7, 2002 and April 9, 2002, six class action
lawsuits were filed in the United States District Court for the
District of New Hampshire. Defendants were the Company, former
chairman and chief executive officer Enrique Fiallo and former
chief financial officer Robert Gagalis. By orders dated
August 2, 2002 and September 25, 2002, these lawsuits,
which are similar in material respects were consolidated into
one class action lawsuit, captioned In re Enterasys Networks,
Inc. Securities Litigation (C.A. No. 02-CV-71).On
December 9, 2002, the plaintiffs filed an amended
consolidated complaint, adding two additional defendants, Piyush
Patel, former chief executive officer of Cabletron Systems, Inc.
(Cabletron) and David Kirkpatrick, former chief
financial officer of Cabletron. The amended complaint alleged
violations of Sections 10(b) and 20(a) of the Exchange Act
and Rule 10b-5 thereunder. Specifically, plaintiffs alleged
that during periods spanning from June 28, 2000 and
August 3, 2001 and in the period between August 6,
2001 and February 1, 2002 (together the Class
Period), defendants issued materially false and misleading
financial statements and press releases that overstated the
Companys revenues, income, and cash, and understated the
Companys net losses, in violation of Generally Accepted
Accounting Principles (GAAP) and the Companys
own accounting policies in connection with various sales and/or
investment transactions. On December 19, 2003, the court
granted final approval of the terms of the settlement reached by
the parties in this matter under which, without admitting
liability, the Company agreed to pay approximately
$17.0 million in cash, to distribute shares of common stock
with a settlement date value of $33.0 million, and to adopt
corporate governance changes.

Shareholder Derivative Action in State of New
Hampshire.On February 22, 2002,
a shareholder derivative action was filed on the Companys
behalf in the Superior Court of Rockingham County, State of New
Hampshire. The suit was captioned Nemes v. Fiallo,
et al. Individual defendants were former chairman and
chief executive officer Enrique Fiallo and certain members of
the Companys Board of Directors. Plaintiffs alleged that
the individual defendants breached their fiduciary duty to
shareholders by causing or allowing the Company to conduct its
business in an unsafe, imprudent, and unlawful manner and
failing to implement and maintain an adequate internal
accounting control system. Plaintiffs alleged that this breach
caused the Company to improperly recognize revenue in violation
of GAAP and the Companys own accounting policies in
connection with transactions in the Companys Asia Pacific
region,

F-37



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ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

and that this alleged wrongdoing resulted in
damages to the Company. On December 18, 2003, the court
granted final approval of the terms of the settlement reached by
the parties in this matter under which, without admitting
liability, the Company agreed to adopt corporate governance
changes and pay attorneys fees up to $0.4 million.

Shareholder Derivative Action in State of
Delaware.On April 16, 2002, a
shareholder derivative action was filed on the Companys
behalf in the Court of Chancery of the State of Delaware in and
for New Castle County. The suit was captioned Meisner v.
Enterasys Networks, Inc., et al. Individual
defendants were former chairman and chief executive officer
Enrique Fiallo and members of the Companys Board of
Directors. Plaintiffs alleged that the individual defendants
permitted wrongful business practices to occur which had the
effect of manipulating revenues and earnings, inadequately
supervised the Companys employees and managers, and failed
to institute legal actions against those officers, directors and
employees responsible for the alleged conduct. The complaint
alleged counts for breach of fiduciary duty, misappropriation of
confidential information for personal profit, and contribution
and indemnification. The parties settled this action in
connection with the settlement of the New Hampshire derivative
action. On January 15, 2004, the court granted final
approval of the terms of the settlement.

Other.In addition,
the Company is involved in various other legal proceedings and
claims arising in the ordinary course of business. Management
believes that the disposition of these additional matters,
individually or in the aggregate, is not expected to have a
materially adverse effect on the financial condition of the
Company. However, depending on the amount and timing of such
disposition, an unfavorable resolution of some or all of these
matters could materially affect the Companys future
results of operations or cash flows in a particular period.

Other
Commitments and Contingencies

The Company leases office facilities under
non-cancelable operating leases expiring through the year 2018.
Some of the leases provide for rent increases based on the
consumer price index and increases in real estate taxes. Rent
expense associated with operating leases was $14.3 million,
$14.5 million and $12.7 million, for fiscal years 2003
and 2002 and transition year 2001, respectively. Total future
minimum lease payments under all non-cancelable operating leases
that the Company has initial or remaining non-cancelable lease
terms in excess of one year at January 3, 2004 were
$12.6 million, $9.9 million, $7.8 million,
$5.6 million, $2.8 million and $7.1 million for
fiscal years 2004, 2005, 2006, 2007, 2008 and for all years
thereafter, respectively.

In some instances prior to fiscal year 2002,
customers of the Company received financing for the purchase of
equipment from third party leasing organizations and the Company
guaranteed the payments of those customers. Most of these
guarantees related to the sale of Riverstone equipment. During
fiscal year 2003, fiscal year 2002 and transition year 2001, the
Company made payments of $3.7 million, $5.1 million
and $28.8 million, respectively, related to these
guarantees. During fiscal year 2003, the Company entered into a
$5.5 million settlement agreement with a Riverstone
customer for reimbursement of lease guarantee payments made by
the Company related to default guarantees of the customers
equipment lease obligations provided in prior years. The Company
recorded the initial receipt of $2.0 million, in fiscal
year 2003, as a reduction to selling, general and administrative
expense in fiscal year 2003, and the balance of
$3.5 million will be paid in 24 installments and
recorded as a reduction to operating expense when received. At
January 3, 2004, the balance remaining to be received is
$2.8 million.

In addition, the Company has guaranteed a portion
of a former subsidiarys (Aprisma) lease obligations and
related maintenance and management fees through 2012. At
January 3, 2004, the amount of the guarantee was
$4.0 million and automatically reduces to $3.0 million
on February 1, 2009, to $2.0 million on
February 1, 2010 and to $1.0 million on
February 1, 2011 and terminates on February 1, 2012.
The Company estimates the fair value of the guarantee to be
between $2.0 million and $4.0 million

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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

based on current market rates for similar
property. The Company is indemnified for up to $3.5 million
in losses it may incur in connection with this guarantee. The
Company has pledged $4.8 million to secure this guarantee.

The Company could be required to make up to
$12.0 million of additional capital contributions to
private venture funds in which it is already an investor. If the
Company fails to make a required contribution, its remaining
capital contribution obligations could be accelerated. The
Company is currently considering selling its interests in
several private venture funds, which would eliminate future
capital call obligations.

At January 3, 2004, the Company had
non-cancelable purchase commitments of approximately
$12.8 million with its contract manufacturers.
Approximately $6.4 million of the non-cancelable purchase
commitments were with Flextronics and $3.8 million with
Accton.



|    |            
|--- | -----------
|21. | 401(K) Plan

The Companys eligible employees may
participate in the Enterasys Networks, Inc.
401(k) Plan (the 401(k) Plan) which
provides retirement benefits to the eligible employees of
participating employers. As allowed under Section 401(k) of
the Internal Revenue Code, the 401(k) Plan provides
tax-deferred salary deductions for eligible employees.
Participants may elect to contribute from 1% to 18% of their
annual compensation to the 401(k) Plan each year, limited
to a maximum annual amount as set periodically by the Internal
Revenue Service. In addition, unless determined otherwise by the
Companys Board of Directors, the 401(k) Plan provides
for a basic matching contribution each quarter on behalf of each
eligible participant equal to the lesser of $250 or 50% of the
participants elective contributions for the quarter. The
401(k) Plan also provides for a quarterly supplemental
matching contribution equal to the lesser of $250 or 50% of the
participants elective contributions if the Companys
performance meets a specified threshold. The 401(k) Plan
also provides for make-up matching contributions to address
specified circumstances where fluctuations in a
participants level of deferrals result in lower basic or
supplemental matching contributions than would be the case with
a level rate of deferrals. Employees become vested in the
matching contributions on their initial date of hire. The
Companys expenses related to matching contributions to the
401(k) Plan for fiscal year 2003, fiscal year 2002 and
transition year 2001 were approximately $0.6 million,
$0.8 million, $0.9 million, respectively.



|    |                           
|--- | --------------------------
|22. | Related Party Transactions

Investments

The Company has minority investments in debt and
equity securities of certain companies. The Company does not
have a controlling interest in these entities. In certain
instances during transition year 2001, the Company recognized
revenue in connection with investments where it received equity
instruments in exchange for products sold. Revenue recognized
from sales to investee companies were cash transactions with
normal terms and conditions. Revenue recognized from investee
transactions was as follows:

|                                                        |                                                         |                 |       |                   |  |                   |       |       |  |   |        |        | 
|------------------------------------------------------- | ------------------------------------------------------- | --------------- | ----- | ----------------- |  | ----------------- | ----- | ----- |  | - | ------ | ------ | 
|                                                        |                                                         | Year Ended      |       | Year Ended        |  | Ten Months Ended 
|                                                        |                                                         | January 3, 2004 |       | December 28, 2002 |  | December 29, 2001
|                                                        |                                                         |                 |       |                   |  |                  
|                                                        |                                                         |                
|                                                        |                                                         | (In thousands) 
|Revenue recognized in connection with investments       |                                                         | $               |      |                   |  | $                 |      |       |  | $ | 6,988  |       
|Revenue recognized from sales to investee
    companies |                                                         |                 | 7,541 |                   |  |                   | 9,217 |       |  |   | 40,196 |       
|                                                        |                                                         |                 |       |                   |  |                   |       |       |  |   |        |       
|                                                        | Total revenue recognized from investee
    transactions |                 | $     | 7,541             |  |                   | $     | 9,217 |  |   | $      | 47,184 | 
|                                                        |                                                         |                 |       |                   |  |                   |       |       |  |   |        |       

F-39



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

Severance

In connection with the merger of the Enterasys
Subsidiary into the Company on August 6, 2001, senior
Cabletron management resigned their executive positions, and the
Company made lump-sum severance payments to them of
approximately $2.4 million.

In connection with the resignations of senior
Enterasys management in April 2002, the Company agreed to make
$1.0 million of severance payments over the twelve-month
period beginning in April 2002. In addition, one senior
executive received a lump sum payment of $0.2 million
during fiscal year 2002. In connection with the resignation of a
senior Enterasys executive in November 2002, the Company agreed
to make $0.3 million of severance payments over the
twelve-month period beginning in November 2002.

In connection with certain resignations of senior
management, the Company paid lump sum severance payments
totaling $0.8 million during fiscal year 2003.

Consulting
Arrangements

In connection with the senior management
resignations in September 2001, the Company entered into
consulting arrangements with two former members of senior
Cabletron management to provide strategic advice and assistance
to the Company for a period of one year. The Company paid
consulting fees of $0.2 million in both fiscal year 2002
and transition year 2001. These arrangements ended in September
2002.

Indebtedness

On April 12, 2000, the Company entered into
a promissory note with Mr. Romulus Pereira, the President
and Chief Executive Officer of Riverstone in the amount of
$0.4 million to be applied to the payment of certain taxes
owed by Mr. Pereira with respect to the Companys
shares that he received in connection with the Companys
acquisition of Yago Systems, Inc. The note with interest at the
rate of 6.46% per annum was forgiven in April 2002.

On August 23, 1999, the Company entered into
an interest-free promissory note with Mr. Enrique Fiallo,
former Chief Executive Officer of the Company, in the amount of
$0.1 million. The outstanding principal balance on the note
of $0.1 million was forgiven by the Company in connection
with Mr. Fiallos resignation and termination of
employment in April 2002.

On January 1, 2000, the Company entered into
interest-free promissory notes with each of Messrs. Fiallo
and Eric Jaeger, former Executive Vice-President of the Company,
each for the principal amount of $0.1 million. The Company
entered into a similar promissory note with Mr. David
Kirkpatrick, former Chief Financial Officer and Chief Operating
Officer of the Company, on June 15, 2000. Pursuant to the
terms of the notes, the Company forgave 25% of the original
principal balance of the notes on January 1, 2001 for
Messrs. Fiallo and Jaeger and on February 28, 2001 for
Mr. Kirkpatrick. In connection with the merger of the
Enterasys Subsidiary into the Company, on August 6, 2001,
the Company forgave the remaining original principal balance of
the notes of $0.1 million issued by each of
Messrs. Fiallo, Jaeger and Kirkpatrick.

On April 12, 2000, the Company entered into
a promissory note with Mr. Piyush Patel, former Chief
Executive Officer and President of the Company, in the principal
amount of $0.4 million bearing interest at a rate of 6.46%
per year. The proceeds of the note were to be applied to the
payment of taxes owed by Mr. Patel relating to the shares
of the Company he received in connection with the Companys
acquisition of Yago Systems in 1998. On August 6, 2001, the
Company forgave the outstanding principal and all accrued
interest on the note of $0.4 million.

F-40



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

On June 1, 2000, the Company entered into a
promissory note with Mr. Kirkpatrick for the principal
amount of $0.2 million bearing interest at a rate of 8% per
year. The outstanding principal balance and all accrued interest
on the note of $0.2 million was forgiven by the Company in
connection with Mr. Kirkpatricks resignation and
termination of employment in April 2002.

On September 6, 2001, the Company entered
into an interest-free promissory note with Mr. James
Riddle, former Executive Vice-President of the Company, for the
principal amount of $0.1 million. The outstanding principal
balance on the note of $0.1 million was forgiven by the
Company in connection with Mr. Riddles resignation
and termination of employment in April 2002.



| |                             
| | ----------------------------
| | Transactions with Riverstone

On February 16, 2001, Riverstone completed
its initial public offering. Prior to the offering, Riverstone
was a wholly owned subsidiary of the Company. The Company
continued to own approximately 85 percent of Riverstone
subsequent to the initial public offering until August 6,
2001, when the Company distributed its shares of Riverstone
common stock to its stockholders.

The Company and Riverstone are parties to a tax
sharing agreement, whereby each entity, for the period of their
parent-subsidiary ownership, will reimburse or seek
reimbursement from the other for the tax consequences for
incremental income or expenses resulting from the filing of
amended tax returns. Additionally, the Company and Riverstone
are parties to an Asset Contribution Agreement pursuant to which
Riverstone is obligated to assume and satisfy liabilities of the
Company relating primarily to the business or assets of
Riverstone, to the extent that such obligations were not
previously assumed by Riverstone. As of August 6, 2001,
Riverstone discontinued the use of corporate and other
infrastructure services that the Company had previously provided
in accordance with a transitional services agreement.



|    |                                     
|--- | ------------------------------------
|23. | Quarterly Financial Data (Unaudited)

|                                                                     |  |                                          |         |                |  |               |         |                |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------- |  | ---------------------------------------- | ------- | -------------- |  | ------------- | ------- | -------------- |  | - | ------- | - |  | - | ------- | -
|                                                                     |  |                                         
|                                                                     |  | Year Ended January 3, 2004              
|                                                                     |  |                                         
|                                                                     |  | First Quarter                            |         | Second Quarter |  | Third Quarter |         | Fourth Quarter
|                                                                     |  | Ended                                    |         | Ended          |  | Ended         |         | Ended         
|                                                                     |  | March 29,                                |         | June 28,       |  | September 27, |         | January 3,    
|                                                                     |  | 2003                                     |         | 2003           |  | 2003          |         | 2004          
|                                                                     |  |                                          |         |                |  |               |         |               
|                                                                     |  |                                         
|                                                                     |  | (In thousands, except per share amounts)
|Net revenue                                                          |  | $                                        | 104,457 |                |  | $             | 108,375 |                |  | $ | 98,417  |   |  | $ | 103,289 |  
|Gross margin(1)                                                      |  | $                                        | 52,950  |                |  | $             | 54,538  |                |  | $ | 43,036  |   |  | $ | 57,851  |  
|Loss from continuing operations available to
    common shareholders |  | $                                        | (12,293 | )              |  | $             | (35,373 | )              |  | $ | (56,050 | ) |  | $ | (8,935  | )
|Loss from discontinued operations                                    |  | $                                        |        |                |  | $             |        |                |  | $ |        |   |  | $ |        |  
|Net loss available to common shareholders
    (2)(3)(4)              |  | $                                        | (12,293 | )              |  | $             | (35,373 | )              |  | $ | (56,050 | ) |  | $ | (8,935  | )
|Basic and diluted loss per common share:                             |  |                                          |         |                |  |               |         |                |  |   |         |   |  |   |         |  
|Loss from continuing operations available to
    common shareholders |  | $                                        | (0.07   | )              |  | $             | (0.17   | )              |  | $ | (0.27   | ) |  | $ | (0.04   | )
|Discontinued operations                                              |  | $                                        |        |                |  | $             |        |                |  | $ |        |   |  | $ |        |  
|Net loss available to common shareholders                            |  | $                                        | (0.07   | )              |  | $             | (0.17   | )              |  | $ | (0.27   | ) |  | $ | (0.04   | )

F-41



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##### Table of Contents



ENTERASYS NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (Continued)

|                                                                     |  |                                          |         |                |  |               |         |                |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------- |  | ---------------------------------------- | ------- | -------------- |  | ------------- | ------- | -------------- |  | - | ------- | - |  | - | ------- | -
|                                                                     |  |                                         
|                                                                     |  | Year Ended December 28, 2002            
|                                                                     |  |                                         
|                                                                     |  | First Quarter                            |         | Second Quarter |  | Third Quarter |         | Fourth Quarter
|                                                                     |  | Ended                                    |         | Ended          |  | Ended         |         | Ended         
|                                                                     |  | March 30,                                |         | June 29,       |  | September 28, |         | December 28,  
|                                                                     |  | 2002                                     |         | 2002           |  | 2002          |         | 2002          
|                                                                     |  |                                          |         |                |  |               |         |               
|                                                                     |  |                                         
|                                                                     |  | (In thousands, except per share amounts)
|Net revenue                                                          |  | $                                        | 120,766 |                |  | $             | 120,062 |                |  | $ | 122,731 |   |  | $ | 121,238 |  
|Gross margin(1)                                                      |  | $                                        | 48,320  |                |  | $             | 60,121  |                |  | $ | 59,059  |   |  | $ | 42,295  |  
|Loss from continuing operations available to
    common shareholders |  | $                                        | (1,996  | )              |  | $             | (51,437 | )              |  | $ | (31,464 | ) |  | $ | (30,611 | )
|Loss from discontinued operations                                    |  | $                                        | (11,700 | )              |  | $             |        |                |  | $ |        |   |  | $ |        |  
|Net loss available to common shareholders(2)(3)                      |  | $                                        | (13,696 | )              |  | $             | (51,437 | )              |  | $ | (31,464 | ) |  | $ | (30,611 | )
|Basic and diluted loss per common share:                             |  |                                          |         |                |  |               |         |                |  |   |         |   |  |   |         |  
|Loss from continuing operations available to
    common shareholders |  | $                                        | (0.01   | )              |  | $             | (0.25   | )              |  | $ | (0.16   | ) |  | $ | (0.15   | )
|Discontinued operations                                              |  | $                                        | (0.06   | )              |  | $             |        |                |  | $ |        |   |  | $ |        |  
|Net loss available to common shareholders                            |  | $                                        | (0.07   | )              |  | $             | (0.25   | )              |  | $ | (0.16   | ) |  | $ | (0.15   | )



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Company recorded inventory write-downs of
    $1.9 million, $0.9 million, $7.8 million and
    $1.6 million for the quarters ended March 29, 2003,
    June 28, 2003, September 27, 2003 and January 3,
    2004, respectively. In addition, the Company recorded inventory
    write-downs of $0.1 million, $0.2 million and
    $17.6 million for the quarters ended June 29, 2002,
    September 28, 2002 and December 28, 2002, respectively.                                                                               
|   
|(2) | The Company recorded recoveries on bad debt and
    lease guarantees of $1.5 million, $6.0 million,
    $1.8 million and $2.7 million for the quarters ended
    March 29, 2003, June 28, 2003, September 27, 2003
    and January 3, 2004, respectively. In addition, the Company
    recorded bad debt and lease guarantees expense of
    $1.1 million, $1.1 million, $1.3 million and
    $0.5 million for the quarters ended March 30, 2002,
    June 29, 2002, September 28, 2002 and
    December 28, 2002, respectively.    
|   
|(3) | Included in the net loss available to common
    shareholders is restructuring charges of $8.2 million,
    $8.3 million and $1.0 million for the quarters ended
    June 28, 2003, September 27, 2003 and January 3,
    2004, respectively. Included in the net loss available to common
    shareholders is restructuring charges of $20.2 million,
    $10.7 million and $1.2 million for the quarters ended
    June 29, 2002, September 28, 2002 and
    December 28, 2002, respectively. See Note 12 for
    further details.
|   
|(4) | Included in the net loss available to common
    shareholders for the quarter ended September 27, 2003 is a
    loss on shareholder litigation of $15.9 million. See
    Note 20 for further details.                                                                                                                                                                                                                                                                                                                               

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##### Table of Contents



ENTERASYS NETWORKS, INC.



SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS


For the Three Years Ended January 3,
2004


|                                     |  |                |         |            |  |       |         |             |  |            |        |     |  |   |          |      |  |   |         | 
|------------------------------------ |  | -------------- | ------- | ---------- |  | ----- | ------- | ----------- |  | ---------- | ------ | --- |  | - | -------- | ---- |  | - | ------- | 
|                                     |  | Balance at     |         | Additions  |  |       |         |             |  | Balance at
|                                     |  | Beginning      |         | Charged to |  |       |         | Amounts     |  | the End   
|                                     |  | of Period      |         | Expense    |  | Other |         | Written Off |  | of Period 
|                                     |  |                |         |            |  |       |         |             |  |           
|                                     |  |               
|                                     |  | (In thousands)
|Allowance for doubtful accounts      |  |                |         |            |  |       |         |             |  |            |        |     |  |   |          |      |  |   |         | 
|January 3, 2004                      |  | $              | 19,250  |            |  | $     | (7,852  | )           |  | $          | 1,518  |     |  | $ | (9,519   | )    |  | $ | 3,397   | 
|December 28, 2002                    |  | $              | 32,569  |            |  | $     | 1,630   |             |  | $          | 154    |     |  | $ | (15,103  | )    |  | $ | 19,250  | 
|December 29, 2001                    |  | $              | 24,784  |            |  | $     | 12,523  |             |  | $          |       |     |  | $ | (4,738   | )    |  | $ | 32,569  | 
|Inventory reserves                   |  |                |         |            |  |       |         |             |  |            |        |     |  |   |          |      |  |   |         | 
|January 3, 2004                      |  | $              | 37,689  |            |  | $     | 12,246  |             |  | $          |       |     |  | $ | (14,687  | )    |  | $ | 35,248  | 
|December 28, 2002                    |  | $              | 82,278  |            |  | $     | 17,885  |             |  | $          | (1,112 | )   |  | $ | (61,362  | )    |  | $ | 37,689  | 
|December 29, 2001                    |  | $              | 42,257  |            |  | $     | 72,888  |             |  | $          |       |     |  | $ | (32,867  | )    |  | $ | 82,278  | 
|Notes receivable valuation allowance |  |                |         |            |  |       |         |             |  |            |        |     |  |   |          |      |  |   |         | 
|January 3, 2004                      |  | $              | 33,625  |            |  | $     | (2,450  | )           |  | $          |       |     |  | $ |         |      |  | $ | 31,175  | 
|December 28, 2002                    |  | $              | 36,125  |            |  | $     | (2,500  | )           |  | $          |       |     |  | $ |         |      |  | $ | 33,625  | 
|December 29, 2001                    |  | $              | 30,000  |            |  | $     | 6,125   |             |  | $          |       |     |  | $ |         |      |  | $ | 36,125  | 
|Deferred tax valuation allowance     |  |                |         |            |  |       |         |             |  |            |        |     |  |   |          |      |  |   |         | 
|January 3, 2004                      |  | $              | 358,479 |            |  | $     | 30,276  |             |  | $          |       |     |  | $ |         |      |  | $ | 388,755 | 
|December 28, 2002                    |  | $              | 452,052 |            |  | $     | 19,828  |             |  | $          |       |     |  | $ | (113,401 | )(a) |  | $ | 358,479 | 
|December 29, 2001                    |  | $              | 230,717 |            |  | $     | 259,963 |             |  | $          | 19,771 | (b) |  | $ | (58,399  | )(c) |  | $ | 452,052 | 



---



|    |  |                                                                                                     
|--- |  | ----------------------------------------------------------------------------------------------------
|(a) |  | Realization of deferred tax assets for which a
    valuation allowance had previously been provided.
|   
|(b) |  | Represents amounts for unbenefited stock
    compensation.                                          
|   
|(c) |  | Represents amounts attributable to the
    distribution of shares of a former subsidiary.           

S-1



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##### Table of Contents





INDEPENDENT AUDITORS REPORT ON FINANCIAL
STATEMENT SCHEDULE


The Board of Directors and Stockholders of
Enterasys Networks, Inc.:

Under date of February 10, 2004, we reported
on the consolidated balance sheets of Enterasys Networks, Inc.
and subsidiaries (the Company) as of January 3,
2004 and December 28, 2002, and the related consolidated
statements of operations, redeemable convertible preferred stock
and stockholders equity, and cash flows for the years
ended January 3, 2004 and December 28, 2002, and for
the ten-months ended December 29, 2001. In connection with
our audits of the aforementioned consolidated financial
statements, we also audited the related consolidated financial
statement schedule listed in Item 15(a)2 of this
Form 10-K. This consolidated financial statement schedule
is the responsibility of the Companys management. Our
responsibility is to express an opinion on this consolidated
financial statement schedule based on our audits.

In our opinion, this consolidated financial
statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, present
fairly, in all material respects, the information set forth
therein.

As discussed in Note 2 to the consolidated
financial statements, effective December 30, 2001, the
Company changed its method of accounting for goodwill and other
intangibles. In addition, also as discussed in Note 2 to
the consolidated financial statements, effective March 4,
2001, the Company changed its method of accounting for
derivative financial instruments and hedging activities.

/s/ KPMG LLP

Boston, Massachusetts

February 10, 2004


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