|UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


FORM 10-K


|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934


For the fiscal year ended December 31, 2001


|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934


Commission File Number:
0-220-20


CASTELLE
             (Exact name of Registrant as specified in its charter)
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|California
(State or other jurisdiction of
incorporation or organization) | 77-0164056                       
(IRS Employer Identification No.)
|------------------------------------------------------------------------- | -------------------------------------------------------------------

|855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)


(408) 852-8000
(Registrants telephone number, including area code)


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


Securities registered pursuant to Section 12(g) of the Act: Common Stock, No Par Value


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 [X] No [_]


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 Registrants knowledge, in any amendment to this Form 10-K or in
definitive proxy or information statements incorporated by reference in Part III
of the Form 10-K. [_]


The approximate aggregate market value of the Common Stock held by
non-affiliates of the Registrant, based upon the last sale price of the Common
Stock reported on the Nasdaq SmallCap Market on March 15, 2002 was $3,428,000.
Shares of the Registrants Common Stock held by directors, executive officers
and holders of more than 10% of the Companys Common Stock have been excluded.
Exclusion of shares held by any person should not be construed to indicate that
such person possesses the power, direct or indirect, to direct or cause the
direction of the management or policies of the Registrant, or that such person
is controlled by or under common control with the Registrant.


The number of shares of Common Stock outstanding as March 15, 2002 was 4,744,795.


DOCUMENTS INCORPORATED BY REFERENCE


The information required by Part III
of this Form 10-K will be incorporated by reference from certain portions of Castelles
Proxy Statement relating to its 2002 Annual Meeting of Shareholders (the Proxy Statement)
to be filed with the SEC no later than April 30, 2002 or will be provided in an amendment to this Form 10-K
to be filed with the SEC no later than April 30, 2002.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS


This Annual Report on Form 10-K
contains forward-looking statements, within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that are based on our
current expectations about our company and our industry. All of our forward-looking
statements involve risks and uncertainties. The Companys actual results could differ
significantly from our expectations and from the results expressed in or implied by these
forward-looking statements. Factors that might cause such a difference include, but are
not limited to, those discussed elsewhere in this Annual Report on Form 10-K. We urge you
to consider these cautionary statements carefully in evaluating our forward-looking
statements. Except as required by law, we undertake no obligation to publicly update any
forward-looking statements to reflect subsequent events and circumstances. Important
factors that may cause results to differ from expectations include those discussed in Risk
Factors beginning on page 25 in this document.


PART I


ITEM 1.    BUSINESS


The
following summary should be read in conjunction with, and is qualified in its entirety
by, the more detailed information and Consolidated Financial Statements and Notes thereto
appearing elsewhere in this Annual Report on Form 10-K.


OVERVIEW


Castelle was incorporated in California in 1987, and its principal offices
are located at 855 Jarvis Drive, Suite 100, Morgan Hill, California 95037.
Unless the context otherwise requires, references in this Form 10-K to we,
us, or the Company refer to Castelle. The Companys telephone number is
(408) 852-8000. Castelle®, LANpress® and JetPress® are registered
trademarks and InfoPress is a trademark of the Company. This Annual Report on
Form 10-K includes trademarks and trade names of other companies.


Castelle designs, develops, markets and supports server appliances
providing office messaging solutions and other shared services. The Companys
current products are focused on two areas: fax and integrated messaging
products, including a range of software enhancements, and print servers. The
Companys products consist of FaxPress, an integrated hardware/software network
faxing solution; OfficeDirect, an integrated fax/email messaging system;
InfoPress, an enterprise-level fax-on-demand software product; and LANpress
print servers.


The Companys products have historically centered on fax and print servers
and related technologies. Starting in 1997, the Companys revenues have declined
as competition increased, primarily with the print server products in the Asia
Pacific Region, while at the same time the Internet and other networking
technologies advanced. As a result, the Company experienced annual operating
losses during fiscal 1997 through 1999. During the past two years, management
has redirected the Companys efforts to focus on server appliances and on
development efforts to integrate existing and future products with the Internet
and emerging networking technologies. Through the introduction of the enhanced
fax messaging products that generate higher gross profits, restructuring and
implementing numerous cost reductions, the Company was able to report operating
profits in the fourth quarter of fiscal 1999 and in each of the four quarters of
fiscal 2000. Although the Company was profitable in fiscal 2000, it incurred
$591,000 of losses in fiscal 2001 resulting from a decrease in demand for our
products due in part to the slowness of the economy.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Industry Background


In the mid-1980s, organizations began to interconnect personal computers
into local area networks (LANs) in order to allow work groups to share files
and peripherals such as printers. As LANs have proliferated throughout
organizations and client/server architectures have gained acceptance, they have
become increasingly complex, the size and multimedia intensity of files being
transmitted has increased and the applications operating on the computer
networks have become more critical to the success of the business enterprise.
The proliferation of the Internet and Intranets and popularity of electronic
communications expanded the role of LANs as a means to provide common access to
the Internet, email and other messaging applications. Installation, maintenance
and administration of LAN equipment have always required a staff of highly
skilled professionals. The costs associated with LANs and related equipment are
significant and typically affordable only by larger organizations. Many small
and medium sized businesses were not able to invest in necessary equipment and
support staff. This created the need for specialized networking equipment that
would allow network administrators to deploy complex networking applications
without the cost and time required to install server-based software solutions.
These devices are known in the industry as Server Appliances or Thin
Servers. A server appliance is an integrated software/hardware solution
designed to reduce the complexity and cost for a specific server based
application. Internet routers, email servers, remote access servers,
communication servers, and print servers are examples of the server appliances
used by businesses today.


Castelle pioneered server appliances, establishing a benchmark for plug
and play and ease of use with its fax and print server product families.


Fax Messaging Products: The increasing popularity of email and the Internet
provided a boost to all types of electronic communications as many users and
organizations become more comfortable and accustomed to their use. To further
simplify and improve inter- and intra-organizational communications, corporate
MIS departments are looking for ways to integrate different types of messaging
into a unified messaging environment. Fax remains one of the key business
communication tools and is one of the essential components of the corporate
messaging environment. In corporate communication infrastructures, fax is being
integrated into email. To facilitate this capability companies install
email-integrated fax server systems.


Fax servers allow users to send and receive faxes as easily as emails,
using the same email application for both types of messages. A fax server can
sort incoming faxes directly and deliver them electronically and confidentially
to the electronic mailboxes of the intended recipients. Fax server can also be
used as an independent network shared messaging system in environments that
require high volume incoming and outgoing faxes. Users are able to send and
receive faxes directly from their computers or workstations, eliminating the
need to print a document, take it to a stand-alone fax machine and wait for its
transmission. Fax servers can help reduce fax transmission costs by sending
non-urgent faxes at off-peak telephone rates and by utilizing fax over the
Internet technology.


These fax servers can be implemented using complex software that require
Windows NT or UNIX systems and specialized expensive fax modems. Our lower cost
solution is a dedicated fax server appliance, such as the Castelle FaxPress.


Automated delivery of information is another popular application of the fax
technology. Fax-on-demand is the ability to use a touch-tone phone and a fax
machine to request and receive copies of documents on demand. Although there are
a wide variety of applications installed, the two most common applications are
customer support and literature fulfillment applications. The largest industry
using fax-on-demand is the high-technology sector, with applications also
installed in travel, government,
newspapers, manufacturing and non-profit
organizations. Essentially, any company with information to disseminate publicly
is a potential information-on-demand customer. Castelles InfoPress product line
provides a comprehensive solution for automated information delivery via fax and
email.


2
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Integrated Messaging Servers. Proliferation of various types of electronic
communications created a need for unified messaging systems. Instead of using
single-function software programs for different types of messages, such as
emails and faxes, many users prefer to use a single application such as
Microsoft Outlook for all messages. Integrating different systems to handle
various message types can be complex and expensive. To simplify this process,
next-generation messaging servers, such as Castelles OfficeDirect Messaging
Server, provide both email and fax capabilities in one integrated system.


Print Servers: The sharing of printers, a basic benefit of a LAN, has
traditionally been provided by connecting a printer either to a network file
server or to a dedicated personal computer on the network. However, direct
connection to the file server has several disadvantages, including the risk of
the file server being overburdened by the processing required to print large or
graphically complex files, lower print transfer speeds and location
inflexibility. Similarly, printer connection to a dedicated personal computer,
while providing better location flexibility, is more costly and offers
substantially lower print file transfer speed than a dedicated print server can
provide. A print server directly connects one or more printers to a LAN,
providing a cost-effective, high-speed solution to the demand for shared print
resources on a LAN. In addition to providing location flexibility and
convenience, print servers improve network performance by relieving the burden
on the file server. Furthermore, print servers enable users to access essential
information about the status of the printer and their print files and to select
their desired printer configuration.


Server appliances, such as communications/messaging servers and print
servers, have emerged to gain significant market acceptance due to their ability
to significantly reduce complexity and cost associated with the installation and
maintenance of networking systems. These appliances also make the complex
functionality of Internet and Intranet communications available and affordable
to many smaller businesses. As MIS professionals in larger organizations and
business owners of smaller enterprises continue to recognize the benefits of
server appliances to provide such critical functionality as Internet and
Intranet communications, remote access, scanning, electronic mail and related
functions, the Company believes that the demand for such network systems will
increase.


Castelle Strategy


Castelles objective is to be a leading worldwide supplier of server
appliances providing office messaging solutions and other shared services.
Castelle pioneered server appliances, establishing a benchmark for plug and
play and ease of use with its fax and print server product families. Castelle
products are installed in many Fortune 1000 companies, and in small and medium
sized businesses worldwide. Castelle is now applying its proven technology to
the office, integrating desktop messaging, Internet connectivity, print and
other shared services.


Focus on Server Appliances: The Company focuses exclusively on providing
innovative, reliable, easy-to-use network products. Since its inception, the
Company has focused on developing networking products that utilize advanced
software to tightly integrate proprietary hardware systems with standard
computing platforms. As a result, the Company believes it has developed a high
level of expertise in networking, software development, hardware design and
telephony technology. The Company plans to capitalize on these attributes by
continuing to focus on providing network enhancement products that enable users
to communicate more effectively.


3
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Focus on Messaging and Communications: The Company focuses on developing
application solutions for inter and intra-company communications. The Company
believes that its focus on application servers rather than on infrastructure
systems enables the Company to offer products that bring higher value services
to customers and provide a higher margin to the Company.


Expand Product Line: The Company is leveraging its expertise in server
appliances to offer new easy-to-use, cost-effective solutions. The Company
continues to expand both its fax and print server products and apply its proven
technology to other areas.


Focus on E-commerce and Other High Volume Distribution Channels: The
Company has established a two-tier domestic and international distribution
network of leading national and regional network product distributors and
resellers including Ingram Micro and TechData. Castelles products are well
suited for sale by e-commerce vendors and the Company has been successful
working with leading suppliers such as CDW and Insight.. The Company also sells
through OEM vendors such as Fujitsu Ltd. in Japan (Fujitsu). The Company is
focused on maintaining and strengthening its current distribution network in
North America, Europe and Asia-Pacific regions.


Leverage Strategic Relationships: The Company augments its product
offerings by establishing relationships with companies able to provide products
in areas outside of the Companys core technical competencies or in instances
where internal development of such products is not cost-effective. The Company
also establishes relationships with numerous leaders in hardware and software
technology to enable it to keep abreast of, and respond quickly to,
technological changes that may affect the network enhancement market.


Products


The Company develops and markets a range of server appliance products that
enhance network productivity, performance and functionality. The Companys
current products are grouped into two areas: fax messaging products, including a
range of software enhancements, and print servers.


Fax Messaging Products: The Company offers the FaxPress family of
email-integrated fax server appliances. The Company positions the FaxPress as
the easiest way to add faxing to your network and integrate fax with email.
FaxPress allows network users to send, receive, route, print, store, edit and
retrieve fax transmissions from their own personal computers on a local area
network. FaxPress can be integrated into an email system creating a unified
fax/email messaging environment. FaxPress enables users to transmit documents
directly to a fax device as easily as if they were printing to a laser printer
or sending an email message. The product also provides network administration
features like control, monitoring, logging or configuration. The Companys fax
server products are designed to comply with current regulatory standards in the
United States, Europe and the Pacific Rim. During fiscal 2001, 2000 and 1999,
fax products represented 91%, 86% and 78%, respectively, of total net sales.


Key features of the FaxPress products (configured with its current software
versions) include:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Easy
Installation and maintenance: FaxPress is a fax server appliance that is packaged with
all necessary hardware and software. The hardware system is a small box with an
integrated 10/100 Base-T Ethernet interface and one to eight intelligent fax modems. The
FaxPress includes all required system and client software.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Support
for popular network operating environments: FaxPress operates in any local area network
based on Microsoft Windows 98, ME and 2000; Windows NT/XP, and NT Terminal Server; Novell NetWare; or Linux servers.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4
|-

|
|

| |  |  | Ability
to create unified fax/email messaging environment: FaxPress has the ability to integrate
fax into a corporate email system, allowing users to send and receive faxes in the same
manner as emails. FaxPress supports Microsoft Exchange/Outlook, Lotus Notes, Novell
GroupWise, Netscape and other SMTP compatible systems. Castelles unique Exchange
Direct interface offloads fax processing from MS Exchange Server while maintaining tight
integration with the Outlook client.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Integration
with many popular accounting and Customer Relationship Management (CRM)
applications: FaxPress is available with the Reform-for-FaxPress software package (Reform)
from FabSoft that allows users to send faxes from many popular accounting, financial and
payroll systems including Oracle, SAP, PeopleSoft, Great Plains, ACCPAC, and Macola.
Reform can support any application that supports form printing.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Ability
to send faxes from many applications: Easy faxing from within any Windows, Windows 95/98
and Windows NT/2000/XP application such as Microsoft Office and Lotus Smart Suite.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Electronic
delivery of faxes to desktops: FaxPress supports several methods to deliver incoming
faxes direct to the email or fax inbox of the intended recipient. Such methods include
DID (Direct Inward Dialing), DTMF (Dual Tone Multifrequency),
T.30 sub-addressing, OCR (Optical Character Recognition) routing, line
routing.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Internet
faxing capabilities reduce transmission costs: FaxPress enables users to connect several
units via the Internet or the Intranet to form a private Fax-over-IP network that can
significantly reduce the cost of fax transmissions.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Integration
into custom applications: The Company provides a software development kit which allows
programmers to integrate faxing functions into their current applications or to create
new customized applications that use the FaxPress server.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Software
Options: The Company offers a range of value-added software options which increase the
functionality of Castelles FaxPress systems and enables the FaxPress to address
specialized applications as mentioned above. Software upgrades and options are available
to the installed base of FaxPress units at prices ranging from $300 to $1,990.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company offers a family of FaxPress fax server systems ranging from
entry-level products targeted to small businesses with fewer than 50 users to
high-end fax solutions capable of supporting enterprise-wide installations. The
suggested U.S. list prices for FaxPress fax server products range from $1,495 to
$9,995. The server pricing is based on hardware model, with no per-user costs.
The FaxPress 2500, 5000 and 7000 families come with the FaxPress 6.x PRO version
that adds integration with popular email packages, and many advanced fax
management and integration features. FaxPress 6.x PRO is optional on FaxPress
SBE. The following table summarizes the Companys FaxPress system products:


5
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|              |       
|------------- | ------
|
|
|
|             
|FaxPress SBE  | 1     
|FaxPress 2500 | 2     
|FaxPress 5000 | 4 or 8
|FaxPress 7000 | 8     
|             

|Information-on-demand systems: InfoPress software enables the access of
information via any touch-tone phone and a fax machine and allows the
dissemination of information via broadcasting to a select database of fax
numbers. InfoPress allows companies to use one source of documents in a Castelle
document library and to automatically publish the documents using either the
fax-on-demand and/or email-on-demand methods.


Castelles InfoPress is a software product designed to operate on the
Microsoft Windows NT/2000/XP platforms. The system utilizes voice and fax
processing hardware, as well as telephone system interface (analog or T1)
hardware with as few as two and as many as 288 ports that are actually deployed
at a customer site.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Fax-on-Demand:
Fax-on-demand allows a user to request and receive information on demand by dialing a
telephone number. The user interacts with a series of voice prompts to select specific
documents, by simply using the telephone keypad, and requesting delivery of these
documents to a fax number.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Email-on-Demand:
Email-on-demand allows a user to request and receive information on demand by using
email. Auto-reply email exists today, but is limited to receiving one document, usually
in text format. The main benefit of email-on-demand is the ability to share the document
library with fax-on-demand.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Web
Integration: InfoPress supports Web HTML documents in the document library. The documents
are automatically rendered into a fax document when required.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|Integrated Messaging Products: The OfficeDirect family of products is
designed to provide integrated email and fax communications to small offices.
The OfficeDirect family consists of the OfficeDirect Messaging Server.100 and
OfficeDirect Storage Server.100. The OfficeDirect Messaging Server is an
integrated e-mail/fax messaging server appliance tailored to meet the needs of
small offices or workgroups that need to provide robust communication services
to network users. It combines an SMTP and POP3 e-mail server with a
full-featured fax server in a plug-n-forget, easy-to-use, economical system,
which includes all necessary hardware and software. The OfficeDirect Messaging
Server integrates e-mail and fax services into the Microsoft Outlook client
software. The OfficeDirect Storage Server is a complimentary product to the
messaging server and provides convenient and reliable storage for the network
system files and messages. It also provides generic network storage and printer
sharing to network users.


Print Servers: Printer sharing continues to be one of the important
benefits of computer
networking. Print servers are the most efficient and economical way of sharing
printers on networks. While demand for print servers in various sizes of
businesses continues to grow, the market is very competitive. Castelle has been
involved in the print server business for more than ten years. After continuous
improvements on the cost and feature set, Castelles LANpress has become a
well-received print server product line. Our latest print server models
incorporate a RISC microprocessor, Fast Ethernet, Windows 2000, Internet
Printing and many other attractive new features. Castelle LANpress JR is the
worlds smallest print server commercially available today. Its similar in size
to that of a standard printer cable connector. The suggested U.S. list price for
LANpress print servers ranges from $149 to $395. During fiscal 2001, 2000 and
1999, print server products represented 9%, 14% and 22%, respectively, of total
net sales.


6
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The following table summarizes the Companys line of LANpress external
print servers:
|-------------------------------------------------------------------------------------

|                          |        |  
|------------------------- | ------ | -
|
|
|
|                         
|LANpress JR 10/100 MP (1) | 10/100 | x
|LANpress 3P/100           | 10/100 | x
|LANpress Jr. MP (2)       | 10     | x
|LANpress 2000 2+1 MP (3)  | 10/100 | x
|                         

| |  |  |  | (1) |  | One
Centronics parallel port
| |  |  |  | --- |  | ----------------------------

| |  |  |  | (2) |  | Connects
directly to port on Printer
| |  |  |  | --- |  | ------------------------------------

| |  |  |  | (3) |  | Numbers
refer to the number of parallel and serial port connections, respectively.
| |  |  |  | --- |  | ----------------------------------------------------------------------------------

|Research and Product Development


The Company has invested substantially in research and product development
since inception. The Company believes its future performance will depend in
large part on its ability to enhance its current products, to expand its product
offerings, to maintain technological competitiveness and meet an expanding range
of customer requirements.


Castelle continues to invest in enhancing its server appliance product
lines by developing new versions of client and server software and server
hardware. The product feature set is driven by the increasing complexity of user
needs. The changing corporate communications/messaging environment and
increasing demand for easy-to-use networking systems define these needs. The
development efforts are focused on enhancing functionality of existing products
and developing other systems to expand our product offerings. The Companys
development efforts are focusing on high value applications, while relying on
its partners to provide basic functionality for some of its product lines.


In fiscal 2000, the Company developed new versions of its FaxPress servers
offering simpler integration with Private Branch Exchanges (PBX) and email
systems. The FaxPress 7500 offers eight lines of fax and a 4-channel integrated
Direct Inward Dialing (DID) or Ear and Mouth (E&M) converter that
significantly simplifies implementation of a fax system that provides automated
delivery of incoming faxes into individual mailboxes.


7
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The current FaxPress fax server product line is continuously enhanced to
offer greater integration into corporate networking environments with such
features as:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Integrated
storage for system files and messages;
| | - |  | -------------------------------------------------

| |  |  | Integrated
email interfaces;
| | - |  | ----------------------------

| |  |  | Network-environment-independent
operation; and
| | - |  | ----------------------------------------------

| |  |  | Always-on
operation.
| | - |  | --------------------

|There can be no assurance that the Company will be successful in developing
and marketing the new software and hardware product versions or in identifying
and responding to other emerging technological developments or that any
development will achieve commercial acceptance. The Company is seeking and will
continue to seek to hire additional skilled development engineers. Such
engineers are likely to be in short supply, and the Companys business,
operating results and financial condition could be adversely affected if it
encounters delays in hiring or fails to retain the required skilled engineers.
See Business  Risk Factors  Key Personnel.


Sales, Marketing and Distribution


Castelle sells its products through multiple channels, determined by the
product, market and customer need. The Company has an established two-tier
domestic and international distribution network of leading national and regional
network product distributors and resellers. The Company also sells through OEM
vendors such as Fujitsu in Japan. Software enhancements and options that
complement the FaxPress products are primarily marketed directly by the Company
to registered end users. The direct sales group works closely with distributors
and VARs in qualifying sales opportunities for the fax and print server
products. The Company also sells some products through the on-line store on its
Web site. Demand for Castelles products is created through a variety of
marketing programs. These programs are targeted toward end-users to stimulate
demand for the products and toward distributors, resellers, VARs and e-commerce
vendors to promote the product in the sales channel. These programs include
targeted and active participation in industry networking and communication trade
shows, as well as advertising in associated publications. The Company increases
awareness of Company products by Internet marketing via targeted e-advertising,
publishing and sponsoring email newsletters, enhancing its Web presence, print
advertising, conducting direct mail campaigns, offering seminars, trade shows
and conferences and other forms of public relations efforts. The Companys Web
site has been updated and designed to assist customers in obtaining information
about Castelle products and contacting Castelle sales personnel, and offers
selected products and services through the Companys on-line store.


The Companys products are well suited for sale by e-commerce vendors, and
the Company has experienced success working with leading suppliers such as CDW
and Insight.


The Companys five largest distributors accounted for approximately 56% of
the Companys net sales in fiscal 2001, 43% of its net sales in fiscal 2000 and
42% of its net sales in fiscal 1999. Ingram and Tech Data, the Companys largest
domestic distributors and Macnica, the Companys principal Japanese distributor,
accounted for approximately 27%, 17% and 10%, respectively, of the Companys net
sales in fiscal 2001, 17%, 10% and 15%, respectively, of its net sales in fiscal
2000 and 12%, 7% and 18%, respectively, of its net sales in fiscal 1999. Sales
to customers located in the Pacific Rim and Europe comprised approximately 20%,
25% and 31% of the Companys net sales in fiscal 2001, 2000 and 1999,
respectively. In fiscal 2000, the Company terminated its agreement with Merisel,
a domestic distributor, due to the change in the distributors business
strategy, which was not in line with the Companys business strategy. The
Companys distributors typically represent other products that are complementary
to or compete with those of the Company. While the Company attempts to encourage
its distributors to focus on Castelles products through a variety of marketing
and support programs, our distributors may give higher
priority to products of other suppliers, thereby reducing the efforts they
devote to selling our products. In particular, certain of our competitors,
including Hewlett-Packard and Intel, sell a substantially higher total dollar
volume of products through several of the Companys large U.S. distributors and,
as a result, the Company believes such distributors give higher priority to
products offered by such competitors. The Companys distributors are not
contractually committed to future purchases of the Companys products and could
discontinue carrying the Companys products at any time for any reason. The
Company has a stock rotation policy with certain of its distributors that allows
them to return marketable inventory against offsetting orders. In the event that
the Company reduces its prices, the Company credits certain of its distributors
for the difference between the purchase price of products remaining in their
inventory and the Companys reduced price for such products. See Risk Factors 
Dependence on Suppliers and Subcontractors.


8
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Customer Service and Support


The Company provides customers with support services, which are available
to assist customers with installation, use and operation issues that will ensure
smooth and reliable operation of Castelle products. The Companys network
engineers, located at corporate headquarters, provide technical support via
telephone, fax and email during normal Company business days from 6:00 a.m. to
5:00 p.m. (Pacific Time). As part of the Companys global partner program, VARs
have access to priority technical support via a special toll-free number that
provides immediate access to Castelle network engineers. Support is provided
under warranty terms as well as through extended warranty agreements sold
directly to the customer by the Company. The Company also provides other
customer support through its web site. The Company has an automated call
management distribution system that provides improved levels of support to help
resolve customer issues.


Manufacturing


The Companys current in-house manufacturing operations consist primarily
of material planning, assembly, final testing, quality control and service
repair. Certain of the Companys manufacturing operations are performed by third
party manufacturers that provide customized, integrated manufacturing services,
including procurement, manufacturing and associated printed circuit board
assembly. The Company also relies on SerComm to manufacture certain of its print
server products. These arrangements enable the Company to shift certain costs to
such providers, thereby allowing the Company to focus resources on its product
development efforts. The failure of such manufacturers, particularly SerComm, to
meet their contractual commitments to the Company could cause delays in product
shipments, thereby potentially adversely affecting the Companys business,
operating results and financial condition.


The Company does not currently have any material long-term supply contracts
with any of its manufacturing subcontractors or component suppliers other than
an agreement with SerComm relating to the manufacture of print servers. The
Company purchases components on a purchase order basis. The Company owns all
engineering, sourcing documentation, functional test equipment and tooling used
in manufacturing its products, except for the products which are produced by
SerComm, and believes that it could shift product assembly to alternate
suppliers if necessary. Certain key components of the Companys products,
including a modem chip set from Conexant, and microprocessors from Motorola, are
currently available from single sources. Other components of the Companys
products are currently available from only a limited number of sources. In
addition, the Company subcontracts a substantial portion of its manufacturing to
third parties, and there can be no assurance that these subcontractors will be
able to support the manufacturing requirements of the Company. The Companys
ability to obtain these components or sub-assemblies is dependent upon its
ability to accurately forecast customer demand for its products and to
anticipate shortages of critical components or sub-assemblies created by
competing demands upon suppliers. If the Company were unable to obtain a
sufficient supply of high-quality
components or sub-assemblies from its current sources, the Company could
experience delays in obtaining such components or sub-assemblies from other
sources. Resulting delays or reductions in product shipments could adversely
affect the Companys business, operating results and financial condition and
damage customer relationships. Furthermore, a significant increase in the price
of one or more of these components or sub-assemblies or the Companys inability
to lower component or sub-assembly prices in response to competitive price
reductions could adversely affect the Companys business operating results and
financial condition. See Risk Factors  Dependence on Suppliers and
Subcontractors.


9
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Competition


The network enhancement products and computer software markets are highly
competitive, and the Company believes that such competition will intensify in
the future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. The
Company currently competes principally in the market for network fax servers and
network print servers and fax-on-demand software. Increased competition, direct
and indirect, could adversely affect the Companys business and operating
results through pricing pressure, loss of market share and other factors. In
particular, the Company expects that, over time, average selling prices for its
print server products will continue to decline, as the market for these products
becomes increasingly competitive. Any material reduction in the average selling
prices of the Companys products would adversely affect gross margins. There can
be no assurance the Company will be able to maintain the current average selling
prices of its products or the related gross margins.


The principal competitive factors affecting the market for the Companys
products include product functionality, performance, quality, reliability, ease
of use, quality of customer training and support, name recognition, price, and
compatibility and conformance with industry standards and changing operating
system environments. Several of the Companys existing and potential
competitors, most notably the Hewlett-Packard Company (Hewlett-Packard) and
Intel Corporation (Intel), have substantially greater financial, engineering,
manufacturing and marketing resources than the Company. The Company also
experiences competition from a number of other software, hardware and service
companies. In addition to its current competitors, the Company may face
substantial competition from new entrants into the network enhancement market,
including established and emerging computer, computer peripherals,
communications and software companies. In the fax server market the Company
competes with companies such as Captaris Inc., Omtool, Ltd. and Computer
Associates International, Inc. There can be no assurance that competitors will
not introduce products incorporating technology more advanced than the
technology used by the Company in its products. In addition, certain competing
methods of communications such as the Internet or electronic mail could
adversely affect the market for fax products. Certain of the Companys existing
and potential competitors in the print server market are manufacturers of
printers and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that the Company will be able to compete successfully or that competition will
not have a material adverse effect on the Companys business, operating results
and financial condition. See Risk Factors  Competition and Price Erosion and
Managements Discussion and Analysis of Financial Condition and Results of
Operations  Results of Operations.


Proprietary Rights


The Companys success depends to a certain extent upon its technological
expertise and proprietary software technology. The Company relies upon a
combination of contractual rights and copyright, trademark and trade secret laws
to establish and protect its technologies. Additionally, the Company generally
enters into confidentiality agreements with those employees, distributors,
customers and suppliers who have access to sensitive information and limits
access to and distribution of its software documentation
and other proprietary information. Because of the rapid pace of technological
change in the LAN product industry, the Company believes that patent protection
for its products is less significant to its success than the knowledge, ability
and experience of its employees, the frequent introduction and market acceptance
of new products and product enhancements, and the timeliness and quality of
support services provided by the Company. See Risk Factors  Dependence on
Proprietary Rights; Uncertainty of Obtaining Licenses.


10
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Despite the precautions taken by the Company, it may be possible for
unauthorized third parties to copy certain portions of the Companys products or
to reverse engineer or obtain and use information that the Company regards as
proprietary. There can be no assurance that the Companys precautions will be
adequate to deter misappropriation or infringement of its proprietary
technologies. Furthermore, while the Company has obtained federal registration
for many of its trademarks in the United States, certain of its trademarks have
not been registered in the United States and the Company has registered some of
its trademarks in foreign jurisdictions. There can be no assurance that the
Companys use of such unregistered trademarks will not be contested by third
parties in the future. In addition, the laws of some foreign countries either do
not protect the Companys proprietary rights or offer only limited protection.
Given the rapid evolution of technology and uncertainties in intellectual
property law in the United States and internationally there can be no assurance
that the Companys current or future products will not be subject to third-party
claims of infringement. Any litigation to determine the validity of any
third-party claims could result in significant expense to the Company and divert
the efforts of the Companys technical and management personnel, whether or not
such litigation is determined in favor of the Company. In the event of an
adverse result in any such litigation, the Company could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that the Company would be successful in such development or that any
such licenses would be available. The Company also relies on technology licenses
from third parties. There can be no assurance that these licenses will continue
to be available to the Company upon reasonable terms, if at all. Any impairment
or termination of the Companys relationship with third-party licensors could
have a material adverse effect on the Companys business, operating results and
financial condition.


Government Regulation


Certain aspects of the networking industry in which the Company competes
are regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, particularly in foreign countries where
telecommunications standards differ from those in the United States, or the
inability to obtain regulatory approvals within a reasonable period of time,
could have a material, adverse effect on the Companys business, operating
results and financial condition. The Companys products must comply with a
variety of equipment, interface and installation standards promulgated by
communications regulatory authorities in different countries. Changes in
government policies, regulations and interface standards could require the
redesign of products and result in product shipment delays which could have a
material, adverse impact on the Companys business, operating results and
financial condition. See Risk Factors  Government Regulations.


Employees


As of February 28, 2002, the Company employed a total of 44 full-time
equivalent personnel, 8 in manufacturing, 12 in sales and marketing, 8 in
engineering, 9 in customer service and 7 in finance and administration. The
Company has not experienced a work stoppage, no employees are represented by a
labor organization and the Company considers its employee relations to be good.


11
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Executive Officers


The names of the executive officers of the Company and their ages as of
February 28, 2002 are set forth below:
|-----------------------------------------------------------------------------------------------------------------------------------

|Name              |  | Age |  | Position                                                                          | 
|----------------- |  | --- |  | --------------------------------------------------------------------------------- | 
|                 
|Donald L. Rich    |  | 60  |  | Chairman of the Board, President, Chief Executive Officer                         | 
|                 
|Paul Cheng        |  | 53  |  | Vice President, Finance and Administration, Chief Financial Officer and Secretary | 
|                 
|Eric Chen         |  | 49  |  | Vice President, Engineering                                                       | 
|                 
|Edward J. Heinze  |  | 56  |  | Vice President, Sales, Americas                                                   | 
|                 
|Michael Petrovich |  | 40  |  | Vice President, International Sales                                               | 

|Donald L. Rich
|--------------

| | Mr. Rich joined the Company in November 1998 and has served as Chief Executive Officer and
President from November 1998 to the present. Mr. Rich became Chairman of the Board in May
1999. Mr. Rich has served as Chief Financial Officer from April 1999 to March 2001 and
Secretary from February 2000 to March 2001. From January 1997 until November 1998, Mr.
Rich was self-employed as a consultant. From 1993 through 1997, Mr. Rich was Chief
Executive Officer and President of Talarian Corporation, a provider of communications
middleware software. Prior to that, he held various sales and marketing management
positions at Integrated Systems, Inc. and International Business Machines Corporation.
Mr. Rich holds a BS degree in Mechanical Engineering from Purdue University and an MBA
from the Stanford Graduate School of Business.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Paul Cheng
|----------

| | Mr.
Cheng joined the Company in April 2000 and has served as Vice President, Finance and
Administration since that time. In March 2001, Mr. Cheng was appointed as Chief Financial
Officer and Secretary. Mr. Cheng brings more than 20 years of financial experience from a
successful career that was launched in Hong Kong where he was the Plant Controller of
Fairchild Semiconductor operations. Before joining Castelle, he served as the Vice
President of Finance and Administration at Eclipse International, Inc., a systems
development company, from April 1997 to March 2000. In addition, he has held various
executive positions including the Vice President of Finance at Quintus Corporation, a
developer of customer relations management software from December 1993 to August 1995 and
Corporate Controller at Power Integration, Inc., a semiconductor manufacturer from
October 1995 to March 1997. Mr. Cheng is a member of the Chartered Certified Accountants
and holds a BS degree in Accounting from the Baptist College in Hong Kong.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Eric Chen
|---------

| | Mr.
Chen joined the Company in 1989 and was appointed Vice President, Engineering in May
2000. Mr. Chen initially worked on software development projects including developing the
first FaxPress e-mail gateways, porting FaxPress to non-Novell platforms, and the first
menu-driven installation and configuration programs for both FaxPress and LANpress. Most
recently, Mr. Chen has been the Director of Print Server Product Marketing and Business
Unit and has managed the engineering development and manufacturing business relationships
with Castelle partners. Before joining Castelle, Mr. Chen was with 3COM, a network
solutions provider. Mr. Chen has a BS in Engineering from Taiwan and an MS in Computer
Science from the University of Massachusetts.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|12
|--

|Edward J. Heinze
|----------------

| | Mr.
Heinze has been with Castelle Inc. since 1994. Mr. Heinze was appointed Vice President,
Sales, Americas in January 2000. Prior to his appointment to Vice President, Mr. Heinze
served Castelle as Product Manager of the Fax Product Line, and Regional Sales Manager.
Before joining Castelle, Mr. Heinze served in several capacities at Visual/White Pine
Software, a software developer, including Vice President of Sales. Prior to his tenure at
White Pine, he was Chief Operations Officer for XMARK, a computer systems manufacturer,
and Vice President of Sales and Marketing at EIT, Millicom, Olympia, and Ontel. He holds
a BS degree from Waynesburg College.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Michael Petrovich
|-----------------

| | Mr.
Petrovich, Vice President, International Sales, joined Castelle in 1992. He was appointed
Vice President, International Sales in October 2000. Prior to joining Castelle, Mr.
Petrovich was the marketing communications manager for Novells National Reseller
Organization, a software company. In this role Mr. Petrovich focused on business
strategies and development of Novells direct reseller sales channel. Before joining
Novell, Mr. Petrovich held sales and marketing positions at Excelan, a LAN manufacturer,
and International Microcircuits Incorporated, a semiconductor company. Since joining
Castelle, Mr. Petrovich has concentrated on developing the Asia Pacific marketplace and
its distribution sales channel. Most recently Mr. Petrovich has taken on the
responsibilities for all sales outside the Americas, including Asia and Europe. Mr.
Petrovich holds a BA in Behavioral Sciences from San Jose State University.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Boris Elpiner, formerly Vice President of Marketing, ceased to be an employee
with the Company on February  28,  2002.


ITEM 2.    PROPERTIES


The Companys headquarters, including its executive offices and corporate
administration, development, manufacturing, marketing, sales and technical
services/support facilities, are located in Morgan Hill, California in
approximately 16,600 square-feet of leased office space. The Company occupies
this facility under a lease, the term of which expires in December 2005 with one
conditional three-year option, which if exercised, would extend the lease to
December 2008. The Company moved into this new facility in December 2000 from
the previous location in Santa Clara, California, after the Santa Clara lease
expired. In fiscal 2001, the Company consolidated its offices in El Dorado
Hills, California and in the United Kingdom with the Companys headquarters in
Morgan Hill, after both of these leases expired. In addition, the Company rents
office space for sales and customer support office in Illinois. The Company
believes its existing facilities will be adequate to meet its requirements for
the foreseeable future.


ITEM 3.    LEGAL PROCEEDINGS


The Company has been contacted by a third party claiming that the Company
needs to obtain licenses of certain patents held by that party for certain of
the Companys fax server products. The Company is continuing to assess the
validity and strength of the claims, believes it has adequate legal defenses and
that the ultimate outcome of any possible action will not have a material effect
on the Companys financial position, results of operations or cash flows
although there can be no assurance as to the outcome of any possible litigation.


13
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS


The Company held its 2001 Annual Meeting of Shareholders on November
7, 2001 (the 2001 Annual Meeting). At the 2001 Annual Meeting, the
Companys shareholders elected five directors nominated by the Board of
Directors by the votes indicated:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Nominee             | Votes in Favor | Votes Withheld | 
| | ------------------- | -------------- | -------------- | 
| | Robert H. Hambrecht | 3,399,531      | 35,700         | 
| | Donald L. Rich      | 3,399,531      | 35,700         | 
| | Peter R. Tierney    | 3,399,531      | 35,700         | 
| | Scott C. McDonald   | 3,399,531      | 35,700         | 
| | Jack Howard         | 3,399,531      | 35,700         | 

|The proposal to ratify the selection of PricewaterhouseCoopers LLP as
the Companys independent accountants for the fiscal year ending December
31, 2001 was approved with 3,429,531 votes in favor of the of the proposal,
300 votes against and 5,400 votes abstained.


14
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART II
|-------

|ITEM 5. |  | MARKET FOR REGISTRANTS COMMON STOCK AND RELATED SHAREHOLDER MATTERS
|------- |  | --------------------------------------------------------------------

|The Companys Common Stock (Nasdaq symbol CSTL) began trading on the
Nasdaq National Market on December 20, 1995 and was transferred to the Nasdaq
SmallCap Market as of April 1999. The following table shows the closing high and
low sale prices per share of Castelles Common Stock as reported on the Nasdaq
SmallCap Market. Such quotations do not include retail markups, markdowns or
commissions.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | FISCAL 2000    | HIGH  | LOW   | 
| | -------------- | ----- | ----- | 
| | First Quarter  | $4.00 | $1.13 | 
| | Second Quarter | $2.13 | $1.16 | 
| | Third Quarter  | $1.88 | $1.00 | 
| | Fourth Quarter | $1.44 | $0.75 | 

| | FISCAL 2001    | HIGH  | LOW   | 
| | -------------- | ----- | ----- | 
| | First Quarter  | $1.53 | $0.88 | 
| | Second Quarter | $1.10 | $0.75 | 
| | Third Quarter  | $1.20 | $0.56 | 
| | Fourth Quarter | $0.89 | $0.56 | 

|As of March 15, 2002, there were 110 holders of record of the Companys
Common Stock. On March 15, 2002 the last sale price reported on the Nasdaq
SmallCap Market for the Companys Common Stock was $0.65 per share.


Dividend Policy


The Company has not paid cash dividends on its Common Stock. The Board of
Directors currently intends to retain any and all earnings for use in the
Companys business and the Company does not anticipate paying cash dividends in
the foreseeable future.


ITEM 6.    SELECTED FINANCIAL DATA


The following selected financial information has been derived from the
audited Consolidated Financial Statements. The information set forth below is
not necessarily indicative of results of future operations, and should be read
in conjunction with Managements Discussion and Analysis of Financial Condition
and Results of Operations and the Consolidated Financial Statements and related
Notes thereto included elsewhere in this Annual Report on Form 10-K.


15
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|                                      | Years ended December 31, |       
|------------------------------------- | ------------------------ | ------
|
|
|INCOME STATEMENT DATA:                |                          |       
|Net Sales                             |                          | $9,620
|Gross Profit                          |                          | $6,531
|Gross Profit as a % of Net Sales      |                          | 68    
|Net (loss)/income                     |                          | ($591 
|Net (loss)/income as a % of Net Sales |                          | (6    
|Net (loss)/income per share  diluted |                          | ($0.12
|                                     
|BALANCE SHEET DATA:                   |                         
|Cash and Cash Equivalents             |                          | $4,568
|Working Capital                       |                          | $3,560
|Total Assets                          |                          | $7,010
|Long-term Liabilities                 |                          | $64   
|Shareholders Equity                  |                          | $4,202

|Net loss for fiscal 2001, 2000, 1999, 1998 and 1997 included net charges
for restructuring and other non-recurring items of $239,000, $0, $400,000, $1.1
million and $6.1 million respectively. For detailed information on these
transactions see Managements Discussion and Analysis of Financial Condition
and Results of Operations - Restructuring and Other Charges and Amortization of
Intangible Assets and the Consolidated Financial Statements and related Notes
thereto included elsewhere in this Annual Report on Form 10-K.


Quarterly Results of Operations


The following table sets forth certain unaudited consolidated quarterly
financial data for the eight quarters ended December 31, 2001. This information
is unaudited, but in the opinion of management, has been prepared substantially
on the same basis as the audited consolidated financial statements appearing
elsewhere in this report, and all necessary adjustments, consisting only of
normal recurring adjustments, hade been included in the amounts stated below to
present fairly the unaudited consolidated financial statements and the notes to
such statements appearing elsewhere in this report. The results of operations
for any quarter are not necessarily indicative of the results of operations for
any future period.


Selected Quarterly Data (unaudited)
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Fiscal Year 2001, Quarter Ended |                                     
| | ------------------------------- | ------------------------------------
|
|
| |                                 | Net Sales                           
| |                                 | Gross Profit                        
| |                                 | (Loss)/Profit from Operations       
| |                                 | Net (Loss)/Profit                   
| |                                 | Net (loss)/Profit per share, basic  
| |                                 | Net (Loss)/Profit per share, diluted

|16
|--

|
|

| | Fiscal Year 2000, Quarter Ended |                              
| | ------------------------------- | -----------------------------
|
|
| |                                 | Net Sales                    
| |                                 | Gross Profit                 
| |                                 | Profit from Operations       
| |                                 | Net Profit                   
| |                                 | Net Profit per share, basic  
| |                                 | Net Profit per share, diluted

|ITEM 7.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS
OF OPERATION


This Managements Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that are subject to
many risks and uncertainties that could cause actual results to differ
significantly from expectations. For more information on forward-looking
statements, refer to the Special Note on Forward Looking Statements at the
front of this Annual Report on Form 10-K.


Our products have historically centered on fax and print servers and
related technologies. Starting in 1997, our revenues have declined as
competition increased, primarily with the print server products in the Asia
Pacific Region, while at the same time the Internet and other networking
technologies advanced. As a result, we experienced annual operating losses
beginning from fiscal 1997 through fiscal 1999. During the past three years, we
have redirected our efforts to focus on server appliances and on development
efforts to integrate existing and future products with the Internet and emerging
networking technologies. We introduced our new products, the FaxPress 5000 in
February 1999, FaxPress 2500 in November 1999, FaxPress SBE in February 2000,
the FaxPress 7500 in September 2000 and the OfficeDirect family of products in
the fourth quarter of fiscal 2000. Through mainly the release of these enhanced
products in the fax messaging family and continuous efforts in product cost
enhancements, our gross profit improved and the total cost of sales as a
percentage of net sales have decreased from 46.7% in fiscal 1997 to 32.1% in
fiscal 2001.


In fiscal 1997, we announced and began to implement a restructuring plan,
which was mostly completed in fiscal 1999. As a result, operating expenses, not
including non-recurring restructuring charges, were reduced from $14.6 million
in fiscal 1997 to $14.1 million, $11.6 million and $8.7 million, respectively,
in fiscal 1998, 1999 and 2000. The economic downturn in early 2001 required us
to streamline operating expenses again to be more in line with the softened
revenue. This restructuring helped us to restore profitability in the third and
fourth quarters of fiscal 2001.


Additionally, improved cash management helped us to provide positive cash
flows in the last several years. Despite the impact from softened revenue and a
one-time use of $600,000 on leasehold improvements to the new Morgan Hill,
California headquarters in the fourth quarter of fiscal 2000 and the first
quarter of fiscal 2001, cash balances at the end of December 31, 2001 remained
at $4.6 million, as compared to $4.7 million at the end of fiscal 1999, but
increased by $675,000 when compared to December 31, 2000.


17
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Critical Accounting Policies


We have identified the policies below as critical to our business
operations and the understanding of our results of operations. We have
defined a critical accounting policy as one that is both important to the
portrayal of our financial condition and results of operations and requires
our management to make difficult, subjective or complex judgments. The
impact and any associated risks related to these policies on our business
operations is discussed throughout managements Discussion and Analysis of
Financial Condition and Results of Operations where such policies affect
our reported and expected financial results. For a detailed discussion on
the application of these and other accounting policies, see Note [2] in the
Notes to the Consolidated Financial Statements in Item 14 of this Annual
Report on Form 10-K, beginning on page [F-6]. Note that our preparation of
this Annual Report on Form 10-K requires us to make estimates and
assumptions that affect the reported amount of assets and liabilities,
disclosure of contingent assets and liabilities at the date of our
financial statements, and the reported amounts of revenue and expenses
during the reporting period. Estimates and assumptions about future events
and their effects cannot be perceived with certainty. We based our
estimates on historical experience and on various other assumptions that
are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments. These estimates may change as new
events occur, as more experience is acquired, as additional information is
obtained and as our operating environment changes.


Revenue recognition


We recognize revenue based on the provisions of Staff Accounting
Bulletin (SAB) No. 101 Revenue Recognition in Financial Statements and
Statement of Financial Accounting Standards (SFAS) No. 48 Revenue
Recognition When Right of Return Exists.


Product revenue is recognized upon shipment if a signed contract
exists, the fee is fixed and determinable, collection of the resulting
receivables is probable and product returns are reasonably estimable.
Shipment generally occurs when product is delivered to a common carrier.


We enter into agreements with certain of our distributors which permit
limited stock rotation rights. These stock rotation rights allow the
distributor to return products for credit but require the purchase of
additional products of equal value. Customers who purchase our products
directly from us also have limited return rights, which expire thirty days
from product shipment. Revenues subject to stock rotation rights are
reduced by our estimates of anticipated exchanges. We establish our returns
allowance policy for distributors based on historic return rates from these
distributors. If the historical data used by the Company to calculate these
estimates does not properly reflect future returns, revenue could be
overstated.


Pursuant to our agreements with distributors, we also protect our
distributors exposure related to the impact of price reductions. Price
adjustments are recorded at the time products are shipped. We estimate the
impact of price reductions based on historical data. Should prices erode
faster than our current estimate, revision to the estimated liability would
be required.


We recognize revenue from the sale of extended warranty contracts
ratably over the period of the contracts.


We recognize royalty on the sale of LANpress products by a Japanese distributor. Royalty is
not recognized as revenue until the products are sold by the distributor.


Provisions for estimated warranty costs are recorded at the time products are shipped. While we
engage in extensive product quality programs and processes, our warranty obligation is
affected by product failure rates, material usage and service delivery costs incurred in
correcting a product failure. Should product failure rates, material usage or service
delivery cost differ from our estimates, revision to the estimated warranty
liability would be required.


18
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Credit, collection and allowance for doubtful accounts


Ongoing customer credit evaluations are performed by us and collateral is
not required. We assess collection based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the customer.
When credit criteria are not met, we require cash-on-delivery or payment by
credit card before the products are shipped. On a quarterly basis, we
specifically analyze accounts receivable, potential returns, historical bad
debts, customer concentration, and changes in our customer payment terms when
evaluating the adequacy of the allowance for doubtful accounts and for potential
returns. Such returns and losses have generally been within our expectations. If
the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required. Three customers accounted for 72% of accounts receivable at December
31, 2001 and three customers accounted for 59% of accounts receivable at
December 31, 2000. In fiscal 2001, three distributors accounted for
approximately 27%, 17% and 10% of our net sales. In fiscal 2000, the same three
distributors accounted for approximately 17%, 10% and 15% of net sales,
respectively.


Inventories and related allowance for obsolete and excess inventory


Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market. Inventories have also been
reduced by an allowance for excess and obsolete inventories. The estimated
allowance is based on managements review of inventories on hand on a quarterly
basis, compared to managements assumptions about future demand, market
conditions and anticipated timing of the release of product upgrades or next
generation products. If actual market conditions for future demand are less
favorable than those projected by us or if product upgrades or next general
products are released earlier than anticipated, additional inventory write-downs
may be required.


Results of Operations


Comparison
of Years Ended December 31, 2001 and 2000
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | NET
SALES
| | ---------

| | Net
sales consist of sales from product sales, which are calculated net of returns and
allowances, plus extended warranty contracts, to distributors and end-users. Sales of
products to end-users are recognized upon shipment. Sales of products to distributors who
have limited stock rotation rights are also recognized upon shipment, but are reduced by
our estimates of anticipated exchanges and returns. Revenue from the sale of extended
warranty contracts is recognized ratably over the period of the contracts.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Net
sales decreased 35% to $9.6 million in fiscal 2001 from $14.8 million in fiscal 2000. The
decline of $5.2 million in net sales resulted primarily from lower sales of our
fax-on-demand products of $2.3 million, or 92%, and fax server products of $1.1 million,
or 11%, in the domestic channel and a decrease of our print server products of $1.2
million, or 59%, mainly due to customers in the Asia Pacific Region. This decline was in
part attributable to the industry wide slowdown in the economy.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | International
sales were $2.0 million in fiscal 2001 as compared to $3.6 million in fiscal 2000,
representing 20% and 25%, respectively, of total net sales. Lower international sales
were largely due to reduced demand for our print server products in the Asia Pacific
region. Most of our international sales have been denominated in U.S. dollars and thus
could be adversely affected by changes in demand resulting from
fluctuations in currency exchange rates.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|19
|--

|
|

| | Domestic
sales were $7.6 million in fiscal 2001 as compared to $11.1 million in fiscal 2000,
representing 80% and 75%, respectively, of total net sales for fiscal 2001 and fiscal
2000, respectively.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
fiscal 2001, three distributors accounted for approximately 27%, 17% and 10% of our net
sales. In fiscal 2000, the same three distributors accounted for approximately 17%, 10%
and 15% of net sales, respectively.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | COST
OF SALES; GROSS PROFIT
| | ---------------------------

| | Gross
profit is equal to net sales less cost of sales. Cost of sales includes cost of
materials, including components, manuals, diskettes, packaging materials, assembly and
shipping, as well as certain royalties. Cost of sales also includes compensation costs
and overhead related to the Companys manufacturing operations, obsolescence and
manufacturing costs and warranty expenses. Gross profit was $6.5 million, or 68% of net
sales, in fiscal 2001, when compared to $9.4 million, or 63% of net sales, in fiscal
2000. Efficiencies realized from the restructuring in fiscal 2001, continuous product
cost reductions, outsourcing of manufacturing and the increasingly favorable mix from the
sales of our fax server products, which has a higher gross profit contribution added to
the total improvements in gross profit in fiscal 2001.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | RESEARCH
AND DEVELOPMENT
| | ------------------------

| | Research
and development expenses consist primarily of employee-related expenses and expensed
material and facility costs associated with the development of new products. Research and
product development expenses were $1.8 million in fiscal 2001, comparable to fiscal 2000,
and represented 19% and 12% of net sales for those periods. Research and development
spending has supported existing products and the development of unified messaging server
appliances. We continue to be committed to the development of highly competitive new
products and services through the efficient utilization of our engineering resources.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | SALES
&MARKETING
| | ----------------

| | Sales
and marketing expenses consist primarily of employee-related expenses, commissions to
sales representatives, product promotion expenses, facilities expenses, including
expenses associated with our regional sales and support offices. Sales and marketing
expenses were $3.9 million and $5.3 million for fiscal 2001 and fiscal 2000,
respectively, and represented 40% and 36% of net sales for those periods. The reduction
in sales and marketing expenses compared to fiscal 2000 was largely due to a reduction in
personnel related costs of $473,000, which was partly realized from the restructuring,
lower product promotional expenses of $406,000, reduced outside consulting expenses of
$136,000 and other occupancy related costs of $148,000.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | GENERAL
& ADMINISTRATIVE
| | ------------------------

| | General
and administrative expenses consist primarily of employee-related expenses for
administration, finance, human resources and general management, as well as consulting,
outside services, legal and auditing expenses. General and administrative expenses were
$1.3 million and $1.7 million for fiscal 2001 and fiscal 2000, respectively, or 14% and
11% of net sales for those periods. The decrease in expenses in fiscal 2001 was mostly
due to lower outside consulting expenses of $50,000, less bad debt expense of $74,000,
reduced recruiting expense of $45,000 and other occupancy related costs of $128,000.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|20
|--

|
|

| | RESTRUCTURING
EXPENSES
| | ----------------------

| | In
response to the continuing economic slowdown and decrease in demand for our products, we
terminated 17 regular, temporary and contractor positions in April 2001, which
constituted approximately 25% of our workforce. This action resulted in a severance
charge of $239,000 in the first nine months of fiscal 2001. The restructuring included an
asset write-off and other direct expenses associated with the consolidation of our
operations in the United Kingdom and El Dorado Hills, California.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Of
the total restructuring charge of $239,000, approximately $124,000 represented cash
charges already paid, $26,000 was for non-cash charges related to the write down of
surplus fixed assets from the consolidation of our United Kingdom and El Dorado Hills
operations and $89,000 denoted obligations in fiscal 2002 mainly for costs associated
with remaining obligations related to our United Kingdom office and the final severance
payment to an employee. The majority of these expenses will be consummated in early
fiscal 2002. The following table sets forth an analysis of the components of the fiscal
2001 restructuring charge, the payments made against the reserve and the balance left as
of December 31, 2001 (in thousands of dollars):
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | TotalCharge |                      | Non-cashCharge |  | CashPayments |      | Reserve Balance atDecember 31, 2001 |  |     
| |  | ----------- | -------------------- | -------------- |  | ------------ | ---- | ----------------------------------- |  | ----
| |  |             | Severance & Benefits |                |  |              | $98  |                                     |  |     
| |  |             | Facilities           |                |  |              | 90   |                                     |  | $(26
| |  |             | Other                |                |  |              | 51   |                                     |  |     
| |  |             |                      |                |  |              |      |                                    
| |  |             | Total                |                |  |              | $239 |                                     |  | $(26

| | There
were no restructuring and other charges recorded in fiscal 2000.
| | ----------------------------------------------------------------------

| | INTEREST
AND OTHER INCOME, NET
| | ------------------------------

| | Interest
and other income, net, was $111,000 and $73,000 in fiscal 2001 and fiscal 2000,
respectively. The increase in other income in fiscal 2001 when compared to fiscal 2000
reflected mostly lower translation losses from foreign currency transactions of $69,000,
higher miscellaneous income of $58,000, offset in part by lower interest income of
$58,000 due to lower interest rates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | PROVISION
FOR INCOME TAXES
| | --------------------------

| | In
fiscal 2001, our current income tax provision was offset by the utilization of our net
operating loss carry forward and there were no substantial federal nor state income taxes
recognized.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
fiscal 2000, our provision for incomes taxes was $6,000, representing state taxes only.
Our current income tax provision was offset by the utilization of our net operating loss
carry forward.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|21
|--

|Comparison of Years Ended December 31, 2000 and 1999
|----------------------------------------------------

| | NET
SALES
| | ---------

| | Net
sales decreased 8% to $14.8 million in fiscal 2000 from $16.1 million in fiscal 1999. The
decline of $1.3 million in net sales resulted primarily from lower sales of our print
server products of $1.1 million, or 35%, mainly to customers in the Asia Pacific region
and a slight decrease of $157,000, or 1%, in sales of our fax server products mainly to
the domestic channels.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | International
sales were $3.6 million in fiscal 2000 as compared to $4.9 million in fiscal 1999,
representing 24% and 31%, respectively, of total net sales. Lower international sales
were largely due to reduced demand for our print server products in the Asia Pacific
region. Most of our international sales have been denominated in U.S. dollars and thus
could be adversely affected by changes in demand resulting from fluctuations in currency
exchange rates.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Domestic
sales were $11.1 million in fiscal 2000 and were consistent with fiscal 1999, and
represented 75% and 69%, respectively, of total net sales for fiscal 2000 and fiscal
1999, respectively.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
fiscal 2000, two distributors and one customer accounted for approximately 17%, 15% and
15% of our net sales. In fiscal 1999, the same two distributors and one customer
accounted for approximately 12%, 18% and 3% of net sales, respectively.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | COST
OF SALES; GROSS PROFIT
| | ---------------------------

| | Gross
profit increased to $9.4 million, or 63% of net sales, in fiscal 2000, from $8.4 million,
or 52% of net sales, in fiscal 1999. Efficiencies realized from the restructuring in
fiscal 1998 and fiscal 1999, continuous product cost reductions and outsourcing of
manufacturing contributed to the improvements in gross profit in fiscal 2000. In fiscal
1999, we also recognized $1.5 million of expenses related to the disposal of obsolete
inventory.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | RESEARCH
AND DEVELOPMENT
| | ------------------------

| | Research
and product development expenses were $1.8 million and $2.7 million in fiscal 2000 and
fiscal 1999, respectively, and represented 12% and 17% of net sales for those periods.
The absolute dollar amount of research and product development expense decreased in
fiscal 2000 due to improved expense controls and staff reductions that occurred in fiscal
1999. Research and development spending in fiscal 2000 and 1999 was primarily
attributable to the support of existing products and the development of unified messaging
server appliances.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | SALES
&MARKETING
| | ----------------

| | Sales
and marketing expenses were $5.3 million and $6.7 million for fiscal 2000 and fiscal
1999, respectively, and represented 36% and 42% of net sales for those periods. The
reduction in expenses compared to fiscal 1999 was largely due to a reduction in personnel
related costs, occupancy and other cost savings.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | GENERAL
&ADMINISTRATIVE
| | -----------------------

| | General
and administrative expenses were $1.7 million and $2.1 million for fiscal 2000 and fiscal
1999, respectively, or 11% and 13% of net sales for those periods. The decrease in
expenses in fiscal 2000 was mostly due to lower legal and personnel related costs.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|22
|--

|
|

| | RESTRUCTURING
AND OTHER CHARGES &AMORTIZATION OF INTANGIBLE ASSETS
| | ------------------------------------------------------------------

| | There
were no restructuring and other charges recorded in fiscal 2000.
| | ----------------------------------------------------------------------

| | In
fiscal 1999, we recognized a restructuring charge of $402,000 for expenses associated
with our exit from the Object-Fax NT product line including the disposition of excess
inventory, reductions in personnel and the write-off of excess office space.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | INTEREST
AND OTHER INCOME, NET
| | ------------------------------

| | Interest
and other income, net, was $73,000 and $99,000 in fiscal 2000 and fiscal 1999,
respectively. The reduction in other income reflected mostly higher translation losses
from foreign currency transactions in fiscal 2000, and higher bank and credit card
processing fees offset in part by higher interest income due to changes in cash balances
and interest rates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | PROVISION
FOR INCOME TAXES
| | --------------------------

| | In
fiscal 2000, our provision for incomes taxes was $6,000, representing state taxes only.
Our current income tax provision was offset by the utilization of our net operating loss
carry forward.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
fiscal 1999, our provision for income taxes was $4,000, representing state taxes only.
Because of our net loss in fiscal 1999, there were no federal nor substantial state
income taxes recognized.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|LIQUIDITY AND CAPITAL RESOURCES


Since our initial public offering of common stock in December 1995, our
principal source of funding has been cash from our operations, with some funding
from capital equipment lease lines. As of December 31, 2001, we had $4.6 million
of cash and cash equivalents, an increase of $675,000 from December 31, 2000.
The increase in cash and cash equivalents in fiscal 2001 was primarily
attributable to operating cash inflows of $643,000 from improved collection of
outstanding balances owed to us by our customers, reduced inventory to meet the
current revenue projections, offset in part by more timely payments to our
vendors. The increase in cash and cash equivalents in fiscal 2001 compares to
cash used in operating activities of $188,000 in fiscal 2000. Working capital,
defined as current assets less current liabilities, decreased to $3.6 million at
December  31, 2001 from $4 million at December  31,  2000.


We have a $3.0 million secured revolving line of credit with a bank, which
expires in March 2003, pursuant to which we may borrow 100% against pledges of
cash at the banks prime rate (4.75% at December 31, 2001). Borrowings under
this line of credit agreement are collateralized by all of our assets. We are in
compliance with the terms of the agreement, and at December 31, 2001 had no
borrowings under the line of credit.


In December 1997, as a source of capital asset financing, we entered into a
loan and security agreement with a finance company for an amount up to $288,000.
The amounts borrowed are subject to interest of 10.11%, were repayable by
December 2000, and were partially collateralized by a certificate of deposit of
$125,000, which is included as restricted cash on the accompanying balance
sheet. The loan was completely paid off as of December 31, 2000. The restricted
cash was returned to us in February 2001.


In December 2000, as a source of capital asset financing, we entered into a
loan and security agreement with a finance company for an amount of $75,000.
This loan is subject to interest of 12.82% and is repayable by December 2006. As of December 31, 2001, the future minimum
payments are $86,000.


23
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In April 2001, as a source of capital asset financing, we entered into a
loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% and is repayable by April 2003. As of
December 31, 2001, the future minimum payments are $22,000.


The Company has entered into noncancelable operating leases that expire at
various stages ending in 2006, and is responsible for certain maintenance costs,
taxes and insurance under the leases. In August 2000, the Company entered into a
lease for a new facility in Morgan Hill, California and relocated its corporate
headquarters in December 2000 after the lease at the Santa Clara, California
location expired at the same time. The lease on the new facility has a term of 5
years, expiring in December 2005 with one conditional three-year option, which
if exercised would extend the lease to December 2008 commencing with rent at
ninety-five percent of fair market value.


The following represents combined aggregate maturities for all the
Companys financing and commitments as of December 31, 2001:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Year Ended December 31, |  | Operating Leases  |  | Capital LeaseObligations |   | TotalCommitments |  |   |    
| | ----------------------- |  | ----------------- |  | ------------------------ | - | ---------------- |  | - | ---
| |                         |  | 2002              |  |                          | $ | 267              |  | $ | 28 
| |                         |  | 2003              |  |                          |   | 280              |  |   | 28 
| |                         |  | 2004              |  |                          |   | 285              |  |   | 20 
| |                         |  | 2005              |  |                          |   | 278              |  |   | 17 
| |                         |  | 2006              |  |                          |   | 14               |  |   | 15 
| |                         | 
| |                         |  | Total Commitments |  |                          | $ | 1,124            |  | $ | 108
| |                         | 

|In addition to the commitments shown above, the Company has a $3.0 million
collateralized revolving line of credit with a bank, which expires in March
2003, pursuant to which the Company may borrow 100% against pledges of cash at
the banks prime rate (4.75% at December 31, 2001). Borrowings under this line
of credit agreement are collateralized by all of the assets of the Company. The
Company was in compliance with the terms of the agreement, and at December 31,
2001 had no borrowings under the line of credit.


Net cash provided by operations in fiscal 2001 was $643,000 as compared to
$188,000 of net cash used in operations in fiscal 2000. The increase was largely
a result of improved collection of outstanding balances owed to us by our
customers, reduced inventory to meet the current revenue projections, offset in
part by more timely payments to our vendors.


Net cash used in investing activities reduced to $105,000 in fiscal 2001,
as compared to $559,000 in fiscal 2000. We acquired additional property and
equipment of $80,000, $593,000 and $184,000, in fiscal 2001, 2000, and 1999,
respectively. The increase in property and equipment in fiscal 2001 and fiscal
2000 were largely a reflection of the investment of leasehold improvements in
our new corporate headquarters, and excluded capital equipment of $25,000 and
$75,000, respectively, in fiscal 2001 and fiscal 2000 purchased through
equipment leases. Other reductions in computer and office equipment in fiscal
2001 represented mostly excess equipment taken out of service from our offices
in El Dorado Hills, California and the United Kingdom, as they were deemed
unnecessary due to the reductions in workforce.


The development and marketing of products requires significant amounts of
capital. The Company believes that its existing cash balances, anticipated cash
flows from operations and available lines of credit will be sufficient to meet
its anticipated capital requirements for the next 12 months. However, a decline
in future orders and revenues might require us to seek additional capital to
meet our working capital needs during or beyond the next twelve months if we are
unable to reduce expenses to the degree necessary to avoid incurring losses. If
we have a need for additional capital resources, we may be required to sell
additional equity or debt securities, secure additional lines of credit or
obtain other third party financing. The timing and amount of such capital
requirements cannot be determined at this time and will depend on a number of
factors, including demand for the Companys existing and new products and
changes in technology in the networking industry. There can be no assurance that
such additional financing will be available on satisfactory terms when needed,
if at all. To the extent that additional capital is raised through the sale of
additional equity or convertible debt securities, the issuance of such
securities would result in additional dilution to our shareholders.


24
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|RISK FACTORS


Shareholders
or investors considering the purchase of shares of the Companys Common Stock should
carefully consider the following risk factors, in addition to other information in this
Annual Report on Form 10-K. Additional risks and uncertainties not presently known to the
Company or that the Company currently deems immaterial also may impair the Companys
business operations.


Fluctuations in Operating Results


The Companys revenue and operating results have fluctuated in the past and
the Companys future revenues and operating results are likely to fluctuate
significantly in the future, particularly on a quarterly basis.


The Companys operating results may vary significantly from quarter to
quarter due to a variety of factors, some of which are outside the control of
the Company, including changes in the Companys product and customer mix,
constraints in the Companys manufacturing and assembling operations, shortages
or increases in the prices of raw materials and components, changes in pricing
policy by the Company or its competitors, a slowdown in the growth of the
networking market, seasonality, timing of expenditures and economic conditions
in the United States, Europe and Asia. The Companys sales will often reflect
orders shipped in the same quarter in which they are received. The Companys
backlog at any given time is not necessarily indicative of actual sales for any
succeeding period. In addition, significant portions of the Companys expenses
are relatively fixed in nature, and planned expenditures are based primarily on
sales forecasts. Therefore, if the Company inaccurately forecasts demand for its
products, the impact on net income may be magnified by the Companys inability
to adjust spending quickly enough to compensate for the net sales shortfall.


Other factors contributing to fluctuations in the Companys quarterly
operating results include changes in the demand for the Companys products,
customer order deferrals in anticipation of new versions of the Companys
products, the introduction of new products and product enhancements by the
Company or its competitors, the effects of filling the distribution channels
following such introductions, potential delays in the availability of announced
or anticipated products, the mix of product and service revenue, the
commencement or conclusion of significant development contracts, changes in
foreign currency exchange rates, the timing of acquisitions and associated
costs, and the timing of significant marketing and sales promotions. Based on
the foregoing, the Company believes that quarterly operating results are likely
to vary significantly in the future and that period-to-period comparisons of its
results of operations are not necessarily meaningful and should not be viewed
upon as indications of future performance.


History of Losses; Accumulated Deficit


The Company has experienced significant operating losses and, as of
December 31, 2001, had an accumulated deficit of $24.8 million. The development
and marketing by the Company of its current and new products will continue to
require substantial expenditures. The Company incurred $591,000 of
losses in fiscal 2001 due to a slowdown in demand for its products due in part
to an industry-wide adverse economic condition. There can be no assurance that
growth in net sales or profitability will be achieved or sustained in future
years. See Managements Discussion and Analysis of Financial Condition and
Results of Operations.


25
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Nasdaq SmallCap Listing; Risk associated with Limited Market


The Companys Common Stock has been listed on the Nasdaq SmallCap Market
since April 1999. In order to maintain its listing on the Nasdaq SmallCap
Market, the Company must maintain total assets, capital and public float at
specified levels, and generally must maintain a minimum bid price of $1.00 per
share. If the Company fails to maintain the standard necessary to be quoted on
the Nasdaq SmallCap Market, the Companys Common Stock could become subject to
delisting. On March 12, 2002, the Company received a notice from the Nasdaq
Stock Market that its common stock had failed to maintain the minimum bid price
of $1.00 per share required for continued listing on the Nasdaq SmallCap Market.
If the Companys common stock fails to meet the $1.00 bid price per share for a
minimum of ten consecutive trading days prior to September 9, 2002, the
Companys Common Stock will be delisted from the Nasdaq SmallCap Market. If the
Common Stock is delisted, trading in the Common Stock could be conducted on the
OTC Bulletin Board or in the over-the-counter market in what is commonly
referred to as the pink sheets. If this occurs, a shareholder will find it
more difficult to dispose of the Common Stock or to obtain accurate quotations
as to the price of the Common Stock. Lack of any active trading market would
have an adverse effect on a shareholders ability to liquidate an investment in
the Companys Common Stock easily and quickly at a reasonable price. It might
also contribute to volatility in the market price of the Companys Common Stock
and could adversely affect the Companys ability to raise additional equity or
debt financing on acceptable terms or at all. Failure to obtain desired
financing on acceptable terms could adversely affect the Companys business,
financial condition and results of operations.


Rapid Technological Change; Risks Associated with New Products


The market for the Companys products is affected by rapidly changing
networking technology and evolving industry standards and the emergence of the
Internet and other new communication technologies. The Company believes that its
future success will depend upon its ability to enhance its existing products and
to identify, develop, manufacture and introduce new products which conform to or
support emerging network telecommunications standards, are compatible with a
growing array of computer and peripheral devices, support popular computer and
network operating systems and applications, meet a wide range of evolving user
needs and achieve market acceptance. There can be no assurance that the Company
will be successful in these efforts. The Company has incurred, and the Company
expects to continue to incur, substantial expenses associated with the
introduction and promotion of new products. There can be no assurance that the
expenses incurred will not exceed research and development cost estimates or
that new products will achieve market acceptance and generate sales sufficient
to offset development costs. In order to develop new products successfully, the
Company is dependent upon timely access to information about new technological
developments and standards. There can be no assurance that the Company will have
such access or that it will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others. Furthermore, the Company expects that printer and other peripheral
manufacturers will add features to their products that make them more network
accessible, which may reduce demand for the Companys print servers. There can
be no assurance that products or technologies developed by others will not
render the Companys products non-competitive or obsolete. The fax-on-demand
market in general has been negatively affected by the growth of the Internet.
Although the Company has new Web/fax/email products in development, there can be
no assurance these products will compete successfully. Complex products such as
those offered by the Company may contain undetected or unresolved hardware
defects or software errors when they are first introduced or as new versions are
released. Changes in the Companys or its suppliers manufacturing processes or
the inadvertent use of defective components by the Company or its suppliers
could adversely affect the Companys ability to achieve acceptable manufacturing
yields and product reliability. The Company has in the past discovered hardware
defects and software errors in certain of its new products and enhancements
after their introduction. There can be no assurance that despite testing by the
Company and by third-party test sites, errors will not be found in future
releases of the Companys products, which would result in adverse product
reviews and negatively affect market acceptance of these products.


26
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The introduction of new or enhanced products requires the Company to manage
the transition, both internally and for customers, from the older products to
the new or enhanced products or versions. The Company must manage new product
introductions so as to minimize disruption in customer ordering patterns, avoid
excessive levels of older product inventories and ensure that adequate supplies
of new products can be delivered to meet customer demands. The Company has from
time to time experienced delays in the shipment of new products. There can be no
assurance that future product transitions will be managed successfully by the
Company.


Key Personnel


The Companys success depends to a significant degree upon the continued
contributions of the Companys key management, marketing, product development
and operational personnel. The success of the Company will depend to a large
extent upon its ability to retain and continue to attract highly skilled
personnel. Competition for employees in the computer industry is intense, and
there can be no assurance that the Company will be able to attract and retain
enough qualified employees. The Companys inability to retain and attract key
employees could have a material adverse effect on the Companys product
development, business, operating results and financial condition. The Company
does not carry key person life insurance with respect to any of its personnel.


Competition and Price Erosion


The network enhancement products and computer software markets are highly
competitive, and the Company believes that such competition will intensify in
the future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. The
Company currently competes principally in the market for network fax servers and
network print servers and fax-on-demand software. Increased competition, direct
and indirect, could adversely affect the Companys business and operating
results through pricing pressure, loss of market share and other factors. In
particular, the Company expects that, over time, average selling prices for its
print server products will continue to decline, as the market for these products
becomes increasingly competitive. Any material reduction in the average selling
prices of the Companys products would adversely affect gross margins. There can
be no assurance the Company will be able to maintain the current average selling
prices of its products or the related gross margins.


The principal competitive factors affecting the market for the Companys
products include product functionality, performance, quality, reliability, ease
of use, quality of customer training and support, name recognition, price, and
compatibility and conformance with industry standards and changing operating
system environments. Several of the Companys existing and potential
competitors, most notably the Hewlett-Packard Company (Hewlett-Packard) and
Intel Corporation (Intel), have substantially greater financial, engineering,
manufacturing and marketing resources than the Company. The Company also
experiences competition from a number of other software, hardware and service
companies. In addition to its current competitors, the Company may face
substantial competition from new entrants into the network enhancement market,
including established and emerging computer, computer peripherals,
communications and software companies. In the fax server market the Company
competes with companies such as Captaris Inc., Omtool, Ltd. and Computer
Associates International, Inc.


27
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|There can be no assurance that competitors will not introduce products
incorporating technology more advanced than the technology used by the Company
in its products. In addition, certain competing methods of communications such
as the Internet or electronic mail could adversely affect the market for fax
products. Certain of the Companys existing and potential competitors in the
print server market are manufacturers of printers and other peripherals, and
these competitors may develop closed systems accessible only through their own
proprietary servers. There can be no assurance that the Company will be able to
compete successfully or that competition will not have a material adverse effect
on the Companys business, operating results and financial condition.


International Sales


Sales to customers located outside Canada and the United States accounted
for approximately 20%, 25% and 31% of the Companys net sales in fiscal 2001,
2000 and 1999, respectively. The Company sells its products in approximately 40
foreign countries through approximately 50 international distributors. Macnica,
the Companys principal Japanese distributor, accounted for approximately 46%,
60% and 60% of the Companys international sales in fiscal 2001, 2000 and 1999,
respectively, and 10%, 15% and 18% of the Companys total net sales in fiscal
2001, 2000 and 1999, respectively. The Company expects that international sales
will continue to represent a significant portion of the Companys product
revenues and that the Company will be subject to the normal risks of
international sales, such as export laws, currency fluctuations, longer payment
cycles, greater difficulties in accounts receivable collections and the
requirement of complying with a wide variety of foreign laws. There can be no
assurance that the Company will not experience difficulties resulting from
changes in foreign laws relating to the export of its products in the future. In
addition, because the Company primarily invoices its foreign sales in U.S.
dollars, fluctuations in exchange rates could affect demand for the Companys
products by causing its prices to be out of line with products priced in the
local currency. Additionally, any such difficulties would have a material
adverse effect on the Companys international sales and a resulting material
adverse effect on the Companys business, operating results and financial
condition. In fiscal 2001, the Company consolidated its operations in the United
Kingdom and entered into an agreement with a distributor to service the region.
In addition, the Company entered into a separate agreement in fiscal 2001 with a
Japanese distributor to sell the Companys LANpress products in Japan, from
which the Company is entitled to receive a royalty on sales of these products.
The Company may experience fluctuations in European sales on a quarterly basis
because European sales may be weaker during the third quarter than the second
quarter due to extended holiday shutdowns in July and August. There can be no
assurance that the Company will be able to maintain the level of international
sales in the future. Any fluctuations in international sales will greatly affect
the Companys operating results and financial condition.


Lack of Product Revenue Diversification


The Company derives substantially all of its sales from its fax and print
server products, with its fax server products accounting for 91% of its total
sales in fiscal 2001. The Company is leveraging its expertise in these areas to
develop new messaging features and products to support greater integration into
corporate network environments and with Internet communications. The Company
expects that its current products will continue to account for a majority of the
Companys sales in the near future. A decline in demand for these products as a
result of competition, technological change or other factors, or a delay in the
development and market acceptance of new features and products, would have a
material adverse effect on the Companys business, operating results and
financial condition.


Product Transition; Risk of Product Returns and Inventory Obsolescence


From time to time, the Company may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release
of a new product or product version may result in the write-down of products in
inventory if such inventory becomes obsolete. The Company has in the past
experienced increased returns of a particular product version following the
announcement of a planned release of a new version of that product. There can be
no assurance that product returns will not exceed the Companys allowance for
such returns in the future and will not have a material adverse effect on the
Companys business, operating results and financial condition.


28
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Concentration of Distributors; Distribution Risks


The Company sells its products primarily through a two-tier domestic and
international distribution network. The Companys distributors sell Castelles
products to VARs, e-commerce vendors and other resellers. The distribution of
personal computers and networking products has been characterized by rapid
change, including consolidations due to the financial difficulties of
distributors and the emergence of alternative distribution channels. In
addition, an increasing number of companies are competing for access to these
channels. The Companys distributors typically represent other products that are
complementary to, or compete with, those of the Company. In particular, certain
of its competitors, including Hewlett-Packard and Intel, sell a substantially
higher dollar volume of products through several of the Companys large U.S.
distributors, and as a result, the Company believes such distributors give
higher priority to products offered by such competitors. The Companys
distributors are not contractually committed to future purchases of the
Companys products and could discontinue carrying the Companys products at any
time for any reason. In addition, because the Company is dependent on a small
number of distributors for a significant portion of the sales of its products,
the loss of any of the Companys major distributors or their inability to
satisfy their payment obligations to the Company could have a significant
adverse effect on the Companys business, operating results and financial
condition. The Company has a stock rotation policy with certain of its
distributors that allows them to return marketable inventory against offsetting
orders. Should the Company reduce its prices, the Company credits certain of its
distributors for the difference between the purchase price of products remaining
in their inventory and the Companys reduced price for such products. In
addition, due to industry conditions or the actions of competitors, inventory
levels of the Companys products held by distributors could become excessive,
resulting in product returns and inventory write-downs. Although the Company
provides an allowance for anticipated returns and for price protection, and
believes its existing policy results in the establishment of an allowance that
is adequate, there can be no assurance that in the future returns and price
protection will not have a material adverse effect on the Companys business,
operating results and financial condition.


Dependence on Third-Party Suppliers and Subcontractors


The Companys products incorporate or require components or sub-assemblies
procured from third-party suppliers. Certain of these components or
sub-assemblies are available only from a single source, and others are available
only from limited sources. Certain key components of the Companys products,
including a modem chip set from Conexant Systems, Inc. (Conexant) and a
microprocessor from Motorola, Inc. (Motorola), are currently available from
single sources. Other product components are currently available from only a
limited number of sources. In addition, the Company subcontracts a substantial
portion of its manufacturing to third parties, and there can be no assurance
that these subcontractors will be able to support the manufacturing requirements
of the Company. Other than an agreement with Sercomm Corporation to manufacture
certain print server products, the Company does not have material long-term
supply contracts with third parties or any other sole or limited source vendors
and subcontractors. The Company purchases components or sub-assemblies on a
purchase order basis. The Companys ability to obtain these components and
sub-assemblies is dependent upon its ability to accurately forecast customer
demand for its products and to anticipate shortages of critical components or
sub-assemblies created by competing demands upon suppliers. If the Company were
unable to obtain a sufficient supply of high-quality components or
sub-assemblies from its current sources, the Company
could experience delays in obtaining such components or sub-assemblies from
other sources. Resulting delays or reductions in product shipments could
adversely affect the Companys business, operating results and financial
condition and damage customer relationships. Furthermore, a significant increase
in the price of one or more of these components or sub-assemblies or the
Companys inability to lower component or sub-assembly prices in response to
competitive price reductions could adversely affect the Companys business,
operating results and financial condition.


29
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company augments its product offerings by obtaining access to
third-party products and technologies in areas outside of its core competencies
or where the Company believes internal development of products and technologies
is not cost-effective. The Companys third-party supplier of certain print
server products is SerComm. There can be no assurance that these products will
produce gross margins comparable to those of the Companys internally generated
products or that the parties with which the Company contracts will continue to
provide the quantities and quality of products needed by the Company or that
they will upgrade their respective products on a timely basis. The termination
of the Companys relationships with third-party product suppliers and with
SerComm, in particular, could result in delays or reductions in product
shipments, which could have a material adverse effect on the Companys business,
operating results and financial condition.


Government Regulation


Certain aspects of the networking industry in which the Company competes
are regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, particularly in foreign countries where
telecommunications standards differ from those in the United States, or the
inability to obtain regulatory approvals within a reasonable period of time,
could have a material, adverse effect on the Companys business, operating
results and financial condition. The Companys products must comply with a
variety of equipment, interface and installation standards promulgated by
communications regulatory authorities in different countries. Changes in
government policies, regulations and interface standards could require the
redesign of products and result in product shipment delays which could have a
material, adverse impact on the Companys business, operating results and
financial condition.


Dependence on Proprietary Rights; Uncertainty of Obtaining Licenses


The Companys success depends to a certain extent upon its technological
expertise and proprietary software technology. The Company relies upon a
combination of contractual rights and copyright, trademark and trade secret laws
to establish and protect its technologies. Despite the precautions taken by the
Company, it may be possible for unauthorized third parties to copy the Companys
products or to reverse engineer or obtain and use information that the Company
regards as proprietary. In addition, the laws of some foreign countries either
do not protect the Companys proprietary rights or offer only limited
protection. Given the rapid evolution of technology and uncertainties in
intellectual property law in the United States and internationally, there can be
no assurance that the Companys current or future products will not be subject
to third-party claims of infringement. Any litigation to determine the validity
of any third-party claims could result in significant expense to the Company and
divert the efforts of the Companys technical and management personnel, whether
or not such litigation is determined in favor of the Company. In the event of an
adverse result in any such litigation, the Company could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that the Company would be successful in such development or that any
such licenses would be available. The Company also relies on technology licenses
from third parties. There can be no assurance that these licenses will continue
to be available to the Company upon reasonable terms, if at all. Any impairment
or termination of the Companys relationship with third-party licensors could
have a material adverse effect on the Companys business, operating results and
financial condition. There can be no assurance that the Companys precautions
will be adequate to deter misappropriation or infringement of its proprietary
technologies. Furthermore, while the Company has obtained federal registration
for many of its trademarks in the United States, certain of its trademarks have
not been registered in the United States or foreign jurisdictions. There can be
no assurance that the Companys use of such registered trademarks will not be
contested by third parties in the future.


30
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The Company has received, and may receive in the future, communications
asserting that its products infringe the proprietary rights of third parties or
seeking indemnification against such infringement. There can be no assurance
that third parties will not assert infringement claims against the Company with
respect to current or future products or that any such assertion may not require
the Company to enter into royalty arrangements or result in costly litigation.
As the number of software products in the industry increases and the
functionality of these products further overlap, the Company believes that
software developers may become increasingly subject to infringement claims. Any
such claims, with or without merit, can be time consuming and expensive to
defend. There can be no assurance that any such intellectual property litigation
that may be brought in the future will not have a material adverse effect on the
Companys business, operating results and financial condition. As a result of
such claims or litigation, it may become necessary or desirable in the future
for the Company to obtain licenses relating to one or more of its products or
relating to current or future technologies, and there can be no assurance that
it would be able to do so on commercially reasonable terms.


Possible Volatility of the Companys Common Stock Price


The price of the Companys Common Stock has fluctuated widely in the past.
Sales of substantial amounts of the Companys Common Stock, or the perception
that such sales could occur, could adversely affect prevailing market prices for
the Companys Common Stock. The management of the Company believes that such
past fluctuations may have been caused by the factors identified above as well
as announcements of new products, quarterly fluctuations in the results of
operations and other factors, including changes in the condition of the personal
computer industry in general. These fluctuations, as well as general economic,
political and market conditions, such as recessions or international currency
fluctuations, may adversely affect the market price of the Companys Common
Stock. Stock markets have experienced extreme price volatility in recent years.
This volatility has had a substantial effect on the market prices of securities
issued by the Company and other high technology companies, often for reasons
unrelated to the operating performance of the specific companies. The Company
anticipates that prices for Castelle Common Stock may continue to be volatile.
Such future stock price volatility for Castelle Common Stock may provoke the
initiation of securities litigation, which may divert substantial management
resources and have an adverse effect on the Companys business, operating
results and financial condition.


Future Capital Requirements


The development and marketing of products requires significant amounts of
capital. The Company believes that its existing cash balances, anticipated cash
flows from operations and available lines of credit will be sufficient to meet
its anticipated capital requirements for the next 12 months. However, a decline
in future orders and revenues might require us to seek additional capital to
meet our working capital needs during or beyond the next twelve months if we are
unable to reduce expenses to the degree necessary to avoid incurring losses. If
we have a need for additional capital resources, we may be required to sell
additional equity or debt securities, secure additional lines of credit or
obtain other third party financing. The timing and amount of such capital
requirements cannot be determined at this time and will depend on a number of
factors, including demand for the Companys existing and new products and
changes in technology in the networking industry. There can be no assurance that
such additional financing will be available on satisfactory terms when needed,
if at all. To the extent that additional capital is raised through the sale of additional equity or convertible debt
securities, the issuance of such securities would result in additional dilution
to our shareholders. See Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and Capital Resources.


31
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Recent Terrorist Activity in the United States and the Military Action to
Counter Terrorism Could Adversely Impact Our Business


The September 11, 2001 terrorist attacks in the United States, the ensuing
declaration of war on terrorism and the continued threat of terrorist activity
and other acts of war or hostility appear to be having an adverse effect on
business, financial and general economic conditions in the U.S. These effects
may, in turn, result in increased costs due to the need to provide enhanced
security, which would have a material adverse effect on our business and results
of operations. These circumstances may also adversely affect our ability to
attract and retain customers and our ability to raise additional capital.


Voting Control by Officers, Directors and Affiliates


At March 15, 2002, the Companys officers and directors and their
affiliates beneficially owned approximately 29% of the outstanding shares of
Common Stock. Accordingly, together they had the ability to significantly
influence the election of the Companys directors and other corporate actions
requiring shareholder approval. Such concentration of ownership may have the
effect of delaying, deferring or preventing a change in control of the Company.


Certain Charter Provisions


The Companys Board of Directors has authority to issue up to 2,000,000
shares of Preferred Stock and to fix the rights, preferences, privileges and
restrictions, including voting rights, of these shares without any further vote
or action by the shareholders. The rights of the holders of the Companys Common
Stock will be subject to, and may be adversely affected by, the rights of the
holders of any Preferred Stock that may be issued in the future. The issuance of
Preferred Stock, while providing desirable flexibility in connection with
possible acquisitions and other corporate purposes, could have the effect of
making it more difficult for a third party to acquire a majority of the
outstanding voting stock of the Company, thereby delaying, deferring or
preventing a change in control of the Company. Furthermore, such Preferred Stock
may have other rights, including economic rights, senior to the Common Stock,
and as a result, the issuance thereof could have a material adverse effect on
the market value of the Companys Common Stock.


Recent Accounting Pronouncements


In July 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS
141 requires the purchase method of accounting for business combinations
initiated after June 30, 2001 and eliminates the pooling-of-interests method. We
believe that the adoption of SFAS 141 will not have a significant impact on our
financial statements.


In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which is effective for fiscal years beginning after March 15, 2001.
SFAS 142 requires, among other things, the discontinuance of goodwill
amortization. In addition, the standard includes provisions upon adoption for
the reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the testing for impairment of existing goodwill and other intangibles. We
believe that the adoption of SFAS 142 will not have a significant impact on our
financial statements.


32
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS 144 supercedes SFAS 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of. SFAS 144 applies to all long-lived assets (including
discontinued operations) and consequently amends Accounting Principles Board
Opinion No. 30. SFAS 144 develops one accounting model for long-lived assets
that are to be disposed of by sale. SFAS 144 requires that long-lived assets
that are to be disposed of by sale be measured at the lower of book value or
fair value less cost to sell. Additionally, SFAS 144 expands the scope of
discontinued operations to include all components of an entity with operations
that (1) can be distinguished from the rest of the entity and (2) will be
eliminated from the ongoing operations of the entity in a disposal transaction.
SFAS 144 is effective for the Company for all financial statements issued in
fiscal 2002. We are currently assessing, but have not yet determined, the impact
of SFAS 144 on the Company.


In November 2001, the Emerging Issues Task Force (EITF) reached consensus
on EITF No. 01-9, Accounting for Consideration Given by a Vendor to a Customer
or Reseller of the Vendors Products. EITF No. 01-9 addresses the accounting
for consideration given by a vendor to a customer and is a codification of EITF
No. 00-14, Accounting for Certain Sales Incentives, EITF No. 00-22,
Accounting for Points and Certain Other Time-Based or Volume-Based Sales
Incentives Offers and Offers for Free Products or Services to be Delivered in
the Future, and EITF No. 00-25, Vendor Income Statement Characterization of
Consideration Paid to a Reseller of the Vendors Products. EITF 01-09 presumes
that consideration from a vendor to a customer or reseller of the vendors
products to be a reduction of the selling prices of the vendors products and,
therefore, should be characterized as a reduction of revenue when recognized in
the vendors income statement and could lead to negative revenue under certain
circumstances. Revenue reduction is required unless consideration relates to a
separate identifiable benefit and the benefits fair value can be established.
This issue should be applied no later than in annual or interim financial
statements for periods beginning after December 15, 2001, which is our first
quarter ended March 31, 2002. Upon adoption we are required to reclassify all
prior period amounts to conform to the current period presentation. We are
currently assessing, but have not yet determined, the impact of EITF No. 01-9 on
our statement of operations.


ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


We considered the provision of Financial Reporting Release No. 48
Disclosure of Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative
Information about Market Risk Inherent in Derivative Financial Instruments,
Other Financial Instruments and Derivative Commodity Instruments. We had no
holdings of derivative financial or commodity instruments at December 31, 2001.
However, we are exposed to financial market risks, including changes in interest
rates and foreign currency exchange rates. While much of our revenue is
transacted in U.S dollars, some revenues and capital spending are transacted in
Pounds Sterling. These amounts are not currently material to our financial
statements; therefore we believe that foreign currency exchange rates should not
materially affect our overall financial position, results of operations or cash
flows. The fair value of our money market account or related income would not be
significantly impacted by increases or decreases in interest rates due mainly to
the highly liquid nature of this investment. However, sharp declines in interest
rates could seriously harm interest earnings on this account.


33
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------------------------------------------------------

| |  | (a) |  | The
following financial statements of the Company and the report of the Companys
independent accountants are included in Item 14:
| |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------

| |  | Page inForm 10-K |                                                                   
| |  | ---------------- | ------------------------------------------------------------------
| |  |                  | Report of Independent Accountants                                 
| |  |                  | Consolidated Balance Sheets as of December 31, 2001 and 2000      
| |  |                  | Consolidated Statements of Operations for the years ended         
| |  |                  | December 31, 2001, 2000 and 1999                                  
| |  |                  | Consolidated Statement of Shareholders Equity for the years ended
| |  |                  | December 31, 2001, 2000 and 1999                                  
| |  |                  | Consolidated Statements of Cash Flows for the years ended         
| |  |                  | December 31, 2001, 2000 and 1999                                  
| |  |                  | Notes to Consolidated Financial Statements                        

| |  | (b) |  | The
following financial statement schedules of Castelle for the years ended December 31,
2001, 2000 and 1999 are filed as part of this Form 10-K and should be read in conjunction
with the Companys Financial Statements.
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Page inForm 10-K |                                                
| |  | ---------------- | -----------------------------------------------
| |  |                  | Report of Independent Accountants              
| |  |                  | Schedule II - Valuation and Qualifying Accounts

| | Schedules
not listed above have been omitted because they are not applicable or are not required or
because the required information is included in the Financial Statements or Notes thereto.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|None


34
|---------

|PART III


ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT


Identification of Directors


The information required by this Item concerning the Companys directors is
incorporated by reference from the sections captioned Proposal 1: Election of
Directors contained in the Companys definitive Proxy Statement (the Proxy
Statement), related to its 2002 Annual Meeting of Shareholders to be filed by the Company
with the Securities and Exchange Commission (SEC) no later than April 30, 2002 or will be
provided in an amendment to this Form 10-K to be filed with the SEC no later than April 30, 2002.


Identification of Executive Officers


The information required by this Item concerning the Companys executive
officers is set forth in Part I of this Report.


ITEM 11.    EXECUTIVE COMPENSATION


The information required by this Item is incorporated by reference to the
section captioned Executive Compensation in the Proxy Statement.


ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


The information required by this Item is incorporated by reference to the
section captioned Security Ownership of Certain Beneficial Owners and
Management contained in the Proxy Statement.


ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


In January 2001, the Company engaged W.R. Hambrecht & Co. (WRH & Co.), an
investment bank in which Mr. Hambrecht, a director of the Company, is a partner,
to provide certain financial advisory services to the Company. As of April 2001,
WRH & Co. had rendered an insignificant level of services to the Company under
this arrangement.


Other information required by this Item is incorporated by reference from
the sections captioned Certain Transactions and Executive Compensation
contained in the Proxy Statement.


35
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART IV


ITEM 14.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|------------------------------------------------------------------------------------

| |  | (a) |  | The
following documents are filed as part of this Annual Report on Form 10-K:
| |  | --- |  | -----------------------------------------------------------------------------

| |  |  |  | 1. |  | Consolidated
Financial Statements required to be filed by Item 8 of Form 10-K. See the list of
Financial Statements contained in Item 8 of this Report.
| |  |  |  | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  | 2. |  | Financial
Statement Schedules required to be filed by Item 8 of Form 10-K. See the list of
Financial Statement Schedules contained in Item 8 of this Report.
| |  |  |  | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (b) |  | Reports
on Form 8-K - None
| |  | --- |  | --------------------------

| |  | (c) |  | Exhibits
| |  | --- |  | --------

| |  |  |  | 3.1 |  | Amended
and Restated Articles of Incorporation of the Company. (1)
| |  |  |  | --- |  | ------------------------------------------------------------------

| |  |  |  | 3.2 |  | Amended
and Restated Bylaws of the Company. (2)
| |  |  |  | --- |  | -----------------------------------------------

| |  |  |  | 4.1 |  | Reference
is made to Exhibits 3.1 and 3.2.
| |  |  |  | --- |  | ------------------------------------------

| |  |  |  | 10.1 | * | 1995
Non-Employee DirectorsStock Option Plan, as amended, and form of Director Stock
Option Agreement.
| |  |  |  | ---- | - | -------------------------------------------------------------------------------------------------------

| |  |  |  | 10.2 | * | Form
of Indemnity Agreement between the Registrant and each of its directors and executive
officers. (1)
| |  |  |  | ---- | - | --------------------------------------------------------------------------------------------------------

| |  |  |  | 10.3 |  | OEM
Purchase Agreement dated May 23, 1995, by and between the Registrant and SerComm
Corporation. (1)
| |  |  |  | ---- |  | -----------------------------------------------------------------------------------------------------

| |  |  |  | 10.4 |  | Distribution
Agreement dated February 26, 1990, by and between the Registrant and Ingram Micro D Inc.
(1)
| |  |  |  | ---- |  | ---------------------------------------------------------------------------------------------------------

| |  |  |  | 10.5 |  | Distributor
Contract dated June 25, 1991, as amended June 25, 1991, by and between the Registrant and
Tech Data Corporation. (1)
| |  |  |  | ---- |  | --------------------------------------------------------------------------------------------------------------------------------

| |  |  |  | 10.6 |  | Distributor
Agreement dated October 1, 1990, by and between the Registrant and Vitek. (1)
| |  |  |  | ---- |  | -----------------------------------------------------------------------------------------

| |  |  |  | 10.7 |  | International
Distributor Agreement dated February 24, 1994, by and between the Registrant and Macnica.
(1)
| |  |  |  | ---- |  | -----------------------------------------------------------------------------------------------------------

| |  |  |  | 10.8* | * | 1988
Equity Incentive Plan, as amended and form of option agreements.
| |  |  |  | ----- | - | ---------------------------------------------------------------------

| |  |  |  | 10.9 | * | Form
of Executive Severance and Transition Benefits Agreement between the Company and Messier.
D. Rich. (3)
| |  |  |  | ---- | - | -----------------------------------------------------------------------------------------------------------

| |  |  |  | 10.10 | * | Employment
agreement between the Company and Messier. D. Rich. (4)
| |  |  |  | ----- | - | ------------------------------------------------------------------

| |  |  |  | 10.11 |  | International
Distributor Agreement dated April 24, 2001 by and between the Registrant and AMS Limited.
| |  |  |  | ----- |  | -------------------------------------------------------------------------------------------------------

| |  |  |  | 10.12 |  | Commercial
Tenant Lease Agreement dated August 16, 2000 by and between the Registrant and Kyung S.
Lee and Ieesun Kim Lee.
| |  |  |  | ----- |  | --------------------------------------------------------------------------------------------------------------------------

| |  |  |  | 10.13 | * | Summary
of Severance Agreements with Named Executive Officers.
| |  |  |  | ----- | - | --------------------------------------------------------------

| |  |  |  | 11.1 |  | Computation
of Net Income (Loss) Per Share. Reference is made to page F-10 of the Notes to
Consolidated Financial Statements.
| |  |  |  | ---- |  | -----------------------------------------------------------------------------------------------------------------------------

| |  |  |  | 23.1 |  | Consent
of PricewaterhouseCoopers LLP.
| |  |  |  | ---- |  | --------------------------------------

| |  |  |  | 24.1 |  | Power
of Attorney. Reference is made to the signature page.
| |  |  |  | ---- |  | -----------------------------------------------------------

_____________

|(1) |  | Previously
filed as an exhibit to the Companys Registration Statement on Form SB-2 (Reg. No.
33-99628-LA-) or amendments thereto and incorporated herein by reference.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Previously
filed with the Companys Form 10-K for the fiscal year ended December 31, 2000.
|--- |  | ------------------------------------------------------------------------------------------

|(3) |  | Previously
filed as an exhibit to the Companys Form 10-K for the fiscal year ended December
31, 1999 and incorporated herein by reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------

|36
|--

|
|

|(4) |  | Previously
filed as an exhibit to the Companys Form 10-K for the fiscal year ended December
31, 1998 and incorporated herein by reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------

|* |  | Indicates
management contracts or compensatory plans or arrangements filed pursuant to Item
601(b)(10) of Regulation S-K.
|- |  | -------------------------------------------------------------------------------------------------------------------------

|37
|--

|SIGNATURES


Pursuant to the requirements of Section 13 or 15(d) of the Securities Act
of 1934, an amended, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized on
the twenty-ninth day of March 2002.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | By: /S/ DONALD L. RICH

Donald L. Rich
Chief Executive Officer and President
| |  | ------------------------------------------------------------------------------------------

|KNOW BY ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Donald L. Rich, as his true and lawful
attorney-in-fact and agent, with full power of substitution for him, and in his
name in any and all capacities, to sign any and all amendments to this Annual
Report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorney-in-fact and agent, full power and authority to do
and perform each and every act and thing requisite and necessary to be done
therewith, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorney-in-fact and
agent, and any of them, or his substitute or substitutes, may lawfully do or
cause to be done by virtue hereof.


Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Name |  | Title |  | Date
|---- |  | ----- |  | ----

|/S/ DONALD L. RICH 

Donald L. Rich |  | Chairman of the Board and Director,
Chief Executive Officer, President
(principal executive officer) |  | March 29, 2002
|---------------------------------------------- |  | ---------------------------------------------------------------------------------------------------- |  | --------------

|/S/ PAUL CHENG

Paul Cheng |  | Vice President, Finance and Administration, Chief
Financial Officer (principal accounting officer),
Secretary |  | March 29, 2002
|------------------------------------- |  | ------------------------------------------------------------------------------------------------------------- |  | --------------

|/S/ PETER TIERNEY

Peter Tierney |  | Director |  | March 29, 2002
|------------------------------------------- |  | -------- |  | --------------

|/S/ SCOTT MCDONALD

Scott McDonald |  | Director |  | March 29, 2002
|--------------------------------------------- |  | -------- |  | --------------

|/S/ ROBERT HAMBRECHT   

Robert Hambrecht |  | Director |  | March 29, 2002
|---------------------------------------------------- |  | -------- |  | --------------

|/s/ JACK HOWARD        

Jack Howard |  | Director |  | March 29, 2002
|----------------------------------------------- |  | -------- |  | --------------

|38
|--

|Castelle
Consolidated Financial Statements
as of December 31, 2001 and 2000
and for each of the three years in the
period ended December 31, 2001
|-------------------------------------------------------------------------------------------------------------------------------------------------

|Report of Independent Accountants


To the Board of Directors and
Shareholders of Castelle


In our opinion, the consolidated financial statements listed in the index
appearing under Item 14 (a)(1) on page 36 present fairly, in all material
respects, the financial position of Castelle and its subsidiaries at December
31, 2001 and December 31, 2000, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2001 in
conformity with accounting principles generally accepted in the United States of
America. In addition, in our opinion, the financial statement schedules listed
in the index appearing under Item 14(a)(2) on page 36 present fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements. These financial statements
and financial statement schedules are the responsibility of the Companys
management; our responsibility is to express an opinion on these financial
statements and financial statement schedules based on our audits. We conducted
our audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.


PricewaterhouseCoopers LLP
San Jose, California
February 21, 2002
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Castelle
Consolidated Balance Sheets(in thousands)
|--------------------------------------------------

|                                                   | December 31, | 
|-------------------------------------------------- | ------------ | 
|
|Assets                                             |              | 
|Current assets:                                    |              | 
|Cash and cash equivalents                          |              | 
|Restricted cash                                    |              | 
|Accounts receivable, net of allowance for          |              | 
|doubtful accounts of $206 in 2001 and $285 in 2000 |              | 
|Inventories                                        |              | 
|Prepaid expenses and other current assets          |              | 
|                                                   |              | 
|Total current assets                               |              | 
|                                                  
|Property and equipment, net                        |              | 
|Other assets                                       |              | 
|                                                   |              | 
|Total assets                                       |              | 
|                                                   |              | 
|Liabilities and Shareholders Equity               |              | 
|Current liabilities:                               |              | 
|Long-term debt, current portion                    |              | 
|Accounts payable                                   |              | 
|Accrued liabilities                                |              | 
|                                                   |              | 
|Total current liabilities                          |              | 
|                                                  
|Long-term debt, net of current portion             |              | 
|                                                   |              | 
|Total liabilities                                  |              | 
|                                                   |              | 
|Commitments (Note 4)                               |              | 
|                                                  
|Shareholders Equity:                              |              | 
|Preferred stock, no par value:                     |              | 
|Authorized:  2,000 shares in 2001 and 2000         |              | 
|Issued and outstanding:  none in 2001 and 2000     |              | 
|Common stock, no par value:                        |              | 
|Authorized:  25,000 shares                         |              | 
|Issued and outstanding: 4,745 shares in 2001       |              | 
|and 4,741 shares in 2000                           |              | 
|Deferred compensation                              |              | 
|Accumulated deficit                                |              | 
|                                                   |              | 
|Total shareholders equity                         |              | 
|                                                   |              | 
|Total liabilities and shareholders equity         |              | 
|                                                   |              | 

|The accompanying notes
are an integral part of these financial statements.


F-2
|--------------------------------------------------------------------------------

|Castelle
Consolidated Statements of Operations(in thousands, except per share data)
|-----------------------------------------------------------------------------------

|                                               | Year ended December 31, | 
|---------------------------------------------- | ----------------------- | 
|
|Net sales                                      |                         | 
|Cost of sales                                  |                         | 
|                                               |                         | 
|Gross profit                                   |                         | 
|                                               |                         | 
|Operating expenses:                            |                         | 
|Research and development                       |                         | 
|Sales and marketing                            |                         | 
|General and administrative                     |                         | 
|Amortization of intangible assets              |                         | 
|Restructuring and other charges                |                         | 
|                                               |                         | 
|                                               |                         | 
|                                               |                         | 
|                                              
|Operating (loss)/income                        |                         | 
|                                              
|Interest income, net                           |                         | 
|Other income/(expense), net                    |                         | 
|                                               |                         | 
|(Loss)/income before provision for             |                         | 
|income taxes                                   |                         | 
|Provision for income taxes                     |                         | 
|                                               |                         | 
|Net (loss)/income                              |                         | 
|                                               |                         | 
|Net (loss)/income per common share - basic     |                         | 
|                                               |                         | 
|Shares used in per share calculation - basic   |                         | 
|                                               |                         | 
|Net (loss)/income per common share - diluted   |                         | 
|                                               |                         | 
|Shares used in per share calculation - diluted |                         | 
|                                               |                         | 

|The accompanying notes
are an integral part of these financial statements.


F-3
|--------------------------------------------------------------------------------

|Castelle
Consolidated Statements of Shareholders Equity
Years Ended December 31, 2001, 2000 and 1999(in thousands)
|-------------------------------------------------------------------------------------------------------------------

|                                             | Common Stock |  | NotesReceivableforPurchaseofCommon |       | Deferred |   | Accumulated |   |  
|-------------------------------------------- | ------------ |  | ---------------------------------- | ----- | -------- | - | ----------- | - | -
|
|Balances, December 31, 1998                  |              |  |                                    | 4,337 |          | $ | 29,255      |   | $
|Issuance of common stock through             |              | 
|exercise of stock options                    |              |  |                                    | 17    |          |   | 10          |   |  
|Issuance of common stock in                  |              | 
|connection with acquisition                  |              |  |                                    | 340   |          |   |            |   |  
|Amortization of deferred compensation        |              |  |                                    |      |          |   |            |   |  
|Repayment of notes receivable                |              |  |                                    |      |          |   |            |   |  
|Cancellation of notes receivable             |              |  |                                    |      |          |   |            |   |  
|Retirement of restricted stock               |              |  |                                    | (53   | )        |   | (263        | ) |  
|Net loss                                     |              |  |                                    |      |          |   |            |   |  
|                                             |              |  |                                    |       |          |   |             |   |  
|Balances, December 31, 1999                  |              |  |                                    | 4,641 |          | $ | 29,002      |   | $
|                                             |              |  |                                    |       |          |   |             |   |  
|Issuance of common stock through             |              | 
|exercise of stock options                    |              |  |                                    | 30    |          |   | 24          |   |  
|Exchange of warrants                         |              | 
|for common stock                             |              |  |                                    | 70    |          |   |            |   |  
|Deferred compensation related to options     |              | 
|issued to consultant                         |              |  |                                    |      |          |   | 17          |   |  
|Write-off of deferred compensation           |              | 
|related to options issued to consultant      |              |  |                                    |      |          |   | (67         | ) |  
|Net                                          |              |  |                                    |      |          |   |            |   |  
|income                                       |              | 
|                                             |              |  |                                    |       |          |   |             |   |  
|Balances, December 31, 2000                  |              |  |                                    | 4,741 |          | $ | 28,976      |   | $
|                                             |              |  |                                    |       |          |   |             |   |  
|Issuance of common stock through             |              | 
|exercise of stock options                    |              |  |                                    | 4     |          |   | 1           |   |  
|Deferred compensation related to options     |              | 
|issued to consultant                         |              |  |                                    |      |          |   | 4           |   |  
|Revaluation of options issued to consultants |              |  |                                    |      |          |   | (4          | ) |  
|Amortization of deferred compensation        |              |  |                                    |      |          |   |            |   |  
|Net loss                                     |              |  |                                    |      |          |   |            |   |  
|                                             |              |  |                                    |       |          |   |             |   |  
|Balances, December 31, 2001                  |              |  |                                    | 4,745 |          | $ | 28,977      |   | $
|                                             |              |  |                                    |       |          |   |             |   |  

|The accompanying notes
are an integral part of these financial statements.


F-4
|--------------------------------------------------------------------------------

|Castelle
Consolidated Statements of Cash Flows
Years Ended December 31, 2001, 2000 and 1999(in thousands)
|---------------------------------------------------------------------------------------------------------

|                                                            | Year ended December 31, | 
|----------------------------------------------------------- | ----------------------- | 
|
|Cash flows from operating activities:                       |                         | 
|Net (loss)/income                                           |                         | 
|Adjustments to reconcile net (loss)/income to               |                         | 
|net cash (used in) provided by operating activities:        |                         | 
|Depreciation and amortization                               |                         | 
|Provision for doubtful accounts and sales returns           |                         | 
|Provision for excess and obsolete inventory                 |                         | 
|Compensation expense related to grant of stock options      |                         | 
|Loss/(profit) on disposal of fixed assets                   |                         | 
|Changes in assets and liabilities:                          |                         | 
|Accounts receivable                                         |                         | 
|Inventories                                                 |                         | 
|Prepaid expenses and other current assets                   |                         | 
|Other assets                                                |                         | 
|Accounts payable                                            |                         | 
|Accrued liabilities                                         |                         | 
|                                                            |                         | 
|Net cash provided by/(used in) operating activities         |                         | 
|                                                            |                         | 
|Cash flows from investing activities:                       |                         | 
|Acquisition of property and equipment                       |                         | 
|Proceeds from sale of fixed assets                          |                         | 
|                                                            |                         | 
|Net cash used in investing activities                       |                         | 
|                                                            |                         | 
|Cash flows from financing activities:                       |                         | 
|Return of restricted cash                                   |                         | 
|Issuance/(Repayment) of notes payable                       |                         | 
|Proceeds from collection of note receivable for stock       |                         | 
|Proceeds from issuance of common stock and warrants, net of |                         | 
|repurchases                                                 |                         | 
|                                                            |                         | 
|Net cash provided by/(used in) financing activities         |                         | 
|                                                            |                         | 
|Net increase/(decrease) in cash and cash equivalents        |                         | 
|Cash and cash equivalents, beginning of period              |                         | 
|                                                            |                         | 
|Cash and cash equivalents, end of period                    |                         | 
|                                                            |                         | 
|Supplemental information:                                   |                         | 
|Cash paid during the period for:                            |                         | 
|Interest                                                    |                         | 
|Income taxes                                                |                         | 
|Noncash investing and financing activities:                 |                         | 
|Note payable for fixed asset acquisition                    |                         | 
|Warrants converted into common stock                        |                         | 

|The accompanying notes
are an integral part of these financial statements.


F-5
|--------------------------------------------------------------------------------

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

|1. |  | Business
and Organization of the Company
|-- |  | ----------------------------------------

| | Castelle
designs, develops, markets and supports server appliances providing office messaging
solutions and other shared services. The Companys current products are focused on
two areas: fax and integrated messaging products, including a range of software
enhancements, and print servers. The Companys products consist of FaxPress, an
integrated hardware/software network faxing solution; OfficeDirect, an integrated
fax/email messaging system; InfoPress, an enterprise-level fax-on-demand software product
and LANpress print servers.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company distributes its products primarily through a two-tier, domestic and international
distribution network, with its distributors selling Castelles products to
value-added resellers, system integrators, e-commerce retailers and other resellers in
the United States, Europe and the Pacific Rim. The Company also has relationships with
selected original equipment manufactures and sells software enhancements and upgrades
directly to end-users.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company believes that its existing cash balances, anticipated cash flows from operations
and available lines of credit will be sufficient to meet its anticipated capital
requirements for the next 12 months. However, a decline in future orders and revenues
might require us to seek additional capital to meet our working capital needs during or
beyond the next twelve months if we are unable to reduce expenses to the degree necessary
to avoid incurring losses. If we have a need for additional capital resources, we may be
required to sell additional equity or debt securities, secure additional lines of credit
or obtain other third party financing. The timing and amount of such capital requirements
cannot be determined at this time and will depend on a number of factors, including
demand for the Companys existing and new products and changes in technology in the
networking industry. There can be no assurance that such additional financing will be
available on satisfactory terms when needed, if at all. To the extent that additional
capital is raised through the sale of additional equity or convertible debt securities,
the issuance of such securities would result in additional dilution to our shareholders.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
addition, because the Company is dependent on a small number of distributors for a
significant portion of the sales of its products, the loss of any of the Companys
major distributors or their inability to satisfy their payment obligations to the Company
could have a significant adverse effect on the Companys business, operating results
and financial condition.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | Castelles
discussion and analysis of its financial condition and results of operations are based on
Castelles consolidated financial statements, which have been prepared in accordance
with accounting principles generally accepted in the United States. The preparation of
these financial statements require Castelle to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. On an on-going basis, Castelle evaluates
its estimates, including those related to product returns, bad debts, incentives to
resellers, inventories, income taxes, warranty obligations, excess components,
restructuring, service contracts and contingencies and litigation. Castelle bases its
estimates on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates under
different assumptions or conditions.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-6
|---

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Basis
of consolidation
| | ----------------------

| | The
consolidated financial statements include the accounts of Castelle and its wholly owned
subsidiaries in the United States, the United Kingdom and the Netherlands. All
intercompany balances and transactions have been eliminated.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Financial
instruments
| | ---------------------

| | Cash
equivalents consist of highly liquid investments with original maturities of three months
or less.
| | -------------------------------------------------------------------------------------------------------

| | Amounts
reported for cash equivalents, receivables and other financial instruments approximate
fair values based upon comparable market information available at the respective balance
sheet dates.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Financial
instruments that potentially subject the Company to concentrations of credit risks
consist principally of cash, notes receivable and trade accounts receivable. The Company
maintains its cash balances at a variety of financial institutions and has not
experienced any losses relating to any of its money market funds or bank deposits.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Derivatives
and hedging activities
| | ----------------------------------

| | The
Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, as amended, at the beginning of its fiscal year 2001. The standard requires
the Company to recognize all derivatives on the balance sheet at fair value. Derivatives
that are not hedges must be adjusted to fair value through the statement of operations.
If the derivative is a hedge, depending on the nature of the hedge, changes in the fair
value of derivatives will either be offset against the change in fair value of the hedged
assets, liabilities or firm commitments through earnings, or recognized in other
comprehensive income (loss) until the hedged item is recognized in earnings. The
ineffective portion of a derivatives change in fair value will be immediately
recognized in earnings. The adoption of SFAS No. 133 did not have a material effect on
the financial statements of the Company. As of December 31, 2001, the Company had not
entered into any derivative or hedging activities.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Certain
risks and concentrations
| | --------------------------------

| | Ongoing
customer credit evaluations are performed by the Company and collateral is not required.
Castelle assesses collection based on a number of factors, including past transaction
history with the customer and the credit-worthiness of the customer. When credit criteria
are not met, the Company requires cash-on-delivery or payments by credit card before the
products are shipped. On a quarterly basis, Castelle specifically analyzes accounts
receivable, potential returns, historical bad debts, customer concentrations, and changes
in customer payment terms when evaluating the adequacy of the allowance for doubtful
accounts and for potential returns. Such returns and losses have generally been within
managements expectations. If the financial condition of Castelles customers
were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. Three customers accounted for 72% of accounts
receivable at December 31, 2001 and three customers accounted for 59% of accounts
receivable at December 31, 2000. In fiscal 2001, three distributors accounted for
approximately 27%, 17% and 10% of our net sales. In fiscal 2000, the same three
distributors accounted for approximately 17%, 10% and 15% of net sales,
respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-7
|---

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | The
Company derives substantially all of its sales from its fax and print server products,
with its fax server products accounting for 91% of its total sales in fiscal 2001. The
Company is leveraging its expertise in these areas to develop new messaging features and
products to support greater integration into corporate network environments and with
Internet communications. The Company expects that its current products will continue to
account for a majority of the Companys sales in the near future. In addition, the
Companys products include components subject to rapid technological change. As
such, significant technological change could adversely affect the Companys
operating results and subject the Company to returns of product and inventory losses.
While the Company has ongoing programs to minimize the adverse effect of such changes and
consider technological change in estimating its allowances, such estimates could change
in the future. In addition, one of the Companys print server products is currently
manufactured by a single supplier and certain key components are currently available from
only single sources.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Inventories and related allowance for obsolete and excess inventory Inventories are stated at the
lower of standard cost (which approximates cost on a first-in, first-out basis) or
market. Inventories have also been reduced by an allowance for excess and obsolete
inventories. The estimated allowance is based on managements review of inventories
on hand on a quarterly basis, compared to managements assumptions about future
demand, market conditions and anticipated timing of the release of product upgrades or
next generation products. If actual market conditions for future demand are less
favorable than those projected by us or if product upgrades or next general products are
released earlier than anticipated, additional inventory write-downs may be required.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Property
and equipment
| | ----------------------

| | Property
and equipment are stated at cost less accumulated depreciation and amortization.
Depreciation is provided using the straight-line method over the estimated useful lives
of the respective assets, generally three to seven years. Amortization of leasehold
improvements is provided on a straight-line basis over the life of the related asset or
the lease term, if shorter. Gains and losses upon asset disposal are recognized in the
year of disposition. Expenditures for replacements and betterments are capitalized, while
expenditures for maintenance and repairs are charged against earnings as incurred.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accounting
for long-lived assets
| | --------------------------------

| | The
Company reviews property and equipment for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be recoverable.
Recoverability is measured by comparison of its carrying amount to future net cash flows
the assets are expected to generate. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying amount of the
asset exceeds its fair market value.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-8
|---

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Revenue
recognition
| | -------------------

| | Castelle
recognizes revenue based on the provisions of Staff Accounting Bulletin (SAB)
No. 101 Revenue Recognition in Financial Statements and Statement of Financial
Accounting Standards (SFAS) No. 48 Revenue Recognition When Right of
Return Exists.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Product
revenue is recognized upon shipment if a signed contract exists, the fee is fixed and
determinable, collection of the resulting receivables is probable and product returns are
reasonably estimable. Shipment generally occurs when product is delivered to a common
carrier.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company enters into agreements with certain of its distributors which permit limited
stock rotation rights. These stock rotation rights allow the distributor to return
products for credit but require the purchase of additional products of equal value.
Customers who purchase our products directly from us also have limited return rights,
which expire thirty days from product shipment. Revenues subject to stock rotation rights
are reduced by managements estimates of anticipated exchanges. Castelle establishes
its returns allowance policy for distributors based on historic return rates from these
distributors.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Pursuant
to the Companys distributor agreements, the Company also protects its distributorsexposure
related to the impact of price reductions. Price adjustments are recorded at the time
products are shipped. Castelle estimates the impact of price reductions based on
historical data.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company recognizes revenue from the sale of extended warranty contracts ratably over the
period of the contracts.
| | ---------------------------------------------------------------------------------------------------------------------

| | Castelle
recognizes royalty on the sale of LANpress products by a Japanese distributor. Royalty is
not recognized as revenue until the products are sold by the distributor.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Provisions
for estimated warranty costs are recorded at the time products are shipped.
| | --------------------------------------------------------------------------------------

| | Advertising
costs
| | -----------------

| | Advertising
costs, included in sales and marketing expenses, are expensed as incurred and were
$713,000, $1,171,000 and $889,000 in 2001, 2000 and 1999, respectively.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Research
and development expenses
| | ---------------------------------

| | Costs
related to the conceptual formulation and design of both hardware and software products
are expensed as research and development while costs incurred subsequent to establishing
technological feasibility of software products are capitalized until general release of
the product. Generally, technological feasibility is established upon completion of a
working model. No significant costs subsequent to such point have been incurred, and all
such costs have been expensed.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Foreign
currency translation
| | ----------------------------

| | The
functional currency of the Companys foreign subsidiaries are the U.S. dollar.
Accordingly, all assets and liabilities are translated into U.S. dollars at the current
exchange rates as of the applicable balance sheet date. Revenues and expenses are
translated at the average exchange rates prevailing during the period. Cumulative gains
and losses from the translation of the foreign subsidiaries financial statements have been included in
shareholders equity. In fiscal year 2001, the foreign currency loss was
$8,000. For fiscal 2000, the Company experienced a foreign currency loss of
$77,000.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-9
|---

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Net
income/(loss) per share
| | ---------------------------

| | Basic
net income/(loss) per share is computed by dividing net income/(loss) available to common
shareholders by the weighted average number of common shares outstanding for that period.
Diluted net income/(loss) per share is computed giving effect to all dilutive potential
common shares that were outstanding during the period. Dilutive potential shares consist
of incremental common shares issuable upon exercise of stock options and warrants.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Basic
and diluted earnings per share are calculated as follows for fiscal 2001, 2000 and 1999
(in thousands except per share amounts):
| | --------------------------------------------------------------------------------------------------------------------------------------

| |  | 2001 |                                             | 2000 |  | 1999 |      
| |  | ---- | ------------------------------------------- | ---- |  | ---- | -----
| |  |      | Basic:                                      |      |  |      |      
| |  |      | Weighted average shares                     |      |  |      | 4,744
| |  |      |                                             |      |  |     
| |  |      | Net (loss)/income                           |      |  | $    | (591 
| |  |      |                                             |      |  |     
| |  |      | Net (loss)/income per share                 |      |  | $    | (0.12
| |  |      |                                             |      |  |     
| |  |      | Diluted:                                    |      | 
| |  |      | Weighted average shares                     |      |  |      | 4,744
| |  |      | Common equivalent shares from stock options |      |  |      |     
| |  |      |                                             |      |  |     
| |  |      | Shares used in per share calculation        |      |  |      | 4,744
| |  |      |                                             |      |  |     
| |  |      | Net (loss)/income                           |      |  | $    | (591 
| |  |      |                                             |      |  |     
| |  |      | Net (loss)/income per share                 |      |  | $    | (0.12
| |  |      |                                             |      |  |     

| | Due
to the losses in the periods, the calculation of diluted shares outstanding for fiscal
2001 and 1999 excludes 901,000, and 1,508,000 shares of common stock subject to
outstanding stock options, respectively, as their effect was antidilutive in the period.
In fiscal 2000, no shares of common stock were excluded.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | The Company accounts for its stock-based compensation plans in accordance with SFAS No. 123,
Accounting for Stock-Based Compensation. As permitted under SFAS No. 123, the Company
uses the intrinsic value-based method of Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, to account for its employee
stock-based compensation plans.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company accounts for stock-based compensation arrangements with nonemployees in
accordance with the Emerging Issues Task Force (EITF) Abstract No. 96-18,
Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring,
or in Conjunction with Selling Goods or Services. Accordingly, unvested options and
warrants held
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-10
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | by
nonemployees are subject to revaluation at each balance sheet date based on the then
current fair market value.
| | ------------------------------------------------------------------------------------------------------------------

| | Comprehensive
income
| | --------------------

| | Castelle
has adopted the provisions of SFAS No. 130, Reporting Comprehensive Income, effective
January 1, 1998. This statement requires the disclosure of comprehensive income and its
components in a full set of general-purpose financial statements. Comprehensive income is
the change in equity from transactions and other events and circumstances other than
those resulting from investments by owners and distributions to owners. There are no
significant components of comprehensive income excluded from net income, therefore, no
separate statement of comprehensive income has been presented.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Segment
information
| | -------------------

| | The
Company has adopted SFAS No. 131, Disclosure about Segments of an Enterprise and
Related Information. SFAS No. 131 establishes a framework on which to base segment
reporting and introduces requirements for interim reporting of segment information. The
Company uses one measurement of profitability of its business for internal purposes and
has determined that it operates in one business segment: server appliances. The Companys
international operations are analyzed in Note 9.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | New
accounting pronouncements
| | -----------------------------

| | In
July 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS 141
requires the purchase method of accounting for business combinations initiated after June
30, 2001 and eliminates the pooling-of-interests method. The Company believes that the
adoption of SFAS 141 will not have a significant impact on its financial statements.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which
is effective for fiscal years beginning after March 15, 2001. SFAS 142 requires, among
other things, the discontinuance of goodwill amortization. In addition, the standard
includes provisions upon adoption for the reclassification of certain existing recognized
intangibles as goodwill, reassessment of the useful lives of existing recognized
intangibles, reclassification of certain intangibles out of previously reported goodwill
and the testing for impairment of existing goodwill and other intangibles. The Company
believes that the adoption of SFAS 142 will not have a significant impact on its
financial statements.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-11
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS 144 supercedes SFAS 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of. SFAS 144 applies to all long-lived assets
(including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30. SFAS 144 develops one accounting model for
long-lived assets that are to be disposed of by sale. SFAS 144 requires
that long-lived assets that are to be disposed of by sale be measured at
the lower of book value or fair value less cost to sell. Additionally, SFAS
144 expands the scope of discontinued operations to include all components
of an entity with operations that (1) can be distinguished from the rest of
the entity and (2) will be eliminated from the ongoing operations of the
entity in a disposal transaction. SFAS 144 is effective for the Company for
all financial statements issued in fiscal 2002. The Company is currently
assessing, but has not yet determined, the impact of SFAS 144 on its
statement of operations.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In November 2001, the Emerging Issues Task Force (EITF) reached consensus
on EITF No. 01-9, Accounting for Consideration Given by a Vendor to a
Customer or Reseller of the Vendors Products. EITF No. 01-9 addresses the
accounting for consideration given by a vendor to a customer and is a
codification of EITF No. 00-14, Accounting for Certain Sales Incentives,
EITF No. 00-22, Accounting for Points and Certain Other Time-Based or
Volume-Based Sales Incentives Offers and Offers for Free Products or
Services to be Delivered in the Future, and EITF No. 00-25, Vendor Income
Statement Characterization of Consideration Paid to a Reseller of the
Vendors Products. EITF 01-09 presumes that consideration from a vendor to
a customer or reseller of the vendors products to be a reduction of the
selling prices of the vendors products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendors
income statement and could lead to negative revenue under certain
circumstances. Revenue reduction is required unless consideration relates
to a separate identifiable benefit and the benefits fair value can be
established. This issue should be applied no later than in annual or
interim financial statements for periods beginning after December 15, 2001,
which is the Companys first quarter ended March 31, 2002. Upon adoption,
the Company is required to reclassify all prior period amounts to conform
to the current period presentation. The Company is currently assessing, but
has not yet determined, the impact of EITF No. 01-9 on its financial
statements.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3. |  | Balance
Sheet Detail (in thousands)
|-- |  | -----------------------------------

| | Inventories:
| | ------------

| |  | December 31, |                   | 
| |  | ------------ | ----------------- | 
|
| |  |              | Raw material      | 
| |  |              | Work in process   | 
| |  |              | Finished goods    | 
| |  |              |                   | 
| |  |              | Total inventories | 
| |  |              |                   | 

|F-12
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Property
and equipment:
| | -----------------------

| |  | December 31, |                                                | 
| |  | ------------ | ---------------------------------------------- | 
|
| |  |              | Production, test and demonstration equipment   | 
| |  |              | Computer equipment                             | 
| |  |              | Office equipment                               | 
| |  |              | Leasehold improvements                         | 
| |  |              |                                                | 
| |  |              |                                                | 
| |  |              | Less accumulated depreciation and amortization | 
| |  |              |                                                | 
| |  |              | Total property and equipment                   | 
| |  |              |                                                | 

| | The
Company recorded depreciation and amortization related to property and equipment of
$230,000, $260,000 and $382,000 in 2001, 2000 and 1999, respectively. Castelle follows
the IRS recommendations regarding useful lives of the assets.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-13
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Accrued
liabilities:
| | --------------------

| |  | December 31, |                             | 
| |  | ------------ | --------------------------- | 
|
| |  |              | Accrued compensation        | 
| |  |              | Accrued sales and marketing | 
| |  |              | Accrued professional fees   | 
| |  |              | Deferred revenue            | 
| |  |              | Other accruals              | 
| |  |              |                             | 
| |  |              | Total accrued liabilities   | 
| |  |              |                             | 

|4. |  | Commitments
|-- |  | -----------

| | The
Company has entered into noncancelable operating leases that expire at various stages
ending in 2006, and is responsible for certain maintenance costs, taxes and insurance
under the leases. In August 2000, the Company entered into a lease for a new facility in
Morgan Hill, California and relocated its corporate headquarters in December 2000 after
the lease at the Santa Clara, California location expired at the same time. The lease on
the new facility has a term of 5 years, expiring in December 2005 with one conditional
three-year option, which if exercised would extend the lease to December 2008 commencing
with rent at ninety-five percent of fair market value. Future minimum payments under
noncancelable operating leases are as follows (in thousands):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Year Ended December 31, |  |     
| | ----------------------- |  | ----
| |                         |  | 2002
| |                         |  | 2003
| |                         |  | 2004
| |                         |  | 2005
| |                         |  | 2006
| |                         | 
| |                         |  |     
| |                         | 

| | Rent
expense, including the facility lease and equipment rental, was $360,000, $510,000, and
$466,000 for 2001, 2000 and 1999, respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company leases certain of its equipment under various operating and capital leases that
expire at various dates through fiscal 2006. The lease agreements frequently include
renewal and escalation clauses and purchase provisions and require the Company to pay
taxes, insurance and maintenance costs. As of December 31, 2001, the Company had loan and
security agreements  for an  aggregate  value of  $100,000,  which  are  subject  to
interest rates of 12.5% to 12.8%.  As of December 31, 2001,  future minimum
lease payments are $108,000 as follows (in thousands):
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-14
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Year Ended December 31, |  |                                               
| | ----------------------- |  | ----------------------------------------------
| |                         |  | 2002                                          
| |                         |  | 2003                                          
| |                         |  | 2004                                          
| |                         |  | 2005                                          
| |                         |  | 2006                                          
| |                         | 
| |                         |  | Total minimum lease payments                  
| |                         |  | Less amount representing interest             
| |                         | 
| |                         |  | Present value of capital lease obligations    
| |                         |  | Less current portion                          
| |                         | 
| |                         |  | Long-term portion of capital lease obligations
| |                         | 

|5. |  | Bank
Borrowings
|-- |  | ---------------

| | The
Company has a $3.0 million collateralized revolving line of credit with a bank, which
expires in March 2003, pursuant to which the Company may borrow 100% against pledges of
cash at the banks prime rate (4.75% at December 31, 2001). Borrowings under this
line of credit agreement are collateralized by all of the assets of the Company. The
Company was in compliance with the terms of the agreement, and at December 31, 2001 had
no borrowings under the line of credit.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|6. |  | Common
Stock
|-- |  | ------------

| | Non-Employee
DirectorsStock Option Plan
| | ----------------------------------------

| | In November 1995, the Companys
Board of Directors adopted the 1995 Non-Employee Directors Stock Option
Plan (Directors Plan). As of December 31, 2001, 120,000 shares of the
Companys common stock have been reserved for issuance under the Directors
Plan and activity under the Plan is as follows (in thousands):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-15
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| |  | Outstanding Options        
| |  | ---------------------------
|
| | 
| |  | Balances, January 1, 1999  
| |  | Options granted            
| |  | Options cancelled          
| |  |                            
| |  | Balances, December 31, 1999
| |  | Options granted            
| |  | Options cancelled          
| |  |                            
| |  | Balances, December 31, 2000
| |  | Options granted            
| |  | Options cancelled          
| |  |                            
| |  | Balances, December 31, 2001
| |  |                            

| | At
December 31, 2001, 2000, and 1999 69,000, 35,000 and 24,000 options, respectively, were
exercisable at a weighted total exercise price of $91,000, $43,000, and $79,000,
respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
options outstanding and currently exercisable by exercise price at December 31, 2001 are
as follows (in thousands, except years and per share data):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------

|F-16
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Options Outstanding |             | Options Exercisable |   
| | ------------------- | ----------- | ------------------- | --
|
| |                     | $0.00-$0.50 |                     | 20
| |                     | $0.51-$0.75 |                     | 2 
| |                     | $0.76-$1.50 |                     | 30
| |                     | $1.51-$2.00 |                     | 40
| |                     | $2.01-$2.50 |                     | 7 
| |                     |             |                     |   
| |                     |             |                     | 99
| |                     |             |                     |   

| | 1988
Incentive Stock Plan
| | -------------------------

| | Under
the 1988 Incentive Stock Plan (1988 Plan), the Board of Directors may grant
either the right to purchase shares or options to purchase shares of the Companys
common stock at prices not less than the fair market value at the date of grant for
incentive stock options and 85% of the fair market value for non-qualified options and
purchase rights. Options granted under the 1988 Plan generally become exercisable, and
the Companys right to repurchase shares issued and sold pursuant to stock purchase
rights lapses, at a rate of one-quarter of the shares under option or purchased under
stock purchase rights at the end of the first year and thereafter ratably over the next
three years and generally expire seven years from the date of grant. As of December 31,
2001, there were no stock purchase rights outstanding, and no shares purchased pursuant
to stock purchase rights were subject to repurchase by the Company.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Option
activity under the 1988 Plan was as follows (in thousands):
| | ------------------------------------------------------------------

|F-17
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| |  | Outstanding Options        
| |  | ---------------------------
|
| | 
| |  | Balances, January 1, 1999  
| |  | Options granted            
| |  | Options cancelled          
| |  | Options exercised          
| |  |                            
| |  | Balances, December 31, 1999
| |  | Options granted            
| |  | Options cancelled          
| |  | Options exercised          
| |  |                            
| |  | Balances, December 31, 2000
| |  | Options granted            
| |  | Options cancelled          
| |  | Options exercised          
| |  |                            
| |  | Balances, December 31, 2001
| |  |                            

| | At
December 31, 2001, 2000 and 1999, 944,000, 721,000 and 644,000 options, respectively,
were exercisable at a weighted average exercise price of $1,053,000, $812,000 and
$761,000, respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The  Company has adopted  the  disclosure-only  provisions  of SFAS No. 123
     Accounting for Stock-Based Compensation. Accordingly no compensation cost
     has been recognized for the  Non-Employee  Directors  Stock Option Plan or
     the 1988 Incentive Stock Plan. Had  compensation  cost for these Plans been
     determined  based on the fair value at the grant date,  the  Companys  net
     (loss) income and net (loss) income per share for 2001, 2000 and 1999 would
     have been reduced to the pro forma amounts indicated below (in thousands):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-18
|----

|
|

| |  | 2001 |                                                     | 2000 |  | 1999 |      
| |  | ---- | --------------------------------------------------- | ---- |  | ---- | -----
| |  |      | Net (loss)/income - as reported                     |      |  | $    | (591 
| |  |      | Net (loss)/income - pro forma                       |      |  | $    | (656 
| |  |      | Net (loss)/income per share - basic - as reported   |      |  | $    | (0.12
| |  |      | Net (loss)/income per share - basic - pro forma     |      |  | $    | (0.14
| |  |      | Net (loss)/income per share - diluted - as reported |      |  | $    | (0.12
| |  |      | Net (loss)/income per share - diluted - pro forma   |      |  | $    | (0.14

| | The
fair value of each option grant is estimated on the date of grant using the Black-Scholes
model with the following assumptions for 2001, 2000 and 1999:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 2001                    |  |  | 2000 |             |  | 1999 |            
| |  |  | ----------------------- |  |  | ---- | ----------- |  | ---- | -----------
| |  |  | Risk-free interest rate |  |  |      | 4.22%-5.25% |  |      | 5.85%-6.44%
| |  |  | Expected life           |  |  |      | 7.0 years   |  |      | 6.71 years 
| |  |  | Expected dividends      |  |  |      |            |  |      |           
| |  |  | Volatility              |  |  |      | 355         |  |      | 163        

| | The
weighted average fair value of options granted in 2001, 2000 and 1999 was $0.67, $1.21
and $0.85 per share, respectively. The options to purchase common stock outstanding and
currently exercisable by exercise price at December 31, 2001, including those issued to
Directors and outsiders, are as follows (in thousands, except years and per share data):
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Options Outstanding |             | Options Exercisable |      
| | ------------------- | ----------- | ------------------- | -----
|
| |                     | $0.00-$0.75 |                     | 116  
| |                     | $0.76-$1.00 |                     | 693  
| |                     | $1.01-$1.25 |                     | 165  
| |                     | $1.26-$1.50 |                     | 85   
| |                     | $1.51-$1.75 |                     | 219  
| |                     | $1.76-$2.00 |                     | 1    
| |                     |             |                     |      
| |                     |             |                     | 1,279
| |                     |             |                     |      

|F-19
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | Non-employees
| | -------------

| | In addition to the options granted to under the plans detailed above,
Castelle granted options to purchase common stock to consultants under
special arrangements. The Company accounts for stock-based compensation
arrangements with nonemployees in accordance with the Emerging Issues Task
Force (EITF) Abstract No. 96-18, Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services. Accordingly, unvested options and warrants held
by nonemployees are subject to revaluation at each balance sheet date based
on the then current fair market value.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During
the year ended December 31, 2001, the Company granted 3,000 options to a consultant.
Under EITF 96-18, the unvested options are revalued at each balance sheet date to reflect
their current fair value. Compensation expense is reflected in our results of operations
over the vesting period. As of December 31, 2001, the following assumptions were used in
determining the fair value of the options: deemed fair market value per share of $0.75,
dividend yield of 0%, expected volatility of 180%, risk-free interest rate of 5.48% and a
contractual life of 3 years.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During
the year ended December 31, 2000, the Company granted 20,000 options to non-employees.
Under EITF 96-18, the unvested options are revalued at each balance sheet date to reflect
their current fair value. Compensation expense is reflected in our results of operations
over the vesting period. As of December 31, 2001, the following assumptions were used in
determining the fair value of the options: deemed fair market value per share of $0.75,
dividend yield of 0%, expected volatility of 180%, risk-free interest rate of 5.48% and a
contractual life of 3 years.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | No
options were issued to consultants in 1999.
| | ----------------------------------------------

| | In
connection with its grant of options to non-employees, the Company has recognized a
reduction in deferred stock-based compensation of $4,000 for the year ended December 31,
2001 due to a reduction in the fair value of the Companys stock during the year and
amortization of deferred stock based compensation of $16,000. During 2000, we cancelled
options for 42,000 shares and, as a result, deferred compensation of $67,000 was written
off in 2000 as the related options were cancelled.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | There
were 35,000, 55,000 and 160,000 of options to consultants outstanding at December 31,
2001, 2000 and 1999, respectively, of which 35,000, 35,000 and 77,000 were exercisable at
a weighted total exercise price of $52,000, $52,000 and $117,000 in 2001, 2000 and 1999,
respectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Notes
receivable
| | ----------------

| | In
1999, the Company repurchased 53,000 shares of its common stock from executive officers
upon their termination of service and cancelled their notes receivable of $263,000.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|7. |  | Income
Taxes
|-- |  | ------------

| | The
Company has no provision for income tax in fiscal 2001 ($6,000 in fiscal 2000; $4,000 in
fiscal 1999).
| | ----------------------------------------------------------------------------------------------------------

|F-20
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | In
fiscal 2001, we did not utilize any losses available for carry-forward to offset the
current federal tax provision ($194,000 was utilized in fiscal 2000 and none in fiscal
1999). There was also no utilization of losses available for carry-forward to offset the
current state tax provision in fiscal 2001 ($255,000 in fiscal 2000 and none in fiscal
1999).
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys tax provision differs from the provision computed using statutory income
tax rates as follows (in thousands):
| | ---------------------------------------------------------------------------------------------------------------------------

| |  | 2001 |                                                         | 2000 |  | 1999 |     
| |  | ---- | ------------------------------------------------------- | ---- |  | ---- | ----
| |  |      | Federal tax provision/(benefit) at statutory rate       |      |  | $    | (201
| |  |      | Permanent difference due to                             |      | 
| |  |      | non-deductible expenses                                 |      |  |      | 8   
| |  |      | State taxes provision/(benefit), net of federal benefit |      |  |      | (7  
| |  |      | Change in valuation allowance                           |      |  |      | 258 
| |  |      | General business credits                                |      |  |      | (58 
| |  |      |                                                         |      |  |     
| |  |      |                                                         |      |  | $    |    
| |  |      |                                                         |      |  |     

| | The
components of the net deferred tax assets are as follows (in thousands):
| | ----------------------------------------------------------------------------

| |  | December 31, |                                      | 
| |  | ------------ | ------------------------------------ | 
|
| |  |              | Inventory allowances and adjustments | 
| |  |              | Accounts receivable allowances       | 
| |  |              | Other liabilities and allowances     | 
| |  |              | Net operating loss carryforwards     | 
| |  |              | Tax credit carryforwards             | 
| |  |              | Depreciation and amortization        | 
| |  |              | Valuation allowance                  | 
| |  |              |                                      | 
| |  |              | Total net deferred tax assets        | 
| |  |              |                                      | 

| | Due
to the uncertainty surrounding the realization of any future benefit from deductible
temporary differences, net operating losses and tax credit carry-forwards, the Company
has placed a full valuation allowance against its deferred tax asset balance.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | At
December 31, 2001, the Company had net operating loss carryforwards of approximately
$13,268,000 and $3,824,000 available to offset future federal and California taxable
income, respectively. These loss carryforwards begins to expire from in 2003 through 2021.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-21
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

| | For
federal and state income tax purposes, a portion of the Companys net operating loss
carryforward is subject to certain limitations on annual utilization in case of changes
in ownership, as defined by federal and state tax laws.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys loss before provision for income taxes is substantially all from domestic
operations.
| | ---------------------------------------------------------------------------------------------------

|8. |  | Retirement
Plan
|-- |  | ---------------

| | The
Company has a voluntary 401(k) plan covering substantially all employees. The plan
provides for employer contributions at the discretion of the Board of Directors. In 2001,
2000 and 1999, the Company made no contributions to the plan.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|9. |  | Major
Customers and Segment Information
|-- |  | ---------------------------------------

| | Revenues
by geographic area are determined by the location of the end user and are summarized as
follows (in thousands):
| | ------------------------------------------------------------------------------------------------------------------------

| | Years Ended December 31, | 
| | ------------------------ | 
|
| |                          | 
| |                          | 
| |                          | 
| |                          | 
| |                          | 
| |                          | 

| | Customers
that individually accounted for greater than 10% of net sales are as follows (in
thousands):
| | ------------------------------------------------------------------------------------------------------

| | Years Ended December 31, |  
| | ------------------------ | -
|
|
| |                          | A
| |                          | B
| |                          | C

|F-22
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

|10. |  | Restructuring
|--- |  | -------------

| | In
response to the continuing economic slowdown and decrease in demand for our products, we
terminated 17 regular, temporary and contractor positions in April 2001, which
constituted approximately 25% of our workforce. This action resulted in a severance
charge of $239,000 in the first nine months of fiscal 2001. The restructuring included an
asset write-off and other direct expenses associated with the consolidation of our
operations in the United Kingdom and El Dorado Hills, California.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Of
the total restructuring charge of $239,000, approximately $124,000 represented cash
charges already paid, $26,000 were for non-cash charges related to the write-down of
surplus fixed assets from the consolidation of our United Kingdom and El Dorado Hills
operations and $89,000 reflected obligations in fiscal 2002 mainly for costs associated
with remaining obligations related to our United Kingdom office and the final severance
payment to an employee. The majority of these expenses will be consummated in early
fiscal 2002. The following table sets forth an analysis of the components of the fiscal
2001 restructuring charge, the payments made against the reserve and the balance left as
of December 31, 2001 (in thousands of dollars):
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | TotalCharge |                      | Non-cashCharge |  | CashPayments |      | Reserve Balance atDecember 31,  2001 |  |     
| |  | ----------- | -------------------- | -------------- |  | ------------ | ---- | ------------------------------------ |  | ----
| |  |             | Severance & Benefits |                |  |              | $98  |                                      |  |     
| |  |             | Facilities           |                |  |              | 90   |                                      |  | $(26
| |  |             | Other                |                |  |              | 51   |                                      |  |     
| |  |             |                      |                |  |              |      |                                     
| |  |             | Total                |                |  |              | $239 |                                      |  | $(26

| | There
were no restructuring and other charges recorded in fiscal 2000.
| | ----------------------------------------------------------------------

| | In
1999, the Company recognized a restructuring charge of $402,000, including the
disposition of assets associated with the Companys exit from the ObjectFax NT
product line of $213,000, reducing headcount by 14 for a charge of $110,000, the
write-off of excess office space of $63,000 and other costs of $16,000. All related
expenses were paid out and written off in fiscal 1999 and fiscal 2000.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|11. |  | Litigation
|--- |  | ----------

| | The
Company has been contacted by a third party claiming that the Company needs to obtain
licenses of certain patents held by that party for certain of the Companys fax
server products. The Company is continuing to assess the validity and strength of the
claims, believes it has adequate legal defenses and believes the ultimate outcome of any
possible action will not have a material effect on the Companys financial position,
results of operations or cash flows although there can be no assurance as to the outcome
of any possible litigation.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-23
|----

|Castelle
Notes to Consolidated Financial Statements
|---------------------------------------------------

|12. |  | Subsequent
Events (unaudited)
|--- |  | -----------------------------

| | On
March 12, 2002, the Company received a notice from the Nasdaq Stock Market that its
common stock had failed to maintain the minimum bid price of $1.00 per share required for
continued listing on the Nasdaq SmallCap Market. If the Companys common stock fails
to meet the $1.00 bid price per share for a minimum of ten consecutive trading days prior
to September 9, 2002, the Companys Common Stock will be delisted from the Nasdaq
SmallCap Market. If the Common Stock is delisted, trading in the Common Stock could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is commonly
referred to as the pink sheets.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|F-24
|----

|
|

|Castelle and Subsidiaries
Valuation and Qualifying Accounts
(In thousands) | Schedule II
|-------------------------------------------------------------------------- | -----------
|                                                                          

|                                            | Balance atBeginningof Period | AdditionalCharged toCosts andExpenses | Deductions | Balance atEnd ofPeriod
|------------------------------------------- | ---------------------------- | ------------------------------------- | ---------- | ----------------------
|Year Ended December 31, 1999:               |                              |                                       |            |                       
|Deducted from asset accounts:               |                             
|Allowance for doubtful accounts             |                              | $  720                                |            | $                    
|Allowance for excess and obsolete inventory |                              | $  791                                |            | $  1,579              
|                                           
|Year Ended December 31, 2000:               |                             
|Deducted from asset accounts:               |                             
|Allowance for doubtful accounts             |                              | $  493                                |            | $     257             
|Allowance for excess and obsolete inventory |                              | $  459                                |            | $       80            
|                                           
|Year Ended December 31, 2001:               |                             
|Deducted from asset accounts:               |                             
|Allowance for doubtful accounts             |                              | $  285                                |            | $       59            
|Allowance for excess and obsolete inventory |                              | $  366                                |            | $     148             

|
|

|
|

|Castelle and Subsidiaries
Index to Exhibits | 
|------------------------------------------- | 
|                                           

|ExhibitNumber |  | Description
|------------- |  | -----------

|10.1* |  | 1995
Non-Employees Directors Stock Option Plan, as amended and form of Director Stock Option
Agreement.
|----- |  | --------------------------------------------------------------------------------------------------------

|10.11 |  | International
Distributor Agreement date April 24, 2001 by and between the Registrant and AMS Limited.
|----- |  | ------------------------------------------------------------------------------------------------------

|10.12 |  | Commercial
Tenant Lease Agreement dated August 16, 2000 by and between the Registrant and Kyung S.
Lee and Ieesun Kim Lee.
|----- |  | --------------------------------------------------------------------------------------------------------------------------

|10.13* |  | Summary
of Severance Agreements with Named Executive Officers.
|------ |  | --------------------------------------------------------------

|23.1 |  | Consent
of PricewaterhouseCoopers LLP.
|---- |  | --------------------------------------

|24.1 |  | Power
of Attorney. Reference is made to the signature page, (page 38).
|---- |  | ----------------------------------------------------------------------

---

|* |  | Indicates
management contracts or compensatory plans or arrangements filed pursuant to
Item 601(b)(10) of Regulation S-K.
|- |  | -------------------------------------------------------------------------------------------------------------------------