<PAGE>
 
================================================================================

                                 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 SEPTEMBER 30, 1996

                                       OR

[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
 
              FOR THE TRANSITION PERIOD FROM ________ TO ________


                         Commission file number 0-28450

                         FARALLON COMMUNICATIONS, INC.
             (Exact name of registrant as specified in its charter)


         DELAWARE                                              94-3033136
(State or other jurisdiction of                             (I.R.S. Employer
 incorporation or organization)                          Identification Number)


                            2470 MARINER SQUARE LOOP
                           ALAMEDA, CALIFORNIA  94501
          (Address of principal executive offices, including Zip Code)

                                -------------- 

                                 (510) 814-5100
              (Registrant's telephone number, including area code)

                                -------------- 

     Indicate by check X whether the registrant (1) has filed all reports
required to be filed by Sections 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 X if disclosure of delinquent filers pursuant to Item 405 of
regulation S-K is not contained herein, and will not be contained, to the best
of the Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in this Form 10-K or any amendment to this Form 10-K.

                           Yes    X        No
                                 ---           ---


     As of December 2, 1996 there were 11,126,239 shares of the Registrant's
Common Stock outstanding. The aggregate market value of the Common Stock held by
non-affiliates of the registrant, based on the closing price of the Common Stock
as reported on The Nasdaq Stock Market (National Market System) on December 2,
1996 was approximately $ 53,362,992.

                      DOCUMENTS INCORPORATED BY REFERENCE

     The Registrant's definitive Proxy Statement for its Annual Stockholders
Meeting to be held on February 14, 1997 is incorporated by reference in Part III
of this Form 10-K.

================================================================================
<PAGE>
 
                         FARALLON COMMUNICATIONS, INC.

                                   FORM 10-K

                                     INDEX
PART I.                                                                   PAGE
                                                                          ----
Item 1.  Description of Business..........................................   2
Item 2.  Properties.......................................................  17
Item 3.  Legal Proceedings................................................  17
Item 4.  Submission of Matters to a Vote of Securities Holders............  17

PART II

Item 5.  Market for Farallon Common Stock.................................  18
Item 6.  Selected Financial Data..........................................  19
Item 7.  Management's Discussion and Analysis of Financial Condition
         and Results of Operations........................................  20
Item 8.  Consolidated Financial Statements and Supplementary Data.........  27
Item 9.  Changes in and Disagreements with Accountants on Accounting
         and Financial Disclosure.........................................  27

PART III

Item 10. Directors and Executive Officers of the Registrant...............  27
Item 11. Executive Compensation...........................................  28
Item 12. Security Ownership of Certain Beneficial Owners and Management...  28
Item 13. Certain Relationships and Related Transactions...................  28

PART IV

Item 14. Exhibits and Consolidated Financial Statement Schedule...........  28
INDEX TO EXHIBITS.........................................................  28
SIGNATURE.................................................................  31

                                       1
<PAGE>
 
PART I.

    The discussion in this Report contains forward-looking statements that
involve risks and uncertainties. The statements contained in this Report that
are not purely historical are forward-looking statements within the meaning of
Section 27A of the Securities Exchange Act of 1933, as amended, including
statements regarding the Company's expectations, beliefs, intentions or
strategies regarding the future. All forward-looking statements included in
this document are based on information available to the Company on the date
hereof, and the Company assumes no obligation to update any such forward-
looking statement. The Company's actual results could differ materially from
those discussed herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in "Other Factors
Affecting Future Operating Results" as well as those discussed in this section
and elsewhere in this Report, and the risks discussed in the Company's
Securities and Exchange Commission Filings.

ITEM 1.   DESCRIPTION OF BUSINESS

COMPANY BACKGROUND

    Farallon Communications, Inc. (the "Company" or "Farallon") develops,
markets and supports complete, easy-to-use, plug-and-play Internet
connectivity and networking solutions and real-time collaboration software.
The Company's products are designed to increase the productivity and
efficiency of Internet, Intranet and LAN users and to target small businesses,
geographically dispersed facilities of large enterprises, home offices, mobile
users, schools and other small organizations that may not have access to
sophisticated technical support. The Company's Internet/Intranet products
include its Netopia routers and modems, which provide high-speed Internet
connectivity for individuals and workgroups, and its Timbuktu Pro
collaboration software, which enables real-time, peer-to-peer collaboration on
the Internet, Intranets and LANs. To assist users in configuring the Netopia
products and in arranging service from Internet and telecommunications service
providers, the Company offers its Up & Running, Guaranteed! program, which
serves as a single source for complete Internet connectivity. The Company's
LAN networking solutions, a substantial majority of which have been sold to
Mac OS customers, include its EtherWave family of products, which enable users
to easily and cost-effectively create Ethernet networks with or without a hub.

    The Company was founded in 1985 and initially focused on the development
of networking products for AppleTalk LANs, including the PhoneNET network
system. In 1993, the Company revised its business strategy to concentrate on
the Internet and Intranet markets through the utilization of its Transmission
Control Protocol/ Internet Protocol ("TCP/IP") and routing expertise. In the
first quarter of fiscal 1994, the Company released its first Timbuktu Pro
Internet/Intranet collaboration software product (TCP/IP enabled), and in the
first quarter of fiscal 1996, the Company introduced its Netopia family of
Internet connectivity products and services.

    The Company was incorporated in California in 1986 as Farallon Computing,
Inc. and was reincorporated in Delaware in June 1996 as Farallon
Communications, Inc. The Company's principal executive offices are located at
2470 Mariner Square Loop, Alameda, California 94501.


INDUSTRY BACKGROUND

    Small businesses, geographically dispersed facilities of large
enterprises, home offices, mobile users, schools and other small organizations
are increasingly using networks of computers to enhance productivity, access
information and communicate more effectively. A number of factors have
contributed to this increase in the use of networks, including increasing
personal mobility, the need for information access, a demand for immediate
information and advances in technology and infrastructure such as the
proliferation of communication-enabled PCs, the availability of intuitive
graphical software and the widespread implementation of distributed local and
wide area networks based on client/server architectures and, more recently,
peer-to-peer architectures. These 

                                       2
<PAGE>
 
factors also have changed substantially the way in which organizations and
individuals communicate and use PCs, generating growing demand for products
that enhance network communications.

    As networking technology has advanced, the scale, scope and functionality
of network communications and computing have increased, resulting in a
corresponding increase in the complexity of these systems. Headquarters
offices of large enterprises that have access to sophisticated technical
support have generally managed this complexity and realized the benefits of
effective network communications. However, individuals and smaller
organizations typically do not have access to the skills or resources required
to manage the complexity of advanced networking systems. As a result, these
users are increasingly seeking networking solutions that are complete, easy-to-
use and cost-effective.

    The emergence of the Internet as a viable communications medium has
substantially enhanced the value and potential of network communications and
computing. The Internet is a global, open network of thousands of
interconnected computer networks and millions of computer connections that
allow businesses, individuals and other organizations to communicate
worldwide. International Data Corporation ("IDC") has estimated that the
number of Internet users will be approximately 200 million by the end of 1999,
an increase from approximately 56 million at the end of 1995. In addition,
large enterprises are increasingly adopting private "Intranets" that employ
Internet data formats and communications protocols, such as TCP/IP, to connect
geographically dispersed networks and facilities. Intranets enable network
users to communicate and access information within an organization,
communicate with external users, such as suppliers, customers and consultants,
and use the World Wide Web (the "Web") to access information available on
the Internet. The emergence of the Internet and Intranets as well as the
increased affordability and availability of advanced hardware, software and
communications services (such as high-speed Integrated Services Digital
Network ("ISDN") telecommunications services) has made network
communications available to a broader range of users.

    As organizations and individuals expand the use of the Internet and
Intranets, the need for real-time collaboration and communication becomes
increasingly important to achieving increased user productivity and
efficiency. Real-time, peer-to-peer collaboration software enables users, such
as those at geographically dispersed facilities of large enterprises, remote
sites, traveling or working at home, to access information and enterprise
applications, and permits two or more users at disparate locations to view and
work with the same information at the same time. Productivity improvements are
also derived from peer-to-peer collaboration software that enables users to
receive real-time technical support and just-in-time training from a help desk
or another knowledgeable user on the Internet or Intranet.

    The increasing utility of the Internet and Intranets and the availability
of high-performance infrastructures that enable advanced capabilities, such as
real-time collaboration, are compelling small businesses, geographically
dispersed facilities of large enterprises, home offices, mobile users, schools
and other small organizations to adopt complex network communications and
computing systems. However, these organizations typically do not have access
to sophisticated technical support and therefore may not be well-served by
complex networking systems requiring extensive technical knowledge or
expertise. Today, the tasks of installing and configuring systems, obtaining
high-speed digital services such as ISDN and arranging for an Internet
connection from an ISP can be costly and burdensome for such users. In
addition, traditional vendors, resellers and systems integrators of networking
products historically have not offered products or services specifically
designed for users who may not have access to sophisticated technical support.
Accordingly, the absence of complete, easy-to-use, plug-and-play solutions for
affordable Internet/Intranet connectivity and real-time collaboration has
constrained the ability of these users to fully achieve the benefits of
network communications and computing.


THE FARALLON SOLUTION

    Farallon develops, markets and supports complete, easy-to-use, plug-and-
play Internet connectivity and networking solutions and real-time
collaboration software. The Company's products are designed to increase the
productivity and efficiency of Internet, Intranet and LAN users and to target
small businesses, geographically dispersed facilities of large enterprises,
home offices, mobile users, schools and other small organizations that may not
have access to sophisticated technical support. The Company's
Internet/Intranet products include its Netopia 

                                       3
<PAGE>
 
routers and modems and its Timbuktu Pro collaboration software. The Company's
LAN products include a broad range of Ethernet network connectivity devices.

    The Company's Netopia product family provides plug-and-play, high-speed
ISDN-based Internet connectivity for workgroups and individuals. The Company
offers comprehensive customer service and technical support, including the Up
& Running, Guaranteed! program, which serves as a single source for complete
Internet connectivity by assisting the user in configuring the Netopia router
and in arranging service from ISPs and telecommunications service providers.
The Timbuktu Pro collaboration software family enables real-time, peer-to-peer
communication and collaboration on the Internet, Intranets and LANs--viewing
other users' screens, revising information, transferring files, controlling
other computers and remotely accessing network resources. The Company's LAN
products allow users to easily and cost-effectively build 10Base-T Ethernet,
100Base-T Ethernet and LocalTalk networks. In particular, the Company's
patented EtherWave family of products enables users to create plug-and-play
10Base-T Ethernet networks with or without a hub.


THE FARALLON STRATEGY

    The Company's objective is to become the leading provider of complete,
high-speed Internet connectivity solutions and real-time, peer-to-peer
Internet/Intranet collaboration software for small businesses, geographically
dispersed facilities of large enterprises, home offices, telecommuting, mobile
users, schools and other small organizations that may not have access to
sophisticated technical support. Key elements of the Company's strategy
include the following:

    Provide Complete, Plug-and-Play Internet/Intranet Connectivity Solutions.
    ------------------------------------------------------------------------
The Company focuses on providing complete, high-speed Internet connectivity
solutions emphasizing ease of use and plug-and-play functionality consistent
with Farallon's tradition of providing products that are simple to install,
use and support. The Netopia products are bundled with Internet software and
are supported with the Company's Up & Running, Guaranteed! program, providing
users a single source for complete Internet connectivity. The Company intends
to develop future generations of its Netopia products that incorporate higher
bandwidth options and increased throughput, while retaining ease of use and
plug-and-play features.

    Leverage Collaboration Software Expertise. Utilizing expertise developed
    -----------------------------------------
in pioneering collaboration software for the workgroup, remote user and help
desk administrator, the Company intends to continue to offer products that
increase user productivity and efficiency by enabling real-time, peer-to-peer
collaboration over the Internet, Intranets and LANs. The Timbuktu Pro
collaboration software expands the functionality of the Internet beyond e-mail
and Web browsing by enabling users in any location to remotely access an
enterprise network and to engage in real-time collaboration with other
Timbuktu Pro users--viewing other users' screens, revising information,
transferring files, controlling other computers and remotely accessing network
resources. The Company intends to expand the number of real-time collaboration
tools it offers as well as broadly distribute its free Timbuktu Pro Look@Me
and FlashNote Internet applets.

    Target Rapidly Growing Markets for Networking and Collaboration Solutions.
    -------------------------------------------------------------------------
The Company targets those segments of the networking market that industry
sources have identified as the most rapidly growing such as small businesses,
geographically dispersed facilities of large enterprises, home offices, mobile
users, schools and other small organizations. These users generally do not
have access to sophisticated technical support and are not well-served by
traditional vendors of networking products, which have not historically
offered products specifically designed for these markets. The Company intends
to leverage its expertise in developing easy-to-use, plug-and-play LAN
networking solutions to more rapidly penetrate the market for the Company's
Internet/ Intranet products.

    Expand Strategic Alliances. The Company has formed a number of strategic
    --------------------------
relationships that assist the Company in developing, distributing and
marketing its products. For example, to assist its customers in gaining
Internet access and to increase sales of Netopia products, Farallon has formed
strategic relationships with PSINet a national Internet Service Provider
("ISP") and over 100 regional ISPs. The Company has also established a
strategic relationship with Microsoft which includes the licensing of
Farallon's patent covering cross-platform screan-sharing technology as well as
the distribution of Farallon's Look@Me Applet in Microsoft's Site Builder 

                                       4
<PAGE>
 
CD-ROM and Internet Explorer Starter Kit. The Company has also established
strategic alliances with Cisco, Shiva and NetManage for the distribution of
Farallon products and has also formed a variety of strategic relationships
with 3Com and Apple. The Company intends to expand its current strategic
relationships and to form additional strategic relationships to augment its
current product development, distribution and marketing strategies.

    Capitalize On Electronic Marketing Expertise. Farallon believes it is a
    --------------------------------------------
leader among networking companies in the effective use of on-line electronic
marketing and distribution. The Company's on-line electronic marketing
initiatives, which Farallon believes represent a cost-effective form of
promotion and sale of its products, currently include the development and
maintenance of a Web server containing in excess of 1,000 pages, hyperlinked
with over 1,000 Web sites, a monthly electronic bulletin for customers and
partners, and electronic software distribution to customers and beta sites.
Customers are currently able to purchase certain Farallon products on-line and
the Company intends to expand its use of on-line electronic advertising and
commerce. The Company currently offers two secure methods for on-line commerce
transactions, including Netscape's Secure (SSL) Commerce Server and
CyberCash's Secure Internet Payment Service. The Company intends to expand its
use of on-line electronic marketing and distribution consistent with evolving
industry standards.

    Leverage Brand Recognition, Distribution Channels and Customer Support
    ----------------------------------------------------------------------
Infrastructure. Since its inception, Farallon has been a leading provider of
--------------
networking solutions for the Mac OS market and intends to maintain this market-
leading position. The Company intends to leverage its reputation and expertise
in providing complete, easy-to-use, plug-and-play networking solutions to more
fully penetrate the market for Internet and Windows users. The Company
believes that its relationships with approximately 75 distributors in 60
countries are a valuable asset and that these distributors will significantly
enhance the marketing and sale of its Internet/Intranet products. In addition,
the Company believes that it is recognized in the industry as providing
outstanding customer service and support. The Company intends to leverage its
positive name recognition, long-standing distribution relationships and its
customer support organization to promote its Internet/Intranet products.


PRODUCTS

    Farallon offers complete, easy-to-use, plug-and-play Internet connectivity
and networking solutions and real-time collaboration software designed for
small businesses, geographically dispersed facilities of large enterprises,
home offices, mobile users, schools and small organizations that may not have
access to sophisticated technical support. The Company's Internet/Intranet
product family includes its Netopia routers and modems, which provide high-
speed ISDN-based Internet connectivity for workgroups and individuals, as well
as its Timbuktu Pro collaboration software, which enables real-time, peer-to-
peer communication and collaboration on the Internet, Intranets and LANs. The
Company's LAN product family includes Ethernet network connectivity devices as
well as other products, which allow users to easily and cost-effectively build
10Base-T Ethernet, 100Base-T Ethernet and LocalTalk networks.


  INTERNET/INTRANET PRODUCTS
  --------------------------

    NETOPIA FAMILY. The Netopia family of products enables cost-effective,
plug-and-play, high-speed Internet connectivity for individual users and
workgroups who may not have access to sophisticated technical support. These
products include the Netopia Internet Router Family, the Netopia ISDN Modem
and the Up & Running, Guaranteed! service program.

    The Netopia Internet Router Family includes the Netopia Internet Router
and the Netopia SO-Smart Internet Router. The Netopia Internet Routers enable
Internet connectivity for multiple users through a single ISDN connection at
substantially faster speed than traditional analog-based Internet connections.
The Netopia Internet Routers include an ISDN basic rate interface ("BRI")
port with built-in NT-1 interface, Point-to-Point Protocol ("PPP"),
Multilink PPP and 4:1 LZS compression. In addition, the Company's Netopia
Internet Routers include Farallon's patented EtherWave technology that enables
connectivity to a 10Base-T Ethernet network in a "daisy-chain" fashion with
or without the use of an Ethernet hub. The Netopia Internet Routers also
include the "Internet 

                                       5
<PAGE>
 
Starter Kit," a software bundle including Netscape Navigator, Microsoft
Windows 95 Internet Jump Start Kit (including SMTP gateway), Qualcomm Eudora
Lite e-mail client and for Mac OS users, AppleTalk services over the Internet.
In December 1996, the Company announced the addition of the new Netopia SO-
Smart Internet Router to the Netopia family of routers. The SO-Smart Routers
are optimized for small office and home use and include SmartIP, a cost-
saving, ease-of-use and security feature that integrates Network Address
Translation ("NAT") technology with Dynamic Host Configuration Protocol
("DHCP") to map multiple IP addresses on the small office LAN to a single
static or dynamically assigned Internet IP address from the Internet Service
Provider ("ISP"), two Plain Old Telephone Service ("POTS") interface ports, an
integrated two-port 10Base-T Ethernet hub and two integrated PC Card slots,
allowing for remote troubleshooting, diagnostics, configuration and firmware
upgrades in the event of ISDN line failure.

    The Netopia ISDN Modem provides individual users reliable, high-speed ISDN
Internet connectivity and telecommuting. The Netopia ISDN Modem includes
Internet connectivity software, Multilink PPP, Stacker LZS data compression
and two POTS interfaces that enable the integration of digital data transfer
with traditional analog telephone, fax or modem use over a single ISDN line.
Additionally, the Netopia Modem includes an ISDN assistant that automatically
detects the switch type at the telephone company, determines the SPID numbers
and automatically configures the modem.

    The Company offers users of Netopia products the Up and Running,
Guaranteed! service program. This optional service program assists these users
in ordering and provisioning the ISDN line, obtaining and establishing their
ISP service, provides remote configuration of the Netopia Internet Routers,
assists in the installation and configuration of the client server software,
and provides technical support for the Netopia product line. Toll-free
technical support is included with this service program for one year.

 
    TIMBUKTU PRO FAMILY. The Timbuktu Pro family of collaboration software
products enables real-time, peer-to-peer collaboration over the Internet,
Intranets and LANs. These products include Timbuktu Pro for Windows and Mac
OS, Internet applets Look@Me and FlashNote and a new product, Netopia Virtual
Office, announced in December, 1996 for initial shipment later during fiscal
1997.

     Timbuktu Pro software enables users to collaborate with other Timbuktu
Pro users in real-time over the Internet, Intranets and LANS--viewing other
users' screens, revising information, transferring files, controlling other
computers and remotely accessing network resources. Timbuktu Pro products are
also used by help desk and information systems personnel to remotely solve
technical problems, update software and train users on new applications and
operating systems. The Company believes that the peer-to-peer collaboration
features in its Timbuktu Pro products bring additional functionality to the
Internet, which has historically been used predominantly for e-mail and Web
browsing.

    The Company's Internet applets, Look@Me and FlashNote, provide enhanced
productivity on the Internet through peer-to-peer collaboration. These applets
are freely downloadable over the Internet to introduce users to the
functionality of Timbuktu Pro collaboration software. Look@Me enables users to
remotely observe another Look@Me or Timbuktu Pro user's screen in real-time
over the Internet. FlashNote enables users to instantly send files and "pop-
up" messages to other FlashNote users over the Internet. The Look@Me applet
may be used within the Netscape Navigator browser as an inline "plug-in" or
as a stand-alone application. Look@Me and FlashNote users may upgrade
electronically over the Internet to a fully functional version of Timbuktu
Pro.

    The Company's recently announced Netopia Virtual Office software, which
provides communication over the Internet and corporate Intranets by allowing
use of a web browser to collaborate in real-time as well as allow 24-hour
unattended information exchange. Netopia Virtual Office installs a small
hypertext transfer protocol ("http") engine on the owners PC, enabling it to
act as a mini-web site hosted by the individual owner. Netopia Virtual Office
owners may designate their personal World Wide Web ("WWW") address which is
automatically registered with Farallon's netopia.com Dynamic Name Server
("DNS"). Netopia Virtual Office software includes a number of security
features designed to protect the owners PC from unauthorized access.

                                       6
<PAGE>
 
    The Company's business is substantially dependent upon continued growth in
the sale of its Internet/Intranet products. Rapid growth in the use of the
Internet and Intranets is a recent phenomenon. There can be no assurance that
communication or commerce over the Internet will become widespread. In
addition, to the extent that the Internet continues to experience significant
growth in the number of users and level of use, there can be no assurance that
the Internet infrastructure will continue to be able to support the demands
placed upon it by such potential growth, or will not otherwise lose its
utility due to delays in the development or adoption of new standards and
protocols required to handle increased levels of activity, or due to increased
government regulation. Although the Company has experienced significant
percentage growth in Internet/Intranet revenues over the last three fiscal
years, the Company does not believe prior percentage growth rates are
sustainable or indicative of future operating results for these products and
services. The Company's limited Internet/Intranet operating history makes the
prediction of future Internet/Intranet operating results difficult, if not
impossible. There can be no assurance that the Company will continue to
increase sales of its Internet/Intranet products, that the Company's existing
distribution channels are appropriate for the sale of its Internet/Intranet
products or that sales of such products will reach levels significant enough
to offset expected declines in sales, average selling prices and gross margins
of the Company's LAN products. Accordingly, the failure of the Company's
Internet/Intranet products to gain market acceptance or to achieve significant
sales would materially adversely affect the Company's business, operating
results and financial condition. The markets in which the Company competes
currently are subject to intense price competition and the Company expects
additional price and product competition as other established and emerging
companies enter these markets and new products and technologies are
introduced. Increased competition may result in further price reductions,
reduced gross margins and loss of market share, any of which could materially
adversely affect the Company's business, operating results and financial
condition.

  LAN PRODUCTS
  ------------

    ETHERWAVE FAMILY. The EtherWave family of products enables users, who
may lack network expertise, to easily connect multiple computers and printers to
each other in a daisy-chain fashion, or to connect multiple devices per port on
standard 10Base-T hubs. These products, which are compatible with the 10Base-T
Ethernet standard, include transceivers, adapters and internal cards. Farallon's
patented EtherWave technology enables the creation of small 10Base-T Ethernet
LANs of up to eight nodes without the use of network hubs, as is required with
traditional 10Base-T Ethernet, by simply plugging together EtherWave products,
thereby reducing the time and complexity of creating or expanding a 10Base-T
network. EtherWave can also be used to easily and flexibly connect up to seven
computers and printers per port to an existing hub on a traditional 10Base-T
Ethernet LAN.

    ETHERNET FAMILY. The Ethernet family of products enables users in
workgroup environments to quickly transfer large data files over a LAN. These
products include a comprehensive line of 100Base-T Fast Ethernet and 10Base-T
Ethernet products, primarily for Mac OS computers. Fast Ethernet products
include the Fast EtherTX-10/100 Cards, the Fast Starlet 100TX/8 Hub, and the
Fast Starlet 10/100 Bridge. The Company's dual speed Fast EtherTX-10/100 Cards
include a speed autosensing port, providing a flexible network speed migration
path from 10Base-T Ethernet, thus protecting existing network investments. The
Fast Starlet 100TX/8 Hub with the add-on 10/100 Bridge includes built-in
EtherWave connectivity ports for easy and cost-effective connection to existing
10Mbps LANs.

    The Company's range of 10Base-T Ethernet products provides solutions to
customers whose networks transfer higher volumes of data than can effectively
be transferred by the LocalTalk-speed hardware built into Mac OS computers.
The Company's 10Base-T Ethernet family includes transceivers and adapters that
connect computers and printers to 10Base-T and 10Base-2 (Thinnet) Ethernet,
add-in cards that connect computers to Ethernet, adapters that connect Mac OS
computers and printers without available slots to Ethernet as well as a family
of 10Base-T hubs and PC Cards.

    LOCALTALK FAMILY. The LocalTalk family of products enables Mac OS users
who lack network implementation expertise to easily connect several computers
or printers. These products include patented PhoneNET connectors which feature
an easy-to-use, plug-and-play approach to creating Mac OS LocalTalk networks
using standard telephone wiring. PhoneNET networks can be created without hubs
by daisy-chaining nodes. Farallon's LocalTalk family also includes hubs and
routers, printer adapters and concentrators designed to expand existing
LocalTalk LANs as well as remote access and LAN software.

                                       7
<PAGE>
 
    To date, the Company has derived a substantial majority of its revenues
from LAN products, which represented 91%, 89% and 73% of total revenues for
fiscal years 1994, 1995 and 1996, respectively. These products have
experienced variable average selling prices and sales volumes, and declining
gross margins for the past six fiscal quarters. The Company anticipates that
the average selling prices and gross margins of its existing LAN products will
continue to decline. Accordingly, to the extent the product mix for any
particular period includes a substantial proportion of LAN products, the
Company's total gross margin will be adversely affected. To date, the Company
has been able to partially reduce the decline in total gross margin by
increasing unit sales of existing LAN products, by reducing the manufacturing
cost of products and by introducing new products with higher margins. There
can be no assurance that the Company will achieve any such reductions in the
future. Although the Company's Internet/Intranet products currently carry a
higher average gross margin than its LAN products, the Company anticipates
that competitive pressures in its Internet/Intranet business may result in
declining average selling prices and gross margins in this business as well.
Historically, a substantial majority of the Company's LAN product revenues
have been derived from sales of products designed for Apple Mac OS and
compatible computers. Net revenues from the Company's LAN products fluctuated
on a quarterly basis during fiscal 1995 and fiscal 1996, and the Company
expects that net revenues from LAN products may decline in the future as a
result of declining average selling prices of the Company's LAN products,
Apple's incorporation of built-in Ethernet connectivity into certain of its
computers, declining sales of Mac OS computers and competition in the LAN
products market. Additionally, sales related to certain of the Company's Mac
OS products are driven in part by the sales of Apple PowerBooks which have
experienced delays, technical difficulties and interrupted supply. As a result
of technical characteristics in the Mac OS environment, Fast Ethernet
products, in general, have not delivered expected performance levels. If these
technical characteristics are not addressed in the future, then Fast Ethernet
product sales in the Mac OS market segment will be below the Company's
expectations, and operating results may be materially adversely affected. The
Company is dependent upon sales and profitability of its LAN products for the
foreseeable future, and to the extent that any decline in revenues and gross
margins from LAN products is not offset by increases in revenues from other
sources, such as sales of the Company's Internet/Intranet products, then the
Company's business, operating results and financial condition will be
materially adversely affected.

    To date, the Company has derived approximately 85% to 90% of its LAN
products revenues from products designed for networking the Apple Mac OS
family of personal computers. Accordingly, the Company is substantially
dependent on the market for Mac OS computers and the development and sale of
new Apple computers, particularly sales of such computers into business
environments. There can be no assurance that competitive personal computers
will not displace the Mac OS products or reduce sales of Mac OS products. In
addition, sales of the Company's products in the past have been adversely
affected by the announcement by Apple of new products with the potential to
replace existing products. The inability of Apple to successfully develop,
manufacture, market or sell new products, and any decrease in the sales or
market acceptance of the Mac OS family of computers, would have a material
adverse effect on the Company's business, operating results and financial
condition.

    The Company relies on an informal working relationship with Apple in
connection with the Company's LAN product development efforts. Although the
Company and Apple have maintained a cooperative working relationship since the
Company's founding, Apple is under no obligation to continue to share product
information or otherwise cooperate with the Company. In addition, there can be
no assurance that Apple will continue to work cooperatively with the Company
in connection with the Company's product development efforts. The absence of
such cooperation in the future, as a result of the restructuring undertaken by
Apple or any other factors, could have a material adverse effect on the
Company's business, operating results and financial condition. Apple currently
offers products that compete directly with certain of the Company's products.
The Company anticipates that Apple will continue to incorporate additional
connectivity, communication and collaboration technologies into more of its
products in the future, which will adversely affect sales of the Company's LAN
products. Since Apple has substantially greater financial, technical, sales,
marketing and other resources than the Company, as well as greater name
recognition and a larger customer base, Apple may be able to respond more
quickly to new or emerging technologies and changes in customer requirements
or to devote greater resources to the development, promotion and sales of its
products. The Company believes that it is likely that Apple will in the future
sell separately or bundle with its computers certain Internet access products,
such as Integrated Services Digital Network ("ISDN")

                                       8
<PAGE>
 
terminal adapters similar to the Company's Netopia ISDN Modem. Any such
additional bundling or enhancement by Apple could have a material adverse
effect on the Company's business, operating results and financial condition.


STRATEGIC ALLIANCES

    The Company has entered into strategic alliances to facilitate the
development, distribution, marketing and support of its products. These
alliances enhance the Company's ability to adapt effectively to technological
change and leverage shared distribution resources, thereby providing increased
utility to end users.

 Product and Technology Alliances
 --------------------------------

    MICROSOFT. Farallon and Microsoft have developed a strategic relationship
including Microsoft's license of Farallon's patent covering cross-platform
screen-sharing technology currently found in the Company's Internet/Intranet
software products. The two companies are also discussing the development of
cross-platform interoperable Internet collaboration products in fiscal 1997.

    3COM. Since 1993, Farallon and 3Com have entered into a series of
agreements under which 3Com has provided Farallon with 3Com's Ethernet
controller technology and certain Ethernet adapter products. Farallon combines
these products and technologies with its own software and firmware
technologies for delivery to certain LAN customers. This strategic
relationship has allowed Farallon to bring 3Com's highly regarded "Parallel
Tasking" technology to Farallon's LAN customers. More recently, 3Com and
Farallon entered into an agreement for the supply of 3Com ISDN modems to
Farallon, which are combined with Farallon-developed Mac OS-based installation
and driver software for delivery to Farallon's Mac OS customers, and with 3Com-
developed PC-based installation and driver software for delivery to Farallon's
PC customers.

    APPLE. Farallon has, from time to time, entered into joint development and
Original Equipment Manufacturer ("OEM") agreements with Apple, such as those
providing for the co-development with Apple of Farallon's AirDock infrared
network adapter and the license by Farallon of Apple's ARA remote access
client software for incorporation into Farallon's Mac OS-based Timbuktu Pro
products. Farallon believes that these agreements enhance its efforts to
deliver new Mac OS products, and additional features and functionality, to its
existing Mac OS customers. Additionally, Farallon has participated in
conferences that preview Apple strategies and initiatives, thereby assisting
the Company in formulating market strategies.

  Distribution Alliances
  ----------------------

    MICROSOFT. Microsoft selected Farallon's Look@Me ActiveX Control to be
included on the Microsoft Site Builder Workshop CD-ROM released in July 1996.
The Site Builder Workshop CD-ROM contains the tools, ActiveX Controls and
samples Webmasters need to begin development of active Web sites. In October
1996, Microsoft selected Farallon's Look@Me ActiveX Control to bundle in all
retail versions of the Internet Explorer Starter Kit. Look@Me users will have
the opportunity to electronically upgrade to the full version of Timbuktu Pro
Software.

    CISCO. In November 1995, Farallon and Cisco entered into a distribution
alliance under which Farallon's Timbuktu Pro collaboration software (Windows
3.X and Windows 95 versions) is bundled with Cisco's CiscoRemote software
package, which is distributed by Cisco to users of its remote access server
products. The agreement provides for the payment of certain royalties to
Farallon for the right to distribute the Timbuktu Pro collaboration software
with CiscoRemote, and provides Farallon access to registered users of
CiscoRemote.

    SHIVA. In November 1994, Farallon and Shiva entered into an agreement to
license ShivaPPP software to Farallon for integration into Farallon's Timbuktu
Pro collaboration software (Windows 3.X version). ShivaPPP is used by
Farallon's Timbuktu Pro customers to establish a remote access connection to
Intranets based upon PPP standards. In addition, in January 1996, Shiva began
distributing evaluation versions of Farallon's Timbuktu Pro collaboration
software (Windows 3.X and Windows 95 versions) with Shiva's LanRover remote
access servers.

                                       9
<PAGE>
 
    NETMANAGE. In April 1996, NetManage selected Farallon's Look@Me applet to
enhance the collaboration module of its Chameleon Internet software products.
Chameleon users will have the opportunity to upgrade electronically from
Look@Me to the full version of Timbuktu Pro.

    INTERNET SERVICE PROVIDERS ("ISPS"). In September 1995, Farallon and PSINet,
a national ISP, entered into a strategic joint marketing relationship under
which users of certain Netopia products are offered various economic
incentives, including discounts on PSINet Internet service registration and
Internet access. Farallon offers training and other incentives to PSINet's
entire sales staff to promote Netopia products. Farallon and PSINet are
jointly developing a set of reseller programs to expand PSINet's Internet
access service with Farallon products.

    In addition, Farallon has established the Netopia Internet Service Partner
Program ("NISPP"), under which ISPs may purchase Netopia Internet
connectivity products directly from Farallon for sale or lease to their
customers. Farallon has contracted with over 100 regional ISPs under the NISPP
program. Under the NISPP, ISPs are offered market development funds, router
preconfiguration services, a dedicated technical support telephone number, use
of Farallon's customer database for joint mailings, and use of Timbuktu Pro
collaboration software to provide their customers with immediate help desk
support.

    In general, each of these alliances may be terminated by either part at
any time with limited notice. There can be no assurance that existing
alliances will remain in effect or that additional relationships will be
successfully established.

    The Company relies on a number of strategic relationships to help achieve
market acceptance of the Company's products and to leverage the Company's
development, sales and marketing resources. Although the Company views these
relationships as important factors in the development and marketing of the
Company's products and services, a majority of the Company's agreements with
its strategic partners or customers do not require future minimum commitments
to purchase the Company's products, are not exclusive and generally may be
terminated at the convenience of either party. There can be no assurance that
the Company's strategic partners regard their relationship with the Company as
strategic to their own respective businesses and operations, that they will
not reassess their commitment to the Company or its products at any time in
the future, or that they will not develop and/or market their own competitive
technology.

    The Company does not manufacture any of the components used in its
products and performs only limited assembly on some products. The Company
relies on independent contractors to manufacture to specification the
Company's components, subassemblies, systems and products. The Company also
relies upon limited source suppliers for a number of components used in the
Company's products, including certain key microprocessors and integrated
circuits. There can be no assurance that these independent contractors and
suppliers will be able to timely meet the Company's future requirements for
manufactured products, components and subassemblies. The Company generally
purchases limited source components pursuant to purchase orders and has no
guaranteed supply arrangements with these suppliers. The Company has
maintained relationships with certain of its domestic manufacturing suppliers
whereby the Company will purchase components used in certain of its products
for resale to its manufacturing suppliers when the Company can secure more
favorable terms for the purchase of such components. As a result of the
Company moving certain of its production offshore and terminating
relationships with certain of its previous manufacturing suppliers, the
Company may be required to repurchase certain of these component parts that
the previous manufacturing suppliers are unable to resell to the Company's new
manufacturing suppliers. The Company currently believes that the component
parts can be sold to its new manufacturing suppliers and does not anticipate
having to repurchase any of these components, although there can be no
assurance that such repurchases will not be required. In addition, the
availability of many of these components to the Company is dependent in part
on the Company's ability to provide its suppliers with accurate forecasts of
its future requirements. However, any extended interruption in the supply of
any of the key components currently obtained from a limited source would
disrupt its operations and have a material adverse effect on the Company's
business, operating results and financial condition. In addition, the Company
anticipates that it will be necessary to establish additional strategic
relationships in the future, in particular with additional national ISPs, and
there can be no assurance that the Company will be able to establish such
alliances or that such alliances will result in increased revenues.

                                       10
<PAGE>
 
SALES AND MARKETING

    The Company's sales force assists end users by providing solutions for
their Internet connectivity, collaboration and LAN networking needs. In
addition, the sales force provides pre-sales and order management support to
distributors, resellers, and ISPs, identifies new opportunities for product
development and provides general market information to management. The
Company's marketing strategy is to achieve broad market penetration by
utilizing multiple distribution channels, including the use of two-tier
distributors, direct sales, mail order, ISPs and Internet Value Added
Resellers ("VARs"), and K-12 and electronic marketing.

    Two-Tier Distributors.  Farallon's major distributors in North America are
    ---------------------
Ingram Micro ("Ingram") and Tech Data which distribute Farallon's products to
resellers, VARs, dealers and dealer chains. Internationally, Farallon
distributes its products through approximately 75 distributors in 60
countries. In Europe, distributors sell primarily in the U.K., France, Germany
and Sweden, and in the Pacific Rim, distributors sell primarily in Japan.
Farallon provides periodic training in the development of network solutions to
networking VARs who purchase the Company's products primarily from
distributors. The Company's agreements with its distributors can generally be
terminated without cause and do not provide for minimum purchase commitments.
Additionally, the agreements provide price protection and grant the
distributors limited rights to return unsold inventories of the Company's
products in exchange for new purchases.

    Direct Sales.  Farallon's direct sales force is primarily focused on the
    ------------
execution of high volume or site license agreements with corporate accounts in
North America. Timbuktu Pro collaboration software is the primary product sold
through this channel. In addition, certain higher education institutions in
North America have historically purchased LAN products directly from the
Company.

    Mail Order. Farallon markets its products in mail order catalogues, such
    ----------
as those offered by MicroWarehouse, to reach users who are generally more
technically sophisticated. Through lower overhead and service costs, mail
order catalogs are generally able to offer lower prices than dealers and
retailers.

    ISPs and Internet VARs. Farallon has formed strategic relationships with
    ----------------------
PSINet, a national ISP, and over 100 regional ISPs to assist its customers in
gaining Internet access and to increase sales of Netopia products. The Company
also has recruited approximately 1,000 Internet VARs for the sale of Netopia
products.

    K-12 Marketing. Farallon also sells through a group of regional VARs known
    --------------
as Apple Education Sales Agents ("AESAs") which are Apple's exclusive North
American resellers of Macintosh computers to K-12 educational institutions.
Farallon maintains relationships with all 15 AESAs and believes these VARs
represent an effective channel for sales to the K-12 market.

    Electronic Marketing. The Company has developed and maintains a Web server
    --------------------
containing over 1,000 pages, hyperlinked with over 1,000 Web sites, a monthly
electronic bulletin for customers and partners, and electronic software
distribution to customers and beta sites. The Company intends to expand its
use of on line electronic advertising and commerce including the on-line sale
of Farallon products. The Company currently supports two secure alternatives
for on line commerce transactions including Netscape's Secure (SSL) Commerce
Server and CyberCash's Secure Internet Payment Service.

    Other Marketing. The Company uses several marketing programs, such as
    ---------------
trade advertising, participation in trade shows, press briefings on strategy
and new products, and telemarketing, to support the sale and distribution of
its products. Through these marketing programs, Farallon seeks to build brand
name recognition, stimulate demand and inform channels about the capabilities
and benefits of the Company's products.

    The Company's Timbuktu Pro products are often licensed to customers on a
volume license basis for use on private wide area network ("WAN") Intranets
involving thousands of nodes. These licenses often involve significant license
and maintenance fees. As a result, the license of the Company's Timbuktu Pro
products often involves a significant commitment of management attention and
resources by prospective customers. Accordingly, the Company's sales process
for these products is often subject to delays associated with long approval
processes that typically accompany significant capital expenditures. For these
and other reasons, the sales cycle associated 

                                       11
<PAGE>
 
with the license of the Timbuktu Pro products is often lengthy and subject to
a number of significant delays over which the Company has little or no
control. There can be no assurance that the Company will not experience these
and additional delays in the future on Timbuktu Pro or other products.

    The Company relies primarily on distributors for the sale of its
Internet/Intranet and LAN products. Revenues from distributors accounted for
76%, 73% and 60% of the Company's total revenues in fiscal 1994, 1995 and
1996, respectively. A substantial amount of the Company's revenues result from
a limited number of these distributors. The Company's three largest
distributors accounted for 45%, 43% and 35% of the Company's total revenues in
fiscal 1994, 1995 and 1996, respectively. During fiscal 1994, 1995 and 1996,
revenue from Ingram accounted for 24%, 22% and 18% of the Company's total
revenues, and revenue from MicroWarehouse accounted for 12%, 13% and 11% of
the Company's total revenues, respectively. No other customers have accounted
for 10% or more of the Company's total revenues during fiscal 1994, 1995 and
1996. The distribution of LAN products such as those offered by the Company
has been characterized by rapid change, including industry consolidations,
financial difficulties of distributors and the emergence of alternative
distribution channels. For example, Merisel continues to publicly announce
certain financial difficulties. There can be no assurance that Merisel will be
able to pay in full the amount currently owed to the Company or that any of
the Company's other current or future distributors will not experience
financial difficulties, which could result in a material adverse effect on the
Company's business, operating results and financial condition. There can be no
assurance that Ingram, MicroWarehouse or Merisel will continue to serve as
distributors for the Company since the Company does not currently have a
written agreement regarding price or quantity commitments with these or other
distributors and operates with these and other distributors on a purchase
order basis. The Company's distributors generally offer products of several
different companies, including products that are competitive with the
Company's products. There can be no assurance that future sales by the
Company's distributors will continue at current levels, that the Company will
be able to retain its current distributors in the future on terms which are
acceptable to the Company, that the Company's current distributors will choose
to or be able to market the Company's products effectively, that economic
conditions or industry demand will not adversely affect these or other
distributors, or that these distributors will not devote greater resources to
marketing products of other companies. Accordingly, the loss of, or a
significant reduction in revenue from, one of the Company's distributors,
including Merisel, could have a material adverse effect on the Company's
business, operating results and financial condition.

    The Company grants to its distributors limited rights to return unsold
inventories of the Company's products in exchange for new purchases and
provides price protection to its distributors. Although the Company provides
allowances for projected returns and price decreases, any product returns or
price decreases in the future that exceed the Company's allowances will
materially adversely affect the Company's business, operating results and
financial condition. The Company also provides end users with a lifetime
warranty on certain products and permits end users to return any product for
its full purchase price if the product does not perform as warranted. To date,
the Company has not encountered material warranty claims. Nevertheless, if
future warranty claims exceed the Company's reserves, the Company's business,
operating results and financial condition could be materially adversely
affected. In addition, the Company attempts to further limit its liability to
end users through disclaimers of special, consequential and indirect damages
and similar provisions in its end user warranty. However, no assurance can be
given that such limitations of liability will be legally enforceable.

    Sales orders are typically shipped shortly after receipt and,
consequently, order backlog at the beginning of any quarter has in the past
represented only a small portion of that quarter's revenues. Accordingly, the
Company's net revenues in any quarter are substantially dependent on orders
booked and shipped during that quarter.

CUSTOMER SERVICE AND SUPPORT

    The Company believes that it is recognized in the networking industry as
having an outstanding customer support organization. Farallon believes that
effective customer support is a key criterion used in selecting networking
solutions. Network managers and administrators, VARs, distributors, resellers,
consultants and other experienced technical experts utilize the Company's toll-
free telephone support lines, fax and on-line services to access Farallon's
internal technical databases and support personnel. Additionally, support
personnel are trained to satisfy the needs of end users who are not technical
experts and do not have access to sophisticated technical support. The Company
believes that its support programs have been successful in creating brand
loyalty through its 

                                       12
<PAGE>
 
focused support of the specialized needs of these end users, and through the
easy-to-use, plug-and-play design of its products.

    Under the Up & Running, Guaranteed! program, Farallon will remotely
configure the Netopia Internet Router and assist users in setting up service
with the user's telephone company and ISP. The program is also available at a
reduced price for users of the Netopia ISDN Modem. Once unique in the
industry, this concept has recently been adopted by at least three of the
Company's competitors. However, the Company believes that its program remains
the most comprehensive in the market. The Company's expertise in solving
technical problems enables it to commit its resources to analyze any problem
an end user may have, even if it involves a product from another company,
thereby building customer loyalty to Farallon as the single source for
networking solutions.


TECHNOLOGY

    The Netopia Internet Routers include several core communications
technologies, including a third-generation multi-protocol routing engine. The
product's operating software has been optimized for the special requirements
of Internet access over high-speed digital WAN links, and provides both packet
header and data-link compression. The routing engine operates in conjunction
with companion modules that provide connection/bandwidth management,
authentication/security and configuration/network management functions. The
connection/ bandwidth management module supports dial-on-demand routing, and
tracks incoming and outgoing data calls. Calls can be initiated based on time
of day, type of data traffic, and packet data thresholds. Utilizing the
standards-based PPP and Multilink PPP protocols, the connection/bandwidth
manager provides a dynamic "bandwidth on demand" capability. By
transparently providing the appropriate amount of bandwidth based on current
utilization, these technologies significantly reduce telecommunications costs,
particularly with ISDN. An authentication/security module provides PPP
authentication services between interconnected routers, dial-back security,
and packet filters that allow a LAN to maintain a degree of network security
while connecting to the Internet. The router supports a wide variety of local
and remote configuration/network management capabilities, including a menu-
based console and virtual terminal ("TELNET") interface, Trivial File
Transfer Protocol ("TFTP"), and the Simple Network Management Protocol
("SNMP"). Finally, the router includes an integrated DHCP server which
automates configuration of the TCP/IP protocol stacks of computers on the
Ethernet LAN.

    The Timbuktu Pro family of collaboration software includes patented cross
platform collaboration technology that provides remote control capabilities
across disparate operating systems. This collaboration system supports text
and graphical image display between homogeneous and heterogeneous computers
connected on a network, the Internet or via other transport media. The system
captures window system event messages during a recording process and then
translates these messages into procedure calls during the imaging process on
the destination platform. For example, this technology allows a Windows NT
workstation to view the screen of a Mac OS computer regardless of the
differences in screen size, resolution or color depth. This technology enables
the Company to better address the heterogeneous requirements of the Internet.
The Company has also developed proprietary compression technologies which are
used to minimize resources required for image transmissions over the Internet
and slow speed networks. Windows GDI and Mac OS Quickdraw compression, Backing
Store Cache compression, and Font Negotiation technology enable the products
to transmit the minimum amount of data necessary to render an image.

    Timbuktu Pro collaboration software also includes multi-level security
technology that protects enterprise network computing resources and individual
users from unauthorized intrusion. Each product maintains its own database
which is used to verify the identity and define the privileges of any user
attempting to gain access to a machine. The Company has also developed unique
administration technology for security-conscious network administrators which
allows them to customize the functionality available to their organization. In
addition, the TCP/IP ports assigned to Farallon by the Internet Engineering
Task Force ("IETF") allow network managers to safeguard their Intranet from
unauthorized access with widely available firewall technology. The Company
believes that the object-oriented modular architecture of its products allows
Farallon to exploit market opportunities quickly and address OEM customer
requirements. For instance, by leveraging the product's built-in Object
Linking and Embedding ("OLE") automation, the Company was one of the first
to market real-time collaboration Netscape plug-ins and Internet applets. This
architecture allows new features, transports, and services 

                                       13
<PAGE>
 
to be quickly incorporated to meet future market demands as well as provide
easy integration into other third-party applications.
 
    The EtherWave family of products incorporates a patented technology that
permits daisy-chained standard 10Base-T Ethernet segments with multiple nodes
on each segment. A non-reclocking repeater re-transmits data packets from each
node to subsequent nodes in a daisy-chained segment. When an EtherWave
connected computer or printer is powered-off, by-pass circuitry built into
every EtherWave enables the device to maintain the network connection without
interruption. Farallon's LAN products include internally developed application-
specific integrated circuits ("ASICs"), that combine large functional logic
blocks into a common silicon core. The Company uses industry-standard software
tools to design these ASICs and several ASIC manufacturing sources for
production. ASIC technology has enabled the Company to provide increased
performance and higher reliability while decreasing production costs. The
Company believes it possesses expertise in real-time, high-speed, embedded
systems hardware design using Complex Instruction Set Controller ("CISC")
and Reduced Instruction Set Controller ("RISC") processors, and Ethernet and
Fast Ethernet technologies. The Company believes it also possesses expertise
in high-volume, low-cost product design and domestic and international
homologation requirements.


PRODUCT DEVELOPMENT

    The Company believes that its future business and operating results depend
in part on its ability to continue to enhance existing products, develop new
products and improve the price and performance of its products in a timely
manner. The Company continuously evaluates the emerging needs, developing
standards and emerging technologies of its target markets to identify new
market or product opportunities. Farallon is focusing its development efforts
on Internet connectivity through high-speed digital services, including ISDN,
T-1, Frame Relay and software enhancements including Netopia Virtual Office, a
Windows NT version of Timbuktu Pro, further internationalization of its
products, PC card-based products for laptop computers and cost-reducing design
improvements. In addition, the Company has relied and will continue to rely on
external development resources, such as OEM suppliers, for the development of
certain of its products and related components. Research and development
expenses were $6.7, $8.4 and $8.9 million for fiscal years 1994, 1995, and
1996, respectively.

    The personal computer industry is characterized by rapidly changing
technologies, evolving industry standards, frequent new product introductions,
short product life cycles and rapidly changing customer requirements. The
introduction of products embodying new technologies and the emergence of new
industry standards can render existing products obsolete and unmarketable. The
Company's Netopia products currently operate only over ISDN telecommunication
service. As other communications technologies, such as 56K analog modems,
Frame Relay, ATM, ADSL and communication over cable or wireless networks, are
developed or gain market acceptance, the Company will be required to enhance
its Internet connectivity products to support such technologies, which will be
costly and time consuming. If the Company is unable to modify its products to
support new Internet access technologies, or if ISDN does not achieve
widespread customer acceptance as a result of the adoption of alternative
technologies or as a result of deemphasis of ISDN by communications service
providers, the Company's business, operating results and financial condition
would be materially adversely affected. In addition, the Company has
historically derived a substantial majority of its revenues from the sale of
Ethernet connectivity products. In the event that current Ethernet network
technology is modified or replaced and the Company is unable to modify its
products to support new Ethernet technologies or alternative technologies, the
Company's business, operating results and financial condition could be
materially adversely affected. The Company has in the past and may in the
future experience delays in new product development. There can be no assurance
that the Company will be successful in developing and marketing product
enhancements or new products that respond to technological change, evolving
industry standards and changing customer requirements, that the Company will
not experience difficulties that could delay or prevent the successful
development, introduction and marketing of these products or product
enhancements, or that its new products and product enhancements will
adequately meet the requirements of the marketplace and achieve any
significant degree of market acceptance. Failure of the Company, for
technological or other reasons, to develop and introduce new products and
product enhancements in a timely and cost-effective manner would have a
material adverse effect on the Company's business, operating results and
financial condition. In addition, the future introduction or even announcement
of products by the Company or one 

                                       14
<PAGE>
 
or more of its competitors embodying new technologies or changes in industry
standards or customer requirements could render the Company's then existing
products obsolete or unmarketable. There can be no assurance that the
introduction or announcement of new product offerings by the Company or one or
more of its competitors will not cause customers to defer purchase of existing
Company products. Such deferral of purchases could have a material adverse
effect on the Company's business, operating results and financial condition.

    Complex products such as those offered by the Company may contain
undetected or unresolved defects when first introduced or as new versions are
released. There can be no assurance that, despite testing by the Company,
defects will not be found in new products or new versions of products
following commercial release, resulting in loss of market share, delay in or
loss of market acceptance or product recall. Any such occurrence could have a
material adverse effect upon the Company's business, operating results and
financial condition.

    As of December 1, 1996, Farallon's research and development staff
consisted of 60 employees. Of these employees 51 were focused primarily on
Internet/Intranet product development and 9 were focused primarily on LAN
product development. The Company believes that its future success will depend
in large part upon its ability to attract and retain highly-skilled
engineering personnel. Competition for such personnel is intense, and there
can be no assurance that the Company will be successful in attracting and
retaining such personnel, the failure of which could have a material adverse
effect on the Company's business, operating results and financial condition.


COMPETITION

    The markets for the Company's products and services are intensely
competitive, highly fragmented and characterized by rapidly changing
technology, evolving industry standards, price competition and frequent new
product introductions. A number of companies offer products that compete with
one or more of the Company's products. The Company's current and prospective
competitors include OEM product manufacturers of Internet access and remote
LAN access equipment, manufacturers of remote control and screen sharing
software and manufacturers of LAN client access and network systems products.
In the Internet access and remote LAN access equipment market, the Company
primarily competes with Ascend, Cisco, Motorola, 3Com, U.S. Robotics, Shiva,
Gandalf and several other companies. In the remote control and screen sharing
software market, the Company competes primarily with Symantec, Microcom,
Traveling Software, Stac Electronics and several other companies. In the LAN
client access and network systems product market, the Company competes
primarily with Apple, Asante, Dayna, Global Village and several other
companies. The Company has experienced and expects to continue to experience
increased competition from current and potential competitors, many of whom
have substantially greater financial, technical, sales, marketing and other
resources, as well as greater name recognition and a larger customer base,
than the Company. Accordingly, such competitors or future competitors may be
able to respond more quickly to new or emerging technologies and changes in
customer requirements or devote greater resources to the development,
promotion and sales of their products than the Company. In particular,
established companies in the personal computer industry may seek to expand
their product offerings by designing and selling products using competitive
technology that could render the Company's products obsolete or have a
material adverse effect on the Company's sales. For example, Microsoft has
available for free, via download on the Internet, communications and
collaboration software compatible with the Microsoft Internet Explorer. This
software product, which enables real-time communication within a workgroup,
could undermine the Company's ability to market its Timbuktu Pro and/or
Netopia Virtual Office collaboration software. In addition, Netscape also
offers software that enables dispersed workgroups to collaborate in the work
environment. Accordingly, there can be no assurance that the Company can
continue to market its collaboration software, which would have a material
adverse effect on the Company's business, operating results and financial
condition. In addition, several of the Company's current competitors have
introduced free and/or paid guaranteed service and support programs that
appear to be similar to the Company's Up & Running, Guaranteed! program. As a
result, there can be no assurance that the Company can continue to charge a
fee for this support program, which could have a material adverse effect upon
the Company's business, operating results and financial condition. The markets
in which the Company competes currently are subject to intense price
competition and the Company expects additional price and product competition
as other established and emerging companies enter these markets and new
products and technologies are introduced. Increased competition may result in
further price reductions, reduced gross margins and loss of market share, any
of which could materially adversely affect the Company's business, operating
results and 

                                       15
<PAGE>
 
financial condition. There can be no assurance that the Company will be able
to compete successfully against current and future competitors, or that
competitive factors faced by the Company will not have a material adverse
effect on the Company's business, operating results and financial condition.

    Farallon believes that the principal competitive factors in its markets
are: (1) product feature, function and reliability, (2) ease of use, (3)
customer service and support, (4) price and performance, (5) timeliness of new
product introductions, (6) brand name recognition, (7) strategic alliances,
(8) size and scope of distribution channels, (9) breadth of product line, and
(10) size of installed customer base. While the Company believes, in general,
that it currently competes favorably with regard to these factors there can be
no assurance that the Company will be able to compete successfully in the
future, the failure of which would have a material adverse effect on the
Company's business, operating results and financial condition.


PROPRIETARY RIGHTS AND TECHNOLOGY

    The Company's ability to compete is dependent in part on its proprietary
rights and technology. The Company relies primarily on a combination of
patent, copyright and trademark laws, trade secrets, confidentiality
procedures and contractual provisions to protect its proprietary rights. The
Company generally enters into confidentiality or license agreements with its
employees, resellers, distributors, customers and potential customers and
limits access to the distribution of its software, hardware designs,
documentation and other proprietary information. There can be no assurance
that the steps taken by the Company in this regard will be adequate to prevent
misappropriation of its technology. The Company currently has nine issued
United States patents, one pending United States patent application, and one
pending application for patent in each of Canada and Australia and within the
European Patent Office. There can be no assurance that the Company's patents
will not be invalidated, circumvented or challenged, that the rights granted
thereunder will provide competitive advantages to the Company or that any of
the Company's pending or future patent applications, whether or not being
currently challenged by applicable governmental patent examiners, will be
issued with the scope of the claims sought by the Company, if at all.
Furthermore, there can be no assurance that others will not develop
technologies that are similar or superior to the Company's technology or
design around the patents owned by the Company. Despite the Company's efforts
to protect its proprietary rights, unauthorized parties may attempt to copy
aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. Policing unauthorized use of the Company's
products is difficult, and while the Company is unable to determine the extent
to which piracy of its software products exists, software piracy is expected
to be a persistent problem. In selling its software products, the Company
relies primarily on "shrink wrap" licenses that are not signed by licensees
and, therefore, it is possible that such licenses may be unenforceable under
the laws of certain jurisdictions. In addition, the laws of some foreign
countries do not protect the Company's proprietary rights as fully as do the
laws of the United States. There can be no assurance that the Company's means
of protecting its proprietary rights in the United States or abroad will be
adequate or that competing companies will not independently develop similar
technology.

    The Company relies upon certain software, firmware and hardware designs
that it licenses from third parties, including firmware that is integrated
with the Company's internally developed firmware and used in the Company's
products to perform key functions. There can be no assurance that these third-
party licenses will continue to be available to the Company on commercially
reasonable terms. The loss of, or inability to maintain, such licenses could
result in shipment delays or reductions until equivalent firmware could be
developed, identified, licensed and integrated which would materially
adversely affect the Company's business, operating results and financial
condition.

                                       16
<PAGE>
 
EMPLOYEES

    As of December 1, 1996 the Company employed 224 persons, including 55 in
sales and marketing, 60 in research and development, 31 in customer service
and support, 44 in manufacturing operations, and 34 in general and
administrative functions. The Company also contracts with consultants who
provide short and long-term services to the Company in various areas. Farallon
believes that its relations with its employees are good. None of Farallon's
employees is represented by a labor union and the Company has not experienced
a work stoppage. The Company believes its business depends to a significant
extent on the contributions of its senior management and other key personnel
and on Farallon's ability to attract and retain highly qualified personnel.
Competition to hire such personnel in Farallon's industry and location is
intense.

    The Company's business and prospects depend to a significant degree upon
the continuing contributions of its key management, sales, marketing, product
development and administrative personnel. The Company does not have employment
contracts with its key personnel and does not maintain any key person life
insurance policies. The loss of key management or technical personnel could
materially adversely affect the Company's business, operating results and
financial condition. The Company believes that its prospects depend in large
part upon its ability to attract and retain highly-skilled engineering,
managerial, sales and marketing, and administrative personnel. Competition for
such personnel is intense, and there can be no assurance that the Company will
be successful in attracting and retaining such personnel. Failure to attract
and retain key personnel could have a material adverse effect on the Company's
business, operating results and financial condition.


ITEM 2.   PROPERTIES

    The Company leases approximately 49,000 square feet of office space for
its headquarters in Alameda, California. The site is used for research and
development, administration, customer service, and sales and marketing
activities. The facility is leased for a five year term, expiring December 31,
1997. The Company has an option to renew this lease for an additional five
years; the option expires February 28, 1997. The Company also holds a right of
first refusal on 3,000 square feet of expansion space in an adjacent building,
and on 65,000 square feet of office space in a new building to be constructed
in the spring of 1997, at the same location as its headquarters. In addition,
the Company leases approximately 29,000 square feet of warehouse space in San
Leandro, California to accommodate the Company's distribution center, which
maintains inventory and provides shipping and handling. The lease is for a
five year term, expiring December 31, 1997. The company holds two five-year
renewal options on this facility. The Company leases approximately 11,000
square feet of research and development office space in Lawrence, Kansas and
2,400 square feet in San Jose, California, the leases on which expire on July
30, 1997 and June 30, 1997, respectively. The Company also leases
approximately 1,200 square feet of sales office space in France. The lease
term is for nine years ending February 28, 2005. The Company believes that its
existing facilities are adequate for its current needs and that additional
space sufficient to meet the Company's needs for the foreseeable future is
available on reasonable terms.


ITEM 3.   LEGAL PROCEEDINGS

    As of December 1, 1996 the Company was not involved in any pending legal
proceedings.


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

    No matters were submitted to a vote of security holders of the Company
during the fourth quarter ended September 30, 1996.

                                       17
<PAGE>
 
PART II.

ITEM 5. MARKET FOR FARALLON'S COMMON STOCK AND RELATED STOCK-HOLDER MATTERS

    The Company's Common Stock trades on The Nasdaq Stock Market under the
symbol "FRLN". The table below sets forth the high and low sales prices per
share as reported on The Nasdaq Stock Market since the Company's initial
public offering on June 13, 1996. The Company's initial public offering price
was $16.00 per share .

 
Fiscal Year Ended September 30, 1996        High     Low
 
Third quarter ended June 30, 1996(1)       19.000   14.750
Fourth quarter ended September 30, 1996    15.000    7.500

(1) Trading of the Company's Common Stock commenced on June 13, 1996,
accordingly the high and low price information represents 12 trading days.

    The Company believes several factors including but not limited to quarter-
to-quarter variances in financial results, announcements of new products and
new orders by the Company or its competitors could cause the market price of
the Company's Common Stock to fluctuate substantially. In addition, the stock
prices for many high technology companies typically experience extreme price
fluctuations, which are often not related to changes in the operating
performance of the specific companies. Broad market fluctuations as well as
general economic conditions such as a recessionary period or high interest
rates may affect the market price of the Company's Common Stock. As of
December 1, 1996 the Company had approximately 800 shareholders of record. The
Company has not paid cash dividends on its Common Stock. The Company currently
anticipates that it will retain all future earnings, if any, for use in its
business and does not anticipate paying any cash dividends on its Common Stock
in the foreseeable future. On June 7, 1997, 360 days after the date of the
Company's prospectus, 480,000 additional shares of the Company's Common Stock
will become available for sale in the public market subject to certain
limitation of Rule 144 and the Company's insider trading policy.

                                       18
<PAGE>
 
ITEM 6.   SELECTED FINANCIAL DATA

    The following selected financial data 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 Form 10-K.
<TABLE>
<CAPTION>
                                                              YEARS ENDED SEPTEMBER 30,
                                           -------------------------------------------------------------
                                             1992       1993         1994         1995          1996
                                           --------   ---------   ----------   ----------   ------------
CONSOLIDATED STATEMENT OF                               (IN THOUSANDS, EXCEPT PER SHARE DATA)
 OPERATIONS DATA:
<S>                                        <C>        <C>            <C>          <C>          <C>
  Revenues:
    Internet/Intranet products..........   $    --    $    --        $ 5,310      $ 6,569       $16,718
    LAN products........................    48,038      48,425        51,691       50,620        44,886
                                           -------     -------       -------      -------       -------
        Total revenues..................    48,038      48,425        57,001       57,189        61,604
  Cost of revenues:
    Internet/Intranet products..........        --          --           447          674         3,811
    LAN products........................    22,954      24,302        30,368       28,842        28,439
                                           -------     -------       -------      -------       -------
        Total cost of revenues..........    22,954      24,302        30,815       29,516        32,250
                                           -------     -------       -------      -------       -------
  Gross profit..........................    25,084      24,123        26,186       27,673        29,354
  Operating expenses:
    Research and development............     7,973       7,434         6,671        8,429         8,919
    Selling and marketing...............    13,614      14,087        13,983       13,691        15,778
    General and administrative..........     3,572       3,216         3,228        2,888         3,429
    Restructuring costs (1).............       500       1,048            --           --            --
                                           -------     -------       -------      -------       -------
        Total operating expenses........    25,659      25,785        23,882       25,008        28,126
                                           -------     -------       -------      -------       -------
  Operating income (loss)...............      (575)     (1,662)        2,304        2,665         1,228
  Other income, net.....................        76         249           291          815         1,040
                                           -------     -------       -------      -------       -------
  Income (loss) before income...........      (499)     (1,413)        2,595        3,480         2,268
            taxes
  Income tax expense....................         1           1           408          974        (1,433)
            (benefit)(2)................   -------     -------       -------      -------       -------
  Net income (loss).....................   $  (500)    $(1,414)      $ 2,187      $ 2,506       $ 3,701
                                           =======     =======       =======      =======       -------
        Net income per share............                                            $0.25         $0.33
                                                                                  =======       -------
Shares used in per share
  computations (3)......................                                            9,891        11,071
                                                                                  =======       =======


                                                                  SEPTEMBER 30,
                                              1992        1993          1994         1995          1996
                                           -------     -------       -------      -------       -------
CONSOLIDATED BALANCE SHEET DATA:                                  (IN THOUSANDS)
<S>                                        <C>         <C>           <C>          <C>           <C> 
Working capital.........................   $17,505     $16,866       $19,569      $21,755       $49,469
Total assets............................    26,913      29,075        29,289       33,872        61,618
Long-term liabilities, net of current          108       1,262           689          218            46
 portion................................
Total stockholders' equity..............    20,395      19,176        21,644       24,279        53,143
</TABLE>

(1)  In fiscal 1992, the Company adopted a plan to close a European facility. As
     a result the Company accrued severance pay and office closure costs,
     including future lease payments for abandoned and excess office space. In
     fiscal 1993, the Company further reduced its number of employees and
     identified certain impaired assets as part of a restructuring.

(2)  As of March 31, 1996, the Company reversed a full valuation allowance that
     it had previously provided against its deferred tax assets, resulting in a
     non-recurring income tax benefit of approximately $2.3 million.

(3)  See Note 1 of Notes to Consolidated Financial Statements.

                                       19
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

    The discussion in this Report contains forward-looking statements that
involve risks and uncertainties. The statements contained in this Report that
are not purely historical are forward-looking statements within the meaning of
Section 27A of the Securities Exchange Act of 1933, as amended, including
statements regarding the Company's expectations, beliefs, intentions or
strategies regarding the future. All forward-looking statements included in this
document are based on information available to the Company on the date hereof,
and the Company assumes no obligation to update any such forward-looking
statement. The Company's actual results could differ materially from those
discussed herein. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed in "Other Factors That May
Affect Future Results" as well as those discussed in this section and elsewhere
in this Report, and the risks discussed in the Company's Securities and Exchange
Commission Filings.

OVERVIEW

    Farallon develops, markets and supports complete, easy-to-use, plug-and-play
Internet connectivity and networking solutions and real-time collaboration
software to increase the productivity and efficiency of Internet, Intranet and
LAN users. The Company was founded in 1985 and initially focused on the
development of networking products for AppleTalk LANs, including the PhoneNET
network system. To date, the Company has derived a substantial majority of its
revenues from its LAN products, including its EtherWave and Ethernet products.
In 1993, the Company revised its business strategy to concentrate on the
Internet and Intranet markets through the utilization of its TCP/IP and routing
expertise. In the first quarter of fiscal 1994, the Company released its first
Timbuktu Pro Internet/Intranet collaboration software product (TCP/IP enabled),
and in the first quarter of fiscal 1996, the Company introduced its Netopia
family of Internet connectivity products and services. Although the Company has
experienced significant percentage growth in Internet/Intranet product revenues
over the last three years, the Company does not believe prior growth rates are
sustainable or indicative of future Internet/Intranet operating results. There
can be no assurance that the Company will remain profitable on a quarterly or
annual basis. The Company's limited Internet/Intranet operating history makes
the prediction of future Internet/Intranet operating results difficult, if not
impossible.

    The Company's total revenues are derived from the sale of Internet/Intranet
and LAN connectivity products. Internet/Intranet product revenues include
license revenues for its Timbuktu Pro software, sales of the Netopia family of
products and fees for related services as well as revenue from licensing its
patent covering cross-platform screen-sharing technology. LAN products revenue
is derived primarily from the sale of EtherWave, Fast Ethernet, Ethernet and
LocalTalk compatible products which include the PhoneNET system network
connectivity products and, historically, remote access and LAN software. Revenue
relating to the sale and licensing of hardware and software products is
recognized upon shipment of the products by the Company, patent revenue is
recognized upon the licensing of the rights to the patent and service revenues
are recognized ratably over the term of the contract. Certain of the Company's
sales are made to customers under agreements permitting limited rights of return
for stock balancing. Revenue is recorded net of an estimated allowance for
returns. Any product returns or price decreases in the future that exceed the
Company's allowances may materially adversely affect the Company's business,
operating results and financial condition.

    As the Company continues to focus on the development of its
Internet/Intranet business, and as a result of variable average selling prices
of the Company's LAN products, declining sales of Mac OS computers and
competitive factors, the Company expects that LAN products revenue may decline
and may account for a decreasing percentage of total revenues in future periods
to the extent that Internet/Intranet product revenues increase. As a result, the
Company's future operating results are dependent upon continued market
acceptance of its Internet/Intranet products and enhancements thereto. However,
the Company is dependent upon sales of its LAN products for the foreseeable
future, and to the extent that any decline in revenues from LAN products is not
offset by increases in revenue from other sources, such as sales of the
Company's Internet/Intranet products, then the Company's business, operating
results and financial condition will be materially adversely affected.

                                       20
<PAGE>
 
    The Company's gross margin has varied significantly in the past and will
likely vary significantly in the future depending primarily on the mix of
products sold by the Company and external market factors including but not
limited to price competition. The Company's Timbuktu Pro collaboration software
products have a higher average gross margin than the balance of the Company's
products. Accordingly, to the extent the product mix for any particular quarter
includes a substantial proportion of lower margin products, there will be a
material adverse effect on the Company's business, operating results and
financial condition.

    Farallon sells its Internet/Intranet and LAN products and related
maintenance, support and other services primarily through distributors, while
certain products are also sold directly through select ISPs or directly by the
Company to corporate accounts and higher education institutions. Revenues from
distributors accounted for 76%, 73% and 60% of the Company's total revenues for
fiscal 1994, 1995 and 1996, respectively. The Company's three largest
distributors accounted for 45%, 43% and 35% of the Company's total revenues for
fiscal 1994, 1995 and 1996, respectively. The Company intends to continue to use
its existing VARs to sell the Company's Internet/Intranet products, and to
recruit additional VARs and pursue other marketing channels in the future. There
can be no assurance that the Company's current distributors will choose to or be
able to market the Company's products effectively, that economic conditions or
industry demand will not adversely affect these or other distributors, or that
these distributors will not devote greater resources to marketing products of
other companies. The loss of, or a significant reduction in revenue from, one of
the Company's distributors could have a material adverse effect on the Company's
business, operating results and financial condition.

    International revenues accounted for 25%, 29%, and 29% of the Company's
total revenues for fiscal 1994, 1995 and 1996, respectively, and are derived
primarily from Europe and Japan. The Company's international revenues are
currently denominated in United States dollars, and revenues generated by the
Company's distributors currently are paid to the Company in United States
dollars. The results of the Company's international operations may fluctuate
from period to period based on global economic factors including, but not
limited to, movements in currency exchange rates. Historically, movements in
exchange rates have not materially affected the Company's total revenues.
However, there can be no assurance that movements in currency exchange rates
will not have a material adverse effect on the Company's revenues in the future.

RESULTS OF OPERATIONS

    The following table sets forth certain consolidated statement of operations
data of the Company expressed as a percentage of total revenues for the periods
indicated:

<TABLE> 
<CAPTION> 
                                               YEARS ENDED SEPTEMBER 30,
                                           ------------------------------------
                                            1994        1995           1996
                                           ------   ------------   ------------
        <S>                                <C>      <C>            <C> 
        Revenues:
          Internet/Intranet products         9.3%          11.5%          27.1%
          LAN products                      90.7           88.5           72.9
                                           -----          -----          -----
            Total revenues                 100.0          100.0          100.0
                                           -----          -----          -----
        Cost of revenues:
          Internet/Intranet products         0.8            1.2            6.2
          LAN products                      53.3           50.4           46.2
                                           -----          -----          -----
            Total cost of revenues          54.1           51.6           52.4
                                           -----          -----          -----
        Gross profit                        45.9           48.4           47.6
                                           -----          -----          -----
        Operating expenses:
          Research and development          11.7           14.7           14.5
          Selling and marketing             24.5           23.9           25.6
          General and administrative         5.7            5.1            5.6
                                           -----          -----          -----
            Total operating expenses        41.9           43.7           45.7
                                           -----          -----          -----
        Operating income                     4.0            4.7            2.0
        Other income, net                    0.5            1.4            1.7
                                           -----          -----          -----
        Income before income taxes           4.5            6.1            3.7
        Income tax expense (benefit)         0.7            1.7           (2.3)
                                           -----          -----          -----
        Net income                           3.8%           4.4%           6.0%
                                           -----          -----          -----
</TABLE> 

                                       21
<PAGE>
 
YEARS ENDED SEPTEMBER 30, 1994, 1995 AND 1996

    Revenues. The Company's total revenues increased slightly from $57.0
    --------
million for fiscal 1994 to $57.2 million for fiscal 1995, and increased 7.7% to
$61.6 million for fiscal 1996.  Internet/Intranet products revenue increased
23.7% from $5.3 million for fiscal 1994 to $6.6 million for fiscal 1995, and
increased 154.5% to $16.7 million for fiscal 1996.  The Internet/Intranet
revenue increase for fiscal 1995 was primarily due to the introduction of the
Windows version of Timbuktu Pro as well as increased volume licensing of
Timbuktu Pro for the Macintosh.  The increase for fiscal 1996 was due to the
introduction and initial market acceptance of the Company's Netopia family of
products and services, increased sales of the Windows versions of Timbuktu Pro
collaboration software (particularly volume licenses in corporate Intranets),
upgrade cycles and increased volume licenses related to the Macintosh version of
Timbuktu Pro as well as the licensing of the Company's patent covering cross-
platform screen-sharing technology. Exclusive of the patent license, revenues
from Timbuktu Pro decreased slightly late in the fiscal year reflecting a
decrease in sales of the  Macintosh version of Timbuktu Pro, partially offset by
slight growth in sales of the Windows version of Timbuktu Pro.  LAN products
revenue decreased 2.1% from $51.7 million for fiscal 1994 to $50.6 million for
fiscal 1995, and decreased 11.3% to $44.9 million for fiscal 1996. The decrease
for fiscal 1995 was primarily due to reduced sales and average selling prices of
LocalTalk products, offset in part by increased Ethernet and EtherWave revenues.
The decrease for fiscal 1996 was due to declining sales and average selling
prices of Etherwave and LocalTalk products, partially offset by the introduction
of new Ethernet, Fast Ethernet and OEM Ethernet products.  The Company believes
declining EtherWave sales are primarily a result of price competition from
standard 10Base-T hubs, cards and transceivers.  Although Ethernet product
revenue increased from fiscal 1995 to fiscal 1996 as a result of new product
introductions, the increase was partially offset by declining demand for certain
Ethernet products due to price competition and vendor incorporation of built-in
Ethernet connectivity into certain new computers.   The Company also believes
its Ethernet and Timbuktu Pro for Macintosh products experienced weakened demand
late in the fiscal year primarily due to delays, technical difficulties and an
interrupted supply of PowerBooks from Apple Computer ("Apple"). To the extent
that the Company continues to experience weakened demand for its products such
as its Timbuktu Pro and Ethernet products, the Company's business, operating
results and financial condition would be materially adversely affected.
Internet/Intranet products revenue accounted for 9.3%, 11.5% and 27.1% of the
Company's total revenues for fiscal 1994, 1995 and 1996, respectively, while LAN
products revenue accounted for 90.7%, 88.5% and 72.9% of the Company's total
revenues for fiscal 1994, 1995 and 1996, respectively.

    Revenues from distributors accounted for 76%, 73% and 60% of the
Company's total revenues for fiscal 1994, 1995 and 1996, respectively.  The
decrease in the percentage of revenues from distributors was primarily due to
declining sales of the Company's LAN products which are sold primarily through
the distribution channel. Revenues from Ingram accounted for 24%, 22% and 18% of
the Company's total revenues for fiscal 1994, 1995 and 1996, respectively, and
revenues from MicroWarehouse accounted for 12%, 13% and 11% of the Company's
total revenues for fiscal 1994, 1995 and 1996, respectively. No other customers
have accounted for 10% or more of the Company's total revenues during fiscal
1994, 1995 and 1996.

    International revenues accounted for 25%, 29% and 29% of total
revenues for fiscal 1994, 1995 and 1996, respectively.  International revenue
increased as a percent of total revenue from fiscal 1994 to fiscal 1995
primarily due to increased demand in the Pacific Rim.  Although international
revenues remained flat as a percentage of total revenue from fiscal 1995 to
fiscal 1996, they increased 8.2% from $16.6 million for fiscal 1995 to $18.0
million  for fiscal 1996 primarily due to increased sales in the Pacific Rim
which the Company believes were partially offset late in the fiscal year by
delays, technical difficulties and interrupted supply of Apple PowerBooks and
decreased international sales of other Apple products. To the extent that the
Company continues to experience weakened international demand for its products
such as its Timbuktu Pro and Ethernet products, the Company's business,
operating results and financial condition would be materially adversely
affected.


    Gross Margin.  The Company's total gross margin increased from 45.9%
    ------------
for fiscal 1994 to 48.4% for fiscal 1995, and decreased to 47.6% for fiscal
1996.  Internet/Intranet products gross margin decreased from 91.6% for fiscal
1994 to 89.7% for fiscal 1995, and decreased to 77.2% for fiscal 1996. The
decrease in Internet/Intranet products gross margin for fiscal 1995 was due to
declining selling prices of Internet/Intranet software products for 

                                       22
<PAGE>
 
the Mac OS
and increasing sales of the Company's Windows Internet/Intranet software
products, which carry a slightly lower gross margin than the Mac OS product due
to higher royalties applicable to the Windows product. The decrease in
Internet/Intranet products gross margin for fiscal 1996 was primarily due to the
introduction of  Netopia routers and modems which have lower gross margins than
the Company's Internet/Intranet software products, partially offset by the
licensing of the Company's patent covering cross-platform screen-sharing
technology.  The Company's gross margin for LAN products increased  from 41.3%
for fiscal 1994 to 43.0% for fiscal 1995, and decreased to 36.6% for fiscal
1996. The increase in LAN products gross margin for fiscal 1995 was primarily
due to increased sales volume and material cost reductions through product re-
designs within the EtherWave product line, partially offset by declining sales
volumes and average selling prices of LocalTalk products.  The decrease in LAN
products gross margins for fiscal 1996 was primarily due to declining sales and
average selling prices on the Company's higher margin EtherWave and LocalTalk
products and increased sales of lower margin Ethernet and Fast Ethernet
products.  Additionally,  LAN products gross margins were adversely affected by
a non-recurring charge to cost of sales resulting from standard cost reductions
on current inventory as well as additional inventory reserves the Company
recorded in the fourth quarter.  These reserves are primarily related to Fast
Ethernet products which have experienced market acceptance below the Company's
expectations.

    Research and Development.  Research and development expenses increased
    ------------------------
from  $6.7 million for fiscal 1994 to $8.4 million for fiscal 1995, and
increased to $8.9 million for fiscal 1996.  The fiscal 1995 increase was
primarily due to significant increases in the use of contractors and product
development expenses associated with development of the Company's
Internet/Intranet products. The increase for fiscal 1996 was primarily a result
of additional headcount and other employee related expenses related to the
development of the Company's Internet/Intranet products. Such expenses
represented  11.7%, 14.7% and 14.5% of the Company's total revenues for fiscal
1994, 1995 and 1996, respectively.  The Company believes that it will continue
to devote substantial resources to product and technological development and
that research and development costs will increase in absolute dollars in fiscal
1997.  Historically, the Company has believed its process for developing
software is essentially completed concurrently with the establishment of
technological feasibility and no software cost have been capitalized to date.
The Company may enter into future development agreements in which the Company
may be required to capitalize the cost of software development.

    Selling and Marketing.  Selling and marketing expenses decreased from
    ---------------------
$14.0 million for fiscal 1994 to $13.7 million for fiscal 1995, and increased to
$15.8 million for fiscal 1996. The decrease for fiscal 1995 was primarily due to
the reduction of manufacturing sales representatives throughout North America,
which was offset in part by expanded advertising and promotional campaigns
associated with the introduction of new and enhanced products during the year.
The increase for fiscal 1996 was primarily due to increased headcount with the
addition of direct software and Netopia sales forces and associated expenses as
well as increased advertising and promotional spending relating to the
introduction of  the Company's new Internet connectivity products and Internet
Applets.  Such expenses represented 24.5%, 23.9% and 25.6% of the Company's
total revenues for fiscal 1994, 1995 and 1996, respectively.  The Company
believes selling, marketing and service expenses will increase in absolute
dollars in fiscal 1997 primarily due to increased personnel related expenses and
increased advertising and promotional activities.

    General and Administrative.  General and administrative expenses
    --------------------------
decreased from $3.2 million for fiscal  1994 to $2.9 million for fiscal 1995,
and increased to $3.4 million for fiscal 1996. The decrease for fiscal 1995 was
primarily due to a significant decline in legal expenses that were incurred in
relation to a suit the Company filed against a former licensee of certain of the
Company's U.S. patents in July 1993 as well as an International Trade Commission
lawsuit filed by the Company in 1994 to ban the importation of network
connectors that violate certain of the Company's patent claims. These claims
were resolved in favor of the Company.  The increase for fiscal 1996 was
primarily due to consulting fees related to the acquisition of the Netopia
trademark and increased personnel related expenses.  Such expenses represented
5.7%, 5.1% and 5.6% of the Company's total revenues for fiscal 1994, 1995 and
1996, respectively.  The Company believes that general and administrative costs
will increase in absolute dollars for fiscal 1997 as the Company incurs
additional costs of being a public company, such as expenses related to
Directors and Officers insurance, investor relations and increased professional
fees.

    Other Income, Net.  Other income, net, represents interest earned by
    -----------------
the Company on its cash, cash equivalents and short-term investments offset by
interest expense on debt.

                                       23
<PAGE>
 
    Provision for Income Taxes.  The effective tax rates for fiscal 1994,
    --------------------------
1995 and 1996 were 16%, 28% and 38%, respectively, prior to the effect of the
adjustment to the valuation allowance against deferred tax assets, as discussed
below.  These rates differ from the statutory rate primarily due to research tax
credits and changes in the valuation allowance against deferred tax assets.  See
Note 4 of Notes to Consolidated Financial Statements.

    At March 31, 1996, the Company reversed a full valuation allowance
that it had previously provided against its deferred tax assets, resulting in a
non-recurring income tax benefit of approximately $2.3 million. Prior to March
31, 1996, the Company believed that, based upon available objective evidence,
there was sufficient uncertainty regarding the realizability of its deferred tax
assets to warrant a full valuation allowance. The factors considered included
prior losses, inconsistent profits, lack of carryback potential to realize
deferred tax assets, dependence on LAN products and associated declining market
and gross margins for LAN products, dependence upon Apple, and uncertain market
acceptance of its Internet/Intranet products. At March 31, 1996, the Company
believed that due to the demonstrated market acceptance of its new
Internet/Intranet products over the previous two fiscal quarters, the
uncertainty regarding the realizability of its deferred tax assets had
diminished to the point where it was more likely than not that the deferred tax
assets would be realized.


OTHER FACTORS THAT MAY AFFECT FUTURE RESULTS

    FLUCTUATIONS IN QUARTERLY RESULTS; FUTURE RESULTS OF OPERATIONS
UNCERTAIN.  The Company's quarterly operating results have varied significantly
in the past and are likely to vary significantly in the future, depending on
factors such as changes in networking and communications technologies, price and
product competition, usage of the Internet and developments and changes in the
Internet market, the demand for the Company's products, demand for Apple
products, changes in pricing policies by the Company or its competitors,
including the grant of price protection terms and discounts by the Company,
changes in the mix of products sold by the Company and the resulting change in
total gross margin, changes in the mix of channels through which the Company's
products are offered, product enhancements and new product announcements by the
Company and its competitors, market acceptance of new products of the Company or
its competitors, raw material costs, write-offs of obsolete inventory, the size
and timing of distributor and end user orders and purchasing cycles, customer
order deferrals in anticipation of enhancements to the Company's or competitors'
products, customer order deferrals in anticipation of new Mac OS product
offerings by Apple, manufacturing delays, disruptions in sources of supply,
product life cycles, product quality problems, personnel changes, changes in the
Company's strategy, changes in the level of operating expenses, the timing of
research and development expenditures, the level of the Company's international
revenues, fluctuations in foreign currency exchange rates, general economic
conditions, both in the United States and abroad, and economic conditions
specific to the industries in which the Company competes, among others. The
Company's limited Internet/Intranet operating history makes the prediction of
future Internet/Intranet operating results difficult, if not impossible. Sales
orders are typically shipped shortly after receipt and, consequently, order
backlog at the beginning of any quarter has in the past represented only a small
portion of that quarter's revenues. Accordingly, the Company's net revenues in
any quarter are substantially dependent on orders booked and shipped during that
quarter. Historically, the Company has often recognized a significant portion of
its revenues in the last weeks, or even days, of a quarter. As a result, the
magnitude of quarterly fluctuations may not become evident until late in, or
after the close of, a particular quarter. In addition, the Company recognizes
revenue on products sold through distributors upon shipment to the distributor.
Although the Company maintains reserves for projected returns and price
decreases, there can be no assurance that such reserves will be adequate. The
Company's business also has experienced seasonality in the past, largely due to
customer buying patterns such as budgeting cycles of educational institutions
that purchase the Company's products. There can be no assurance that the
Company's operating results will not be affected by seasonality in the future or
that such  will occur in a manner consistent with prior periods.

    The Company's expense levels are based in large part on expectations
as to future revenues and as a result are relatively fixed in the short term. If
revenues are below expectations in any given quarter, net income is likely to be
disproportionately affected. Due to all of the foregoing factors, and other
factors discussed herein, revenues and net income for any future period are not
predictable with any significant degree of certainty. Accordingly, the Company
believes that period-to-period comparisons of its results of operations are not
necessarily meaningful and 

                                       24
<PAGE>
 
should not be relied upon as indications of future performance. There can be no
assurance that the Company's business strategies will be successful or that the
Company will be able to sustain profitability on a quarterly or annual basis in
the future. It is likely that in some future quarter the Company's operating
results will be below the expectations of public market analysts and investors.
In such event, the price of the Company's Common Stock would likely be
materially adversely affected.

    MANAGEMENT OF CHANGING BUSINESS.  The Company has recently shifted its
business strategy from providing only LAN products to reducing its reliance on
LAN products and focusing development and management efforts on its
Internet/Intranet business. This transition represents a significant challenge
for the Company and its administrative, operational and financial resources and
places increased demands on its systems and controls. The Company's ability to
manage the continuing development of its Internet/Intranet business will require
the Company to continue to change, expand and improve its operational,
management and financial systems and controls and to expand its manufacturing
capacity. This transition has resulted in a continuing increase in the level of
responsibility for both existing and new management personnel. The Company
anticipates that any growth in its Internet/Intranet business will require it to
recruit and hire a substantial number of new engineering, sales and marketing,
customer service, managerial and administrative personnel. There can be no
assurance that the Company will be successful in hiring or retaining these
personnel, if needed. If the Company is unable to manage the transition
effectively, the Company's business, operating results and financial condition
will be materially adversely affected.

    INTERNATIONAL OPERATIONS.  International revenues accounted for 25%,
29% and 29% of the Company's total revenues in fiscal 1994, 1995 and 1996,
respectively. The Company expects that international revenues will continue to
represent a significant portion of its total revenues. Any significant decline
in international demand for the Company's products would have a material adverse
effect on the Company's business, operating results and financial condition. The
Company believes that in order to increase sales opportunities and profitability
it will be required to expand its international operations. The Company has
committed and continues to commit significant management attention and financial
resources to developing international sales and support channels. There can be
no assurance that the Company will be able to maintain or increase international
market demand for its products. In addition, the Company is dependent upon the
international demand for Apple products. To the extent that the Company is
unable to maintain or increase international demand for its products, or that
international demand for Apple products does not meet the Company's
expectations, the Company's international sales will be limited, and the
Company's business, operating results and financial condition would be
materially adversely affected.

    The Company's international business is subject to inherent risks,
including the impact of possible recessionary environments in economies outside
the United States, costs of localizing products for foreign countries, longer
receivable collection periods and greater difficulty in accounts receivable
collection, unexpected changes in regulatory requirements, difficulties and
costs of staffing and managing foreign operations, reduced protection for
intellectual property rights in some countries, potentially adverse tax
consequences and political and economic instability. There can be no assurance
that the Company will be able to sustain or increase international revenues, or
that the foregoing factors will not have a material adverse effect on the
Company's future international revenues and its business, operating results and
financial condition. The Company's international revenues are currently
denominated in United States dollars, and revenues generated by the Company's
distributors currently are paid to the Company in United States dollars. If, in
the future, international revenues are denominated in local currencies, foreign
currency translations may contribute to significant fluctuations in, and could
have a material adverse effect on, the Company's business, operating results and
financial condition. In addition, the Company has a substantial portion of its
products and components manufactured by foreign suppliers. The Company's
operating results are subject to the risks inherent in international purchases,
including, but not limited to, various regulatory requirements, political and
economic changes and disruptions, transportation delays, export/import controls,
tariff regulations, higher freight rates and potentially adverse tax
consequences. Duty, tariff and freight costs can materially increase the cost of
crucial components for the Company's products.

    LITIGATION.  From time to time, the Company has received claims of
infringement of other parties' proprietary rights. Although the Company believes
that all such claims received to date are immaterial, there can be no assurance
that third parties will not assert infringement claims in the future with
respect to the Company's current or future products. The Company expects that it
will increasingly be subject to infringement claims as the number 

                                       25
<PAGE>
 
of products and competitors in the Company's industry segments grow and the
functionality of products in different industry segments overlaps. Any such
claims, with or without merit, could be time consuming to defend, result in
costly litigation, divert management's attention and resources, cause product
shipment delays or require the Company to enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to the Company, if at all. In the event of a
successful claim of product infringement against the Company and failure or
inability of the Company to license the infringed or similar technology, the
Company's business, operating results and financial condition would be
materially adversely affected.

    TARIFF AND REGULATORY MATTERS.  The Company is not currently subject
to direct regulation by any government agency, other than regulations applicable
to businesses generally. However, rates for telecommunications services are
governed by tariffs of licensed carriers that are subject to regulatory
approval. Future changes in these tariffs could have a material adverse effect
on the Company's business, operating results and financial condition. For
example, if tariffs for public switched digital services increase in the future
relative to tariffs for private leased services, then the cost-effectiveness of
the Company's products would be reduced, and its business, operating results and
financial condition would be materially adversely affected. In addition, the
Company's telecommunications products must meet standards and receive
certification for connection to public telecommunications networks prior to
their sale. In the United States, such products must comply with Part 15(a)
(industrial equipment), Part 15(b) (residential equipment) and Part 68 (analog
lines) of the Federal Communications Commission regulations. The Company's
telecommunications products also must be certified by domestic
telecommunications carriers. In foreign countries, such products are subject to
a wide variety of governmental review and certification requirements. While
certain foreign countries and the European Economic Community regulate the
importation and certification of the Company's products, most foreign customers
typically require that the Company's products receive certification from their
country's primary telecommunication carriers. Any future inability to obtain on
a timely basis or retain domestic certification or foreign regulatory approvals
could have a material adverse effect on the Company's business, operating
results and financial condition.


    VOLATILITY OF STOCK PRICE.  The market price of the shares of the
Company's Common Stock is highly volatile and may be significantly affected by
factors such as actual or anticipated fluctuations in the Company's results of
operations, announcements of technological innovations, introduction of new
products by the Company or its competitors, developments with respect to
patents, copyrights or proprietary rights, conditions and trends in the
networking and other technology industries, changes in or failure by the Company
to meet securities analysts' expectations, general market conditions and other
factors. In addition, the stock market has from time to time experienced
significant price and volume fluctuations that have particularly affected the
market prices for the common stocks of technology companies. These broad market
fluctuations may adversely affect the market price of the Company's Common
Stock. In the past, following periods of volatility in the market price of a
particular company's securities, securities class action litigation has often
been brought against that company. There can be no assurance that such
litigation will not occur in the future with respect to the Company. Such
litigation could result in substantial costs and a diversion of management's
attention and resources, which could have a material adverse effect upon the
Company's business, operating results and financial condition.


LIQUIDITY AND CAPITAL RESOURCES

          The Company has funded its operations to date primarily through cash
flow from operations, the private sale of equity securities and the Initial
Public Offering ("IPO") of the Company's Common Stock. Since inception, the
Company has raised $19.4 million from the private sale of equity securities and
approximately $24.8 million of cash, net of offering expenses, from the
Company's IPO completed in June, 1996. As of September 30, 1996, the Company had
cash, cash equivalents and short-term investments representing 60% of total
assets.

          The Company generated cash from operating activities of $3.6 million
and $5.0 million in fiscal 1994 and 1995, respectively, and used $3.3 million in
fiscal 1996.  The improvements in cash flow from operations in fiscal 1994 and
1995 are largely due to growth in the Company's operating income.  The cash used
in operations in fiscal 1996 was primarily due to increases in accounts
receivable related to volume license sales of the Company's 

                                       26
<PAGE>
 
software products, that occurred in the last weeks of the fourth quarter ended
September 30, 1996, increases in operating expenses related to the introduction
of Netopia products, reduction in accounts payable and increases in inventory
related to the Company's new Netopia and Fast Ethernet products. Netopia and
Fast Ethernet products represented 2% and 7% of the total gross inventory as of
September 30, 1995, respectively, and represented 12% and 23% of total gross
inventory as of September 30, 1996, respectively.

    The Company's investing activities in fiscal 1994, 1995 and 1996, have
consisted primarily of purchases of short-term investments, and capital
equipment.  Expenditures for capital equipment totaled $600,000, $1.3 million
and $2.2 million for fiscal 1994, 1995 and 1996, respectively, representing
acquisitions of tooling and test fixtures for new products as well as computer
equipment used predominantly in product development. The Company expects that
its capital expenditures will increase in future periods to support new product
development and production.  The Company's financing activities in fiscal 1994,
1995 and 1996, represent activity on loans, exercise of stock options, the
Company's line of credit, and the IPO. The Company's principal commitments
consist primarily of leases on its headquarters facilities and operating
equipment. See Note 7 of Notes to Consolidated Financial Statements.

    The Company maintains a $5.0 million credit facility, bearing an
interest rate of 7.18%, secured by the assets of the Company, which expires on
February 28, 1997. There were no borrowings under the credit facility as of
September 30, 1996.

    The Company believes that its existing cash, cash equivalents and
short-term investments will be adequate to meet its cash needs for working
capital and capital expenditures for at least the next 12 months. Thereafter, if
cash generated from operations is insufficient to satisfy the Company's
liquidity requirements, the Company may seek to sell additional equity or
convertible debt securities or obtain additional credit facilities. The sale of
additional equity or convertible debt securities could result in additional
dilution to the Company's stockholders. A portion of the Company's cash may be
used to acquire or invest in complementary businesses or products or to obtain
the right to use complementary technologies. From time to time, in the ordinary
course of business, the Company evaluates potential acquisitions of such
businesses, products or technologies. The Company has no agreements or
commitments, and is not currently engaged in any negotiations with respect to
any such transaction.


ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
    See Item 14(a) for an index to the consolidated financial statements
and supplementary financial information which are attached hereto.


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

    Not  applicable.

PART III.

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    The information required by this item is incorporated by reference to
the information contained in the section captioned "Proposal 1 Election of
Directors" in the Proxy Statement to be filed with the Commission within 120
days after the end of the fiscal year ended September 30, 1996.

                                       27
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION

    Pursuant to General Instruction G(3) to Form 10-K, the information
required by this item is incorporated by reference to the information contained
in the section captioned "Executive Compensation and Other Matters" in the Proxy
Statement to be filed with the Commission within 120 days after the end of the
fiscal year ended September 30, 1996.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICAIL OWNERS AND MANAGEMENT

    The information required by this item is incorporated by reference to
the information contained in the section captioned "Security Ownership of
Certain Beneficial Owners and Management" in the Proxy Statement to be filed
with the Commission within 120 days after the end of the fiscal year ended
September 30, 1996.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    The information required by this item is incorporated by reference to
the information contained in the section captioned "Compensation Committee and
Insider Participation" in the Proxy Statement to be filed with the Commission
within 120 days after the end of the fiscal year ended September 30, 1996.


PART IV.

ITEM 14.  EXHIBITS, FINANCIAL SCHEDULES, AND REPORTS ON FORM 8-K
 
(a)  FINANCIAL SCHEDULES

    The following financial statements of Farallon Communications, Inc. are 
filed as part of this report on Form 10-K:

 
INDEX TO FINANCIAL STATEMENTS                                          PAGE

Independent Auditors' Report.........................................    32

Consolidated Balance Sheets at September 30, 1995 and 1996...........    33

Consolidated Statements of Earnings for
the Years Ended September 30, 1994, 1995 and 1996....................    34

Consolidated Statements of Stockholders' Equity for the Years           
Ended September 30, 1994, 1995 and 1996..............................    35

Consolidated Statements of Cash Flows for the Years Ended 
September 30, 1994, 1995 and 1996....................................    36

Notes to Consolidated Financial Statements...........................    37


    (b)   EXHIBITS

    Exhibits have been filed separately with the Securities and Exchange
Commission in connection with the Annual Report on Form 10-K or have been
incorporated into the report by reference.  Copies of such exhibits may be
obtained from the Company upon request.  The Company did not file any Form 8-K's
for fiscal 1996.
 
          EXHIBIT
             NO.       DESCRIPTION
          -------      ----------- 
          *3.1         Restated and Amended Certificate of
                       Incorporation of the Registrant.
                  
          *3.2         Restated and Amended Bylaws of the Registrant.
                  

                                       28
<PAGE>
 
          *4.1         Specimen Certificate Representing the Common
                       Stock
                  
          *4.2         Amended and Restated Investor Rights Agreement,
                       dated March 27, 1992, among the Registrant and
                       the investors and founders named therein, as
                       amended.
                  
          *10.1        Form of Indemnification Agreement entered into
                       between the Registrant and its directors and
                       officers.
                  
          *10.2        1996 Stock Option Plan and forms of agreements
                       thereunder.
                  
          *10.3        Employee Stock Purchase Plan.
                  
          *10.4        Office Lease Agreement between the Company and
                       Paragon Alameda Gateway Associates, Ltd., dated
                       June 26, 1992.
                  
          *10.5        Real Property Lease Agreement between the
                       Company and Bank of New York Trust Company of
                       California, dated July 20, 1993.
                  
          *10.6        Real Property Lease Agreement between the
                       Company and Bobwhite Meadow, L.P., dated 
                       March 1, 1996.
                  
           11.1        Statement of computation of per share earnings.
                  
           23.1        Report on Schedule and Consent of Independent
                       Auditors'
                  
          *21.1        Subsidiary of the Registrant.
                  
           27.1        Financial Data Schedule.


                       * Incorporated herein by reference to the Company's 
                         Registration Statement on From S-1 (No. 333-3868).

                                       29
<PAGE>
 
    (c)  FINANCIAL STATEMENT SCHEDULE

Schedule--Valuation and Qualifying Accounts

                         FARALLON COMMUNICATIONS, INC.
                       VALUATION AND QUALIFYING ACCOUNTS

                                 (in thousands)
<TABLE>
<CAPTION>
                                                                  Charged
                                              Balance            (Credited)
                                                 at               to Costs                        Balance at 
                                              beginning              and                             End of
           Description                        of Period            Expenses        Deductions        Period 
           -----------                        ---------           ----------       ----------     -----------
<S>                                           <C>                 <C>              <C>            <C> 
Allowance for Doubtful Accounts                                                               
   Year ended September 30, 1994                 $  876            $     120           $464            $  532
   Year ended September 30, 1995                 $  532            $     121           $136            $  517
   Year ended September 30, 1996                 $  517            $     179           $ 37            $  659
                                                                                              
Allowance for Returns                                                                         
   Year ended September 30, 1994                 $  408            $     151           $171            $  388
   Year ended September 30, 1995                 $  388            $     434           $ 85            $  737
   Year ended September 30, 1996                 $  737            $     300           $368            $  669
                                                                                              
Valuation Allowance for Deferred Tax Assets                                                   
   Year ended September 30, 1994                 $2,638                  ---           $530            $2,108
   Year ended September 30, 1995                 $2,108            $     187            ---            $2,295
   Year ended September 30, 1996                 $2,295              ($2,295)           ---               ---
</TABLE>

    (d)  Reports on Form 8-K.

    No reports on Form 8-K were filed during the last quarter of fiscal 1996.

                                       30
<PAGE>
 
SIGNATURES

Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on behalf
by the undersigned, thereunto duly authorized, in the City of Alameda, State of
California on this 16/th/ day of December, 1996.

FARALLON COMMUNICATIONS, INC.
 
BY: /s/ Alan B. Lefkof
   ------------------------- 
   Alan B. Lefkof
   President and Chief Executive Officer

Dated December 16, 1996


Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on behalf
by the undersigned, thereunto duly authorized.
<TABLE>
<CAPTION>
 
          SIGNATURE                         TITLE                     DATE
          ---------                         -----                     ----
<S>                             <C>                             <C>
/s/ Alan B. Lefkof              President, Chief Executive      December 16, 1996 
---------------------------     Officer and        
Alan B. Lefkof                  Director (Principal
                                Executive Officer)  
                                
/s/ James A. Clark              Vice President and Chief        December 16, 1996 
---------------------------     Financial Officer        
James A. Clark                  (Principal Financial and 
                                Accounting Officer)       
                                
/s/ Reese M. Jones              Chairman of the Board of        December 16, 1996 
---------------------------     Directors 
Reese M. Jones                  
                                

/s/ Bandel L. Carano            Director                        December 16, 1996 
---------------------------
Bandel L. Carano                
 

/s/ David F. Marquardt          Director                        December 16, 1996 
---------------------------
David F. Marquardt              
 

/s/ James R. Swartz             Director                        December 16, 1996 
---------------------------
James R. Swartz                 
</TABLE>

                                       31
<PAGE>
 
                          INDEPENDENT AUDITORS' REPORT

The Board of Directors
Farallon Communications, Inc. and subsidiary:

     We have audited the accompanying consolidated balance sheets of
Farallon Communications, Inc. and subsidiary as of September 30, 1995 and 1996,
and the related consolidated statements of earnings, stockholders' equity, and
cash flows for each of the years in the three-year period ended September 30,
1996. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

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

     In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the financial position of
Farallon Communications, Inc. and subsidiary as of September 30, 1995 and 1996,
and the results of their operations and their cash flows for each of the years
in the three-year period ended September 30, 1996 in conformity with generally
accepted accounting principles.


                                   KPMG PEAT MARWICK LLP

San Francisco, California
November 5, 1996

                                       32
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
                          CONSOLIDATED BALANCE SHEETS
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                                           SEPTEMBER 30,
                                                                        1995            1996
                                                                       -------         -------
<S>                                                                   <C>             <C>
ASSETS
Current assets:
   Cash and cash equivalents.........................................  $13,963         $19,910
   Short-term investments............................................    3,680          17,235
   Trade accounts receivable, less allowance for doubtful
      accounts and returns of $1,254 and $1,328, respectively.......    7,724          11,172
   Inventories, net..................................................    4,758           6,295
   Deferred tax asset................................................       --           1,829
   Prepaid expenses and other current assets.........................    1,005           1,457
                                                                       -------         -------
         Total current assets........................................   31,130          57,898
Furniture, fixtures, and equipment, net..............................    2,457           2,935
Deposits and other assets............................................      285             785
                                                                       -------         -------
                                                                       $33,872         $61,618
                                                                       =======         =======
LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable..................................................  $ 6,841         $ 4,979
   Accrued compensation..............................................    1,482           2,023
   Accrued liabilities...............................................      701             470
   Deferred revenue..................................................      168             787
   Other short-term liabilities......................................      183             170
                                                                       -------         -------
   Total current liabilities.........................................    9,375           8,429
                                                                       -------         -------
Other long-term liabilities..........................................      218              46
                                                                       -------         -------
         Total liabilities...........................................    9,593           8,475
                                                                       -------         -------

Commitments and contingencies

Stockholders' equity:
   Preferred stock:
   $0.001 par value, 5,000,000 shares authorized; 5,591,207 shares
     issued and outstanding at September 30, 1995 and none issued
     and outstanding at September 30, 1996, respectively.............        6               -
   Common stock:
   $0.001 par value, 25,000,000 shares authorized; 3,624,231 and
      11,119,961 shares issued and outstanding at September 30, 1995
      and September 30, 1996, respectively...........................        4              12
   Additional paid-in capital........................................   23,990          49,232
   Deferred compensation.............................................        -             (81)
   Retained earnings.................................................      279           3,980
                                                                        24,279          53,143
                                                                       -------         -------
         Total stockholders' equity..................................  $33,872         $61,618
                                                                       =======         =======
</TABLE>

                    See accompanying notes to consolidated financial statements.

                                       33
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC.AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF EARNINGS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                 YEARS ENDED SEPTEMBER 30,
                                             --------------------------------- 
                                                1994       1995         1996
                                             --------    --------    ---------
<S>                                          <C>         <C>         <C> 
Revenues:
   Internet/Intranet products..............  $  5,310    $  6,569    $  16,718
   LAN products............................    51,691      50,620       44,886
                                             --------    --------    ---------
         Total revenues....................    57,001      57,189       61,604
                                             --------    --------    ---------

Cost of revenues:
   Internet/Intranet products..............       447         674        3,811
   LAN products............................    30,368      28,842       28,439
                                             --------    --------    ---------
      Total cost of revenues...............    30,815      29,516       32,250
                                             --------    --------    ---------
      Gross profit.........................    26,186      27,673       29,354
                                             --------    --------    ---------
Operating expenses:
   Research and development................     6,671       8,429        8,919
   Selling and marketing...................    13,983      13,691       15,778
   General and administrative..............     3,228       2,888        3,429
                                             --------    --------    ---------
      Total operating expenses.............    23,882      25,008       28,126
                                             --------    --------    ---------
      Operating income.....................     2,304       2,665        1,228
Other income, net..........................       291         815        1,040
                                             --------    --------    ---------

   Income before income taxes..............     2,595       3,480        2,268
Income tax provision (benefit).............       408         974       (1,433)
                                             --------    --------    ---------
   Net income..............................  $  2,187    $  2,506    $   3,701
                                             ========    ========    =========
Net income per share.......................              $   0.25    $    0.33
                                                         ========    =========
Shares used in per share calculation.......                 9,891       11,071
                                                         ========    ========= 
</TABLE>



          See accompanying notes to consolidated financial statements.

                                       34
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
                                                                                                               Foreign     Total
                                    Preferred Stock     Common Stock     Additional  Deferred     Retained     currency    stock-
                                    ----------------   ---------------     paid-in    compen-     earnings    translation  holders'
                                     Shares   Amount   Shares   Amount     capital      sation    (deficit)    adjustment  equity
                                     -------  -----  ---------- ------    --------   --------     ---------   ---------     -------
<S>                                <C>         <C>      <C>        <C>       <C>        <C>        <C>           <C>       <C>
Balances, September 30, 1993.....   5,412,649   $ 5   3,220,213     $ 3    $23,611      $  --       $(4,414)      $(29)    $19,176
Exercise of stock options........     138,250     1     250,282      --        251         --            --         --         252
Net income.......................         --     --          --      --         --         --         2,187         --       2,187
Functional currency change.......         --     --          --      --         --         --            --         29          29
                                     -------  -----  ---------- ------    --------   --------     ---------   ---------     -------
Balances, September 30, 1994.....  5,550,899      6   3,470,495       3     23,862         --        (2,227)        --      21,644
Exercise of stock options........     40,308     --     153,486       1        128         --            --         --         129
Issuance of common stock bonus...         --     --         250      --         --         --            --         --          --
Net income.......................         --     --          --      --         --         --         2,506         --       2,506
                                     -------  -----  ---------- ------    --------   --------     ---------   ---------     -------
Balances, September 30, 1995.....  5,591,207      6   3,624,231       4     23,990         --           279         --      24,279
Exercise of stock options........         --     --     135,238      --        148         --            --         --         148
Issuance of common stock net
  of issuance costs of $1,222....         --     --   1,750,000       2     24,812         --            --         --      24,814
Conversion of preferred stock
  to common stock................ (5,591,207)    (6)  5,591,207       6         --         --            --         --          --
Issuance of common stock for
  consulting services............         --     --       5,000      --         30         --            --         --            9
Issuance of common stock for
  rights and services............         --     --      14,285      --        162         --            --         --          162
Deferred compensation related
  to grant of stock options......         --     --          --      --         90        (90)           --         --           --
Amortization of deferred
  compensation...................         --     --          --      --         --          9            --         --           30
Net income.......................         --     --          --      --         --         --         3,701         --        3,701
                                     -------  -----  ---------- ------    --------   --------     ---------   ---------     -------
Balances, September 30, 1996.....         --    $--  11,119,961     $12    $49,232       $(81)       $3,980        $--      $53,143
                                     =======  =====  ========== ======    ========   ========     =========   =========     =======
</TABLE>



          See accompanying notes to consolidated financial statements.

                                       35
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                                                        YEARS ENDED SEPTEMBER 30,
                                                                   -----------------------------------
                                                                    1994         1995          1996
                                                                   -------     --------      ---------
<S>                                                               <C>           <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.......................................................  $  2,187     $  2,506     $   3,701
Adjustments to reconcile net income to
  net cash provided by operating activities:
    Depreciation and amortization................................     1,443       1,466          1,757
    Deferred income taxes........................................       --           --         (2,197)
    Amortization of deferred compensation........................       --           --              9
    Noncash compensation.........................................       --           --            192
    Change in doubtful accounts and returns
      on accounts receivable.....................................     (364)         334             74
    Changes in operating assets and liabilities:
       Trade accounts receivable.................................    1,368         (838)        (3,522)
       Inventories...............................................      763         (363)        (1,537)
       Prepaid expenses and other current assets.................      158         (593)          (453)
       Deposits and other assets.................................        2         (109)          (186)
       Accounts payable and accrued liabilities..................     (839)       2,968         (1,563)
       Deferred revenue..........................................     (373)        (125)           619
       Accrued restructuring costs...............................     (150)          --             --
       Other liabilities.........................................     (558)        (257)          (173)
                                                                   -------     --------      ---------
          Net cash provided by (used in) operating activities....    3,637        4,989         (3,279)
                                                                   -------     --------      ---------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of furniture, fixtures, and equipment................     (637)      (1,335)        (2,182)
   Purchase of short-term investments............................  (20,994)      (7,273)      (124,337)
   Proceeds from the sale of short-term investments..............   16,498       15,325        110,783
                                                                   -------     --------      ---------
      Net cash provided by (used in) investing activities........   (5,133)       6,717        (15,736)
                                                                   -------     --------      ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from issuance of common stock, net...................      252          129         24,962
   Net repayments on loans and line of credit....................     (333)        (639)            --
                                                                   -------     --------      ---------
      Net cash provided by (used in) financing activities........      (81)        (510)        24,962
                                                                   -------     --------      ---------
Effect of foreign exchange rates.................................       29           --             --
                                                                   -------     --------      ---------
Net increase (decrease) in cash and  cash equivalents............   (1,548)      11,196          5,947
Cash and cash equivalents, beginning of year.....................    4,315        2,767         13,963
                                                                   -------     --------      ---------
Cash and cash equivalents, end of year...........................  $ 2,767     $ 13,963      $  19,910
                                                                   =======     ========      =========

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
   Interest paid.................................................  $    94     $     57      $       3
                                                                   =======     ========      =========
   Income taxes paid.............................................  $    --     $  1,014      $   1,050
                                                                   =======     ========      =========
SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES:
   Accrual of stock option deferred compensation.................       --           --      $      90
                                                                   =======     ========      =========
   Issuance of common stock for consulting services..............       --           --      $      30
                                                                   =======     ========      =========
   Issuance of common stock and redeemable common stock
      for rights and services....................................       --           --      $     162
                                                                   =======     ========      =========

</TABLE>
          See accompanying notes to consolidated financial statements.

                                       36
<PAGE>
 
                 FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.  NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

    Nature of Business
    ------------------

    Farallon Communications, Inc. (the "Company"), develops, markets, and
supports complete, easy-to-use Internet/Intranet connectivity and networking
solutions and real-time Internet/Intranet collaboration software. Historically,
revenues attributable to the Company's Internet/Intranet products have primarily
resulted from the licensing of software and sale of hardware, and revenues
attributable to the Company's LAN products have primarily resulted from the sale
of hardware.

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

    The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiary located in France. All significant
intercompany balances and transactions have been eliminated in consolidation. In
fiscal 1994, the Company changed the functional currency for its French
subsidiary to the U.S. dollar.

    Cash Equivalents and Short-Term Investments
    -------------------------------------------

    Cash equivalents consist of instruments with purchased maturities of 90 days
or less. Certain cash equivalents and all of the Company's investments are
classified as available-for-sale under the provisions of Statement of Financial
Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in
Debt and Equity Securities. The securities are carried at fair value which
approximates cost.

    The amortized cost of available-for-sale debt securities are adjusted for
amortization of premiums and accretion of discounts to maturity. Such
amortization is included in other income, net. Realized gains and losses, and
declines in value judged to be other than temporary on available-for-sale
securities are included in other income, net. The cost of securities sold is
based on the specific identification method. Interest and dividends on
securities classified as available-for-sale are included in other income, net.

    As of September 30, 1996, cash equivalents and short-term investments, which
are classified as available-for-sale under the provisions of SFAS No. 115,
amounted to $12,985,000 and $17,235,000, respectively. Cash equivalents and
short-term investments classified as available-for-sale as of September 30, 1995
and 1996 consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                      SEPTEMBER 30,
                                               --------------------------
                                                  1995             1996
                                               ---------        ---------
<S>                                            <C>              <C>
Municipal securities........................   $      --        $  15,207
U.S. Treasury notes.........................          --            2,028
Commercial paper............................      15,384           12,985
                                               ---------        ---------
                                               $  15,384        $  30,220
                                               =========        =========
</TABLE>

                                       37
<PAGE>
 
                 FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


    Available-for-sale securities as of September 30, 1996 consisted of the
following, by contractual maturity (in thousands):

                                                                      1996
                                                                     ------
Due in one year or less........................................ $    30,220

    Revenue Recognition
    -------------------

    The Company recognizes revenues from licenses of computer software provided
that a firm purchase order has been received, the software and related
documentation have been shipped, collection of the resulting receivable is
deemed probable, and no other significant vendor obligations exist. Patent
revenue is recognized upon the licensing of the rights to the patent.
Maintenance and service revenues, which have been relatively immaterial, are
recognized over the period in which services are provided. Hardware revenues are
recognized upon shipment. Certain of the Company's sales are made to customers
under agreements permitting right of return for stock balancing. Revenue is
recorded net of an estimated allowance for returns.

    Concentrations of Credit Risk
    -----------------------------

    Financial instruments that potentially expose the Company to concentrations
of credit risk principally consist of cash, cash equivalents, short-term
investments, and accounts receivable.

    The Company limits the amounts invested in any one type of investment.
The Company maintains its cash investments with two financial institutions.
Management believes the financial risks associated with such deposits are
minimal.

    The Company sells its products primarily through distributors and other
large scale resellers. Sales are generally not collateralized, credit
evaluations are performed as appropriate, and allowances are provided for
estimated credit losses. Historically, the Company has not experienced
significant losses on trade receivables from any particular customer, industry,
or geographic region.

    Inventories
    -----------

    Inventories are stated at the lower of cost or market. Cost is determined by
the first-in, first-out (FIFO) method.

    Furniture, Fixtures, and Equipment
    ----------------------------------

    Furniture, fixtures, and equipment are stated at cost. Depreciation is
calculated using the straight-line method over the shorter of estimated useful
lives or related lease terms ranging from one to seven years.

    Software Development Costs
    -------------------------

    Product development costs include costs related to software products that
are expensed as incurred until the technological feasibility of the product has
been established. The Company has defined technological feasibility as
completion of a working model. After technological feasibility is established,
any additional software development costs would be capitalized in accordance
with SFAS No. 86. Through September 30, 1996, the Company believes its process
for developing software was essentially completed concurrently with the
establishment of technological feasibility and no software development costs
have been capitalized to date.

                                       38
<PAGE>
 
                 FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


    Income Taxes
    ------------

    Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years that those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.

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

    In October 1995, the Financial Accounting Standards Board issued SFAS
No. 123, Accounting for Stock Based Compensation. SFAS No. 123 will be effective
for fiscal years beginning after December 15, 1995, and will require that the
Company either recognize in its financial statements costs related to its
employee stock-based compensation plans, such as stock option and stock purchase
plans, or make pro forma disclosure of such costs in a footnote to the
consolidated financial statements.

    The Company expects to continue to use the intrinsic value based method of
Accounting Principles Board Opinion No. 25, as allowed under SFAS No. 123, to
account for all of its employee stock-based compensation plans. SFAS No. 123 is
not expected to have material effect on the Company's results of operations or
financial position.
 
    Use of Estimates
    ----------------

    The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the consolidated
financial statements and the recorded amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.

    Stock Split
    -----------

    On April 16, 1996, the Company's Board of Directors authorized a one-
for-two reverse stock split on outstanding shares and options. Accordingly, all
share and per share amounts have been adjusted to reflect the stock split.

    Net Income Per Share
    --------------------

    Net income per share is based on the weighted average number of shares of
common stock, common equivalent shares from the convertible preferred stock
using the "as-converted" method and dilutive common equivalent share from
options outstanding during the period using the treasury stock method.

    Pursuant to certain SEC Staff Accounting Bulletins, common stock issued for
consideration below the assumed IPO price and stock options granted with
exercise prices below the assumed IPO price during the 12-month period prior to
the date of the initial filing of the registration statement, even when
antidilutive, have been included in the calculation of net income per share,
using the treasury stock method based on the IPO filing price, as if they were
outstanding for all periods presented prior to their issuance or grant.

                                       39
<PAGE>
 
                 FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


2.  INVENTORIES

    Inventories consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                             SEPTEMBER 30,
                                                          --------------------
                                                           1995         1996
                                                          -------      -------
<S>                                                       <C>          <C>
Raw materials and work in process........................ $ 1,594      $ 2,477
Finished goods...........................................   3,164        3,818
                                                          -------      -------
                                                          $ 4,758      $ 6,295
                                                          =======      =======
</TABLE>

3.  FURNITURE, FIXTURES, AND EQUIPMENT
 
    Furniture, fixtures, and equipment consisted of the following (in 
thousands):
 
<TABLE>
<CAPTION>
                                                         SEPTEMBER 30,
                                                   --------------------------
                                                     1995              1996
                                                   -------            -------
<S>                                                <C>                <C>
Office equipment.................................  $ 2,296            $ 2,989
Furniture and fixtures...........................    1,091              1,255
Computers........................................    5,916              7,231
Leasehold improvements...........................      508                518
                                                   -------            -------
                                                     9,811             11,993
Accumulated depreciation and amortization........   (7,354)            (9,058)
                                                   -------            -------
                                                   $ 2,457            $ 2,935
                                                   =======            =======
</TABLE>

4.  INCOME TAXES
 
    Income tax expense (benefit) consisted of the following (in thousands):
 
<TABLE>
<CAPTION>
                                          YEARS ENDED SEPTEMBER 30,
                                   ---------------------------------------
                                     1994           1995             1996
                                   -------        -------          -------
<S>                                <C>            <C>              <C> 
Current:
   Federal......................   $   350        $   922          $   472
   State........................        43             16              244
   Foreign......................        15             36               48
                                   -------        -------          -------
                                       408            974              764
                                   -------        -------          -------
Deferred:
   Federal......................        --             --           (1,814)
   State........................        --             --              383
   Foreign......................        --             --               --
                                   -------        -------          -------
                                        --             --           (2,197)
                                   -------        -------          -------
Total tax expense (benefit).....   $   408        $   974          $(1,433)
                                   =======        =======          =======
</TABLE> 

                                      40

<PAGE>
 
                 FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)

    Income tax expense (benefit) differs from the amounts computed by applying 
the statutory income tax rate of 34% of pretax income as a result of the 
following (in thousands):


<TABLE>
<CAPTION>
                                               YEARS ENDED SEPTEMBER 30,
                                           --------------------------------
                                            1994        1995         1996
                                           -----       ------      -------- 
<S>                                        <C>      <C>          <C>
Computed "expected" tax expense of 34%     $ 882       $1,183      $    771
Change in beginning balance of the
 valuation allowance for deferred 
 tax assets.............................    (530)         187        (2,295)
Research credits........................      --         (433)          (72)
State tax and other, net................      56           37           163
                                           -----       ------      -------- 
                                           $ 408       $  974      $ (1,433)
                                           =====       ======      ======== 
</TABLE>

    The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets are presented below (in thousands):

<TABLE>
<CAPTION>
                                                            SEPTEMBER 30,
                                                          1995        1996
                                                         -------     -------
<S>                                                     <C>           <C>
Deferred tax asset:
  Reserves and accruals not currently deductible......   $ 1,174     $ 1,421
  Deferred rent.......................................       141          79
  Research credit.....................................       730         197
  Alternative minimum tax credit carryforward.........        90          92
  Tangible and intangible assets......................        --         325
  State tax and other, net............................       160          83
                                                         -------     -------
      Total gross deferred assets.....................     2,295       2,197
      Less valuation allowance........................    (2,295)         --
                                                         -------     -------
      Net deferred tax assets.........................   $    --     $ 2,197
                                                         =======     =======
</TABLE>

    The net change in the total valuation allowance for the years ended
September 30, 1995 and 1996 were an increase of $187,000 and a decrease of
$2,295,000, respectively. As of September 30, 1995, the Company believed that,
based upon available objective evidence, there was sufficient uncertainty
regarding the realizability of its deferred tax assets to warrant a full
valuation allowance. The factors considered included prior losses, inconsistent
profits, lack of carryback potential to realize deferred tax assets, dependence
on LAN products and associated declining market and gross margins for LAN
products, and dependence upon Apple.

    At September 30, 1996, the Company believed that due to the demonstrated
market acceptance of Internet/Intranet products over the previous year, the
uncertainty regarding the realizability of its deferred tax assets had
diminished to the point where it was now more likely than not that the deferred
tax assets would be realized.

    As of September 30, 1996, the Company had research credit carryforwards of
approximately $197,000 for federal tax purposes and no research credit
carryforwards for state tax purposes. If not utilized, the federal credit
carryforwards will expire in years 2007 through 2011. Also, the Company had
alternative minimum tax credit carryforwards of approximately $92,000.

                                       41
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


5.  CREDIT FACILITIES

    In November 1995, the Company obtained a $5,000,000 line of credit, bearing
interest at 7.18%. The principal balance plus accrued interest is due on
February 28, 1997. There were no borrowings outstanding under the line of credit
as of September 30, 1996.

6.  STOCKHOLDERS' EQUITY AND STOCK OPTION PLAN

    On April 23, 1996 the Company was reincorporated in the State of Delaware.
The Company's authorized capital consists of 25,000,000 shares of $0.001 par
value Common Stock and 5,000,000 shares of $0.001 par value Preferred Stock.
 
    Common Stock
    ------------

    In June 1996, the Company completed the sale of 1,750,000 shares of Common
Stock, which generated net proceeds of approximately $24.8 million.

    The holders of Common Stock are entitled to one vote per share on all
matters to be voted upon by the stockholders. Subject to preferences that may be
applicable to any outstanding Preferred Stock, the holders of Common Stock are
entitled to receive ratably such dividends, if any, as may be declared from time
to time by the Board of Directors out of funds legally available therefore. In
the event of the liquidation, dissolution or winding up of the Company, the
holders of Common Stock are entitled to share ratably in all assets remaining
after payment of liabilities, subject to prior distribution rights of Preferred
Stock, if any, then outstanding. The Common Stock has no preemptive or
conversion rights or other subscription rights.

    Preferred Stock
    ---------------

    Upon the Company's initial public offering of its Common Stock on June 13,
1996, all shares of issued and outstanding Preferred Stock were converted to
5,591,207 shares of Common Stock. Following the conversion, the Company had no
Preferred Stock outstanding.

    Stock Option Plan
    -----------------

    On April 16, 1996, the Board adopted the 1996 Stock Option Plan (the "1996
Plan") providing for the issuance of incentive or non-statutory options to
directors, employees, and non-employee consultants. Options are granted at the
discretion of the Board of Directors.

    The 1996 Plan succeeds the previous equity incentive program and 2,166,995
shares of the Company's Common Stock have been authorized under the 1996 Plan.
This share reserve is comprised of (i) 294,945 shares available for issuance
under the predecessor plan and 1,372,050 shares subject to outstanding options
thereunder at March 31, 1996 and (ii) an additional increase of 500,000 shares.
As of September 30, 1996 the 1996 Plan share reserve of 2,104,119 shares is
comprised of (i) 1,601,305 shares subject to outstanding options and (ii)
502,814 shares available for grant.

    Incentive stock may be granted at not less than 100% of the fair market
value per share and non-statutory stock options may be granted at not less than
85% of the fair market value per share at the date of grant as determined by the
Board of Directors or committee thereof, except for options granted to a person
owning greater than 10% of the total combined voting power of all classes of
stock of the Company, for which the exercise price of the options must be not
less than 110% of the fair market value.

                                       42
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    Included in the 1996 Plan is a provision for the automatic grant of
non-statutory options to non-employee Board of Director members of 25,000 shares
on the effective date of the Company's proposed IPO at the initial offering
price. These shares have been granted to three non-employee Board of Director
members. Thereafter, each new director will be granted an option to purchase
25,000 shares of Common Stock on the date they become a Board member of the
Company at the then current fair market value. Options issued to Directors are
exercisable immediately subject to the Company's right of repurchase, which will
lapse ratably over five years or upon the Director's departure from the Board.

    The Board of Directors, on July 24, 1996, unanimously amended the Notice of
Grant to provide for a four year vesting schedule commencing on the date of the
grant. Grants prior to that date normally vest over five years commencing on the
date of the grant.

    The Company has the right of first refusal to acquire shares obtained by the
exercise of options at a price equal to or greater than the price being offered
for such shares by a third party. For options granted prior to February 22,
1991, the Company has a right to repurchase shares obtained by the exercise of
options in the event of termination of employment of the optionee stockholder at
a price equal to fair market value on the date of termination of employment.
 
    Farallon has recorded deferred compensation of $90,000 for the difference
between the grant price and the deemed fair value of the Common Stock underlying
options granted in October and December of 1995. This amount is being amortized
over the vesting period of the individual options, generally five years.
Amortization of deferred compensation is being charged to operating expense.

    In 1990, the Company effected a recapitalization whereby each share of the
Company's Common Stock outstanding or reserved for issuance upon exercise of
options was converted into a unit for one share of Common Stock and one share of
Series A Preferred Stock. The options relating to these units are included in
the table below.

    The following table summarizes activity under the 1996 Plan (and its
predecessor):

<TABLE>
<CAPTION>
                                                                          INCENTIVE STOCK OPTIONS
                                                       ----------------------------------------------------------------- 
                                                                                               UNITS OF 1 SHARE
                                                                                             EACH COMMON STOCK AND
                                                       COMMON STOCK                         SERIES A PREFERRED STOCK
                                                       ------------                ------------------------------------- 
                                                         NUMBER OF                    PRICE      NUMBER OF       PRICE
                                                          OPTIONS                     RANGE       OPTIONS        RANGE
                                                       ------------                -----------    --------    ---------- 
<S>                                                    <C>                        <C>             <C>          <C>
Outstanding as of September 30, 1993............         1,270,257                 $ 1.00-1.20     178,558    $1.00-3.68
Options granted.................................           214,825                        1.20          --
Options exercised...............................          (112,032)                  1.00-1.20    (138,250)   $     1.00
Options canceled................................          (316,663)                  1.00-1.20          --
                                                         ---------                 -----------    -------- 
Outstanding as of September 30, 1994............         1,056,387                   1.00-1.20      40,308    $     3.68
Options granted.................................           517,975                   1.20-1.60          --
Options exercised...............................          (113,177)                  1.00-1.20     (40,308)   $     3.68
Options canceled................................          (110,646)                  1.00-1.60          --
                                                         ---------                 -----------    -------- 
Outstanding as of September 30, 1995............         1,350,539                   1.00-1.60          --
Options granted.................................           518,975                  1.60-16.00          --
Options exercised...............................          (135,238)                 1.60-16.50          --
Options canceled................................          (132,971)                 1.00-12.50          --
                                                         ---------                 -----------    -------- 
Outstanding as of  September 30, 1996...........         1,601,305                 $1.00-16.00          --
                                                         =========                 ===========    -------- 
Exercisable.....................................           769,623                                      --
                                                         =========                                ========
</TABLE>

                                       43
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    1996 Employee Stock Purchase Plan
    ---------------------------------

    On April 16, 1996, the Board adopted the 1996 Employee Stock Purchase Plan
(the "Purchase Plan") and reserved 300,000 shares of Common Stock for issuance
under the Purchase Plan. As of September 30, 1996 no shares have been issued
under the Purchase Plan.

7.  COMMITMENTS AND CONTINGENCIES

    Leases
    ------

    The Company conducts its operations in leased facilities and with equipment
under operating lease agreements expiring at various dates through 1999.

    The following is a schedule of future minimum rental payments required under
these leases that have initial or remaining noncancelable lease terms in excess
of one year (in thousands):

<TABLE>
<CAPTION>
 
YEARS ENDING SEPTEMBER 30,
-------------------------
<S>                                                                    <C> 
    1997.............................................................  $ 1,234
    1998.............................................................      323
    1999.............................................................       37
    2000.............................................................       27
    2001.............................................................       27
    Thereafter........................................................      91
                                                                       -------
        Total minimum lease payments.................................  $ 1,739
                                                                       =======
</TABLE>

    Total rental expense for all operating leases amounted to approximately
$1,092,000, $1,169,000 and $1,117,000 for the years ended September 30, 1994,
1995 and 1996, respectively.

    Litigation
    ----------

    The Company is involved in various legal matters that have arisen in the
normal course of business. Management believes, after consultation with counsel,
any liability that may result from the disposition of such legal matters will
not have a material adverse effect on the Company's operating results and
financial condition.

    Plan for Savings and Investments
    --------------------------------

    The Company maintains a plan for savings and investments under which
eligible employees may contribute up to 15% of their annual compensation. In
addition, the Company may make discretionary retirement contributions to the
plan. No discretionary retirement contributions were made in any period
presented.

8.  SIGNIFICANT CUSTOMERS AND REVENUE BY GEOGRAPHIC REGION

    During the years ended September 30, 1994, 1995 and 1996, one customer
accounted for approximately 24%, 22% and 18%, respectively, and a second
customer accounted for approximately 12%, 13% and 11%, respectively, of total
net revenues. No other customers have accounted for 10% or more of the Company's
total revenue for the last three fiscal years.

                                       44
<PAGE>
 
                  FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    Revenue by geographic region are as follows (in thousands):

<TABLE>
<CAPTION>

                                         YEARS ENDED SEPTEMBER 30,
                                       1994          1995        1996
                                      -------      -------     -------
<S>                                  <C>        <C>          <C>
United States.......................  $42,879      $40,552     $43,609
Europe..............................    7,943        8,833       9,274
Asia/Pacific........................    4,207        5,355       6,322
Canada..............................    1,034        1,443       1,263
Latin America.......................      938        1,006       1,136
                                      -------      -------     -------
Total revenues......................  $57,001      $57,189     $61,604
                                      =======      =======     =======
</TABLE>

    The Company has no material operating assets outside the United States.
                                                                                

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