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

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

                                   FORM 10-K

[X]  Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 for the fiscal year ended December 31, 1999

                                      or

[_]  Transition report pursuant to Section 13 of 15(d) of the Securities
     Exchange Act of 1934 for the transition period

                    from                 to

                        Commission file number: 0-24360

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

                             COBALT NETWORKS, INC.
            (Exact name of registrant as specified in its charter)

<TABLE>
<S>                                <C>
            Delaware                                  77-0440751
  (State or other jurisdiction                     (I.R.S. Employer
of incorporation or organization)               Identification Number)
</TABLE>

<TABLE>
<S>                        <C>
    555 Ellis Avenue
Mountain View, California                       94043
                                              (Zip Code)
</TABLE>

      Registrant's telephone number, including area code: (650) 623-2500

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

<TABLE>
<CAPTION>
 Title
  of
 each                Name of each exchange
 class                on which registered
 -----               ---------------------
 <S>    <C>
 None                         None
</TABLE>

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

                         Common Stock, $.001 par value

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

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

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

   The aggregate market value of the voting stock held by non-affiliates of
the registrant, based upon the closing sale price of the Common Stock on March
29, 2000 as reported on the Nasdaq National Market, was approximately $871.4
million. Shares of Common Stock held by each executive officer and director
and by each person who owns 5% or more of the outstanding Common Stock have
been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes.

   As of December 31, 1999, registrant had outstanding 28,317,000 shares of
Common Stock.

                      DOCUMENTS INCORPORATED BY REFERENCE

   The Registrant has incorporated by reference into Part III of this Annual
Report on Form 10-K portions of its Proxy Statement for the 2000 Annual
Meeting of Stockholders.

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                                    PART I

ITEM 1. BUSINESS

   This Annual Report on Form 10-K, the exhibits hereto and the information
incorporated by reference herein contain "forward looking statements" within
the meaning of Section 27A of the Securities Act of 1933, as amended (the
"Securities Act") and Section 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), and such forward looking statements involve
risks and uncertainties. When used in this Report, the words "expects,"
"anticipates," and "estimates" and similar expressions are intended to
identify forward looking statements. Such statements are subject to risks and
uncertainties that could cause actual results to differ materially from those
projected. These risks and uncertainties include those discussed below and
those discussed in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" or incorporated by reference herein.
Cobalt Networks, Inc. undertakes no obligation to publicly release any
revisions to these forward looking statements to reflect events or
circumstances after the date this Report is filed with the Securities and
Exchange Commission or to reflect the occurrence of unanticipated events.

   Our company, Cobalt Networks, Inc., is a Delaware corporation. Our
principal executive offices are located at 555 Ellis Street, Mountain View,
California 94043. Our telephone number is (650) 623-2500.

Overview

   We provide server appliances, which are a new category of network
infrastructure devices that combine hardware and software to deliver one or a
few network-based applications well. Server appliances differ from general
purpose servers, which are designed to support a broad range of applications
and are not designed specifically to perform any particular function. Our
server appliances enable organizations that could not previously establish an
online presence to do so easily, cost-effectively and reliably. As the number
of internet users and businesses online increases, we believe the demand for
server appliances will continue to grow.

   Our principal product lines, the Cobalt Qube and Cobalt RaQ, enable our
customers to perform critical internet-related applications including file
serving, web hosting and providing software applications over the internet,
such as electronic mail and electronic commerce. We also offer network-
attached storage products, which provide overflow file storage for network
users, and network caching products, which enable more efficient bandwidth
usage and improve speed of internet content delivery. Our products are
designed to enable Linux, an open source operating system for which the source
code is available at little or no cost, to work well with software
applications and hardware components delivered pre-configured in our products.
These software applications include applications for web-based communications
developed by us and by the open source software developer community, as well
as proprietary third party applications. Our use of the Linux operating system
enables us to leverage the rapid application development cycles of the open
source software community to reduce the time to market for our new and
innovative products.

   As of December 31, 1999, we had sold over 25,000 server appliances to more
than 1,900 end user customers in more than 70 countries. We market and sell
our products globally through our direct sales force and our channel partners.
Our target customers are small- to medium-sized organizations, including
businesses, educational and government entities and branch offices of large
organizations. We also target web hosting and application service providers
that offer outsourced internet services to these end users.

Industry Background

   The emergence of the internet as the backbone of electronic commerce and
content delivery has created the opportunity for small- to medium-sized
organizations to significantly expand their market reach. The internet allows
these organizations to benefit from powerful information technology previously
beyond their economic and technical resources. In order to create an online
presence, these organizations can purchase and deploy their own network
infrastructure or rely upon outsourced infrastructure deployed by web hosting
and application service providers that offer services such as electronic mail
and electronic commerce.

                                       1
<PAGE>

   Traditionally, creating an online presence required the deployment of
general purpose servers and complex network technologies. General purpose
servers are designed to perform a large variety of functions including
providing database, electronic mail, network management, file management and
application services. However, the high cost of ownership and the complexity
of general purpose servers often discourage their adoption by small- and
medium-sized organizations, due to limited budgets and scarce and costly
technology skills. The high cost and complexity also create challenges for web
hosting and application service providers that seek to profitably
differentiate themselves in an intensely competitive and price sensitive
market by offering high value added services to small- to medium-sized
organizations.

   Server appliances have been developed to address the challenges faced by
small- to medium-sized organizations and web hosting and application service
providers in deploying their internet infrastructures. Because server
appliances are explicitly designed and customized to provide one or a few
dedicated applications, they can:

  . be easy to install, use and administer;

  . be easy to integrate with other infrastructure components;

  . have a low acquisition price and low total cost of ownership; and

  . deliver robust and scalable performance on an ongoing basis.

   These benefits enable small- to medium-sized organizations to rapidly and
cost-effectively establish an online presence through the use of server
appliances. These benefits also enable larger organizations to easily
complement their existing general purpose servers by deploying application
specific server appliances and thereby reduce conflicting capacity demands on
their general purpose servers. In addition, these benefits allow web hosting
and application service providers to increase profitability by offering value
added services. In situations that may require the dedication of a single
server to a single customer to provide customized services, server appliances
enable these providers to avoid the high cost and complexity of a general
purpose server.

   Server appliances can be developed either with proprietary or open source
operating systems, such as Linux. Proprietary operating systems are owned and
protected by a single vendor. A single vendor's limited engineering staff may
be the only developers with access to the source code needed to create other
software applications. As a result, the owner of the proprietary operating
system is the primary developer of new applications. Other developers may be
required to satisfy lengthy qualification procedures and pay license fees for
access to the elements of source code needed to create compatible
applications. These access limitations and fees result in slower development
cycles and higher end user costs of proprietary operating systems than can be
achieved using open source software. Open source software uses publicly
available source code that can be copied, modified and distributed by any
software developer with very few restrictions. Unlike proprietary, or closed,
software products, open source software is developed by a community of
independent developers who permit others to access their improvements and
modifications freely. Open source software, such as Apache web server, Perl
and Sendmail, is gaining increasing acceptance, particularly among web hosting
and application service providers. Open source software may provide the
following benefits to server appliances:

  . Better application integration and higher reliability: because the source
    code is open, server appliance vendors may have a better understanding of
    the interaction of all system components, which allows them to more
    thoroughly coordinate their applications with the operating system and
    improve system stability.

  . Lower cost base: open source operating systems and software are available
    at no cost and therefore can be incorporated in a system without the need
    for royalty payments or significant internal research and development
    costs.

  . Shorter development cycles: the collaborative nature of the worldwide
    developer base for open source software enables server appliance vendors
    to improve their products more quickly than they can improve products
    based on proprietary operating systems.

                                       2
<PAGE>

The Cobalt Solution

   We provide server appliances that deliver network-based applications in a
flexible and reliable manner that are simpler and more cost-effective than
other current solutions. Our server appliances include a tailored version of
the Red Hat Linux operating system that we have customized to more effectively
perform the particular applications for which our products are designed. Our
server appliances also include web-based communications applications that have
been developed by us and the open source software developer community, and
industry-standard hardware components. We believe that we are well positioned
to become the leading provider of server appliance solutions for small- to
medium-sized organizations and web hosting and application service providers
by offering the following advantages:

 Complete, integrated solutions

   Our products provide our customers with complete solutions that do not
require additional hardware or software to cost-effectively deliver the
specific applications for which the product is designed. Our use of open
source software and industry standard hardware enables us to fully understand
the interaction of all components of the system and design an efficient and
reliable solution. In addition, our products provide significant advantages
over other servers based on open source operating systems that are not
customized to fully integrate the applications and operating system to perform
a specific function. The integrated design of our software applications,
operating system and hardware results in a more reliable and stable product
that is less likely to cause disruptions in network services. This integration
also enhances the security of our solutions and enables us to design the
hardware in a cost-effective manner.

 Ease of installation and use

   Our products are pre-configured and include a simple set up procedure
designed to require less than 15 minutes for deployment by a non-technical
person. In addition, our products are easy to use, can be administered from
any internet-accessible location and require minimal space and power. Our web-
based user interface shields the user from technical complexities and
minimizes the need for trained information technology staff.

 Low cost of ownership

   We design our server appliances to deliver robust performance at an
installed cost that is 15% to 60% less than the published list prices of
general purpose servers equipped to perform the same functions. We can sell
our products at lower prices because our operating systems are based on
royalty-free open source software, and we avoid the use of unnecessary
hardware components by designing our products to perform a specific function.
Our products require limited skills and time to deploy and do not require a
network shutdown to install or add additional appliances. In addition, the
software tools included in our products minimize ongoing system management and
support efforts that would otherwise be provided by trained information
technology staff, thus greatly reducing the appliances' lifetime cost of
ownership.

 Building blocks for future growth

   As the amount of data traffic handled by a Cobalt server appliance
increases, additional units can be added to increase capacity at little
incremental expense beyond the cost of the units themselves. The ability to
easily add additional server appliances provides an evolution path that
enables customers to develop their network services and its architecture
according to their needs without a high up-front investment. Our low cost
server appliances are designed to be building blocks for scalable solutions.

   To assist customers in managing vast installations of our server
appliances, we have developed a software tool to enable our Cobalt RaQ
products to interoperate in a fully scalable fashion. This software tool, the
Cobalt Management Console, is specifically designed to allow system
administrators to monitor and perform management tasks on large installations
of Cobalt RaQ server appliances from a single management console.

                                       3
<PAGE>

 Stable, open source development environment

   Our products use a version of the Red Hat Linux operating system, an open
source operating system that undergoes a continuous cycle of enhancement by a
global community of open source developers. We customize Red Hat Linux for our
server appliances by eliminating large portions of general purpose source code
that is unnecessary for a dedicated server appliance and tailoring the
remaining source code to work effectively with our dedicated hardware. Our
open source operating system is designed to work with our hardware components
to provide a reliable and stable environment upon which we and third party
developers can develop applications with a rapid time to market. In addition,
because our source code is royalty free and open, we believe our products will
attract a large community of third party application developers. We enjoy the
benefits of our customized operating system exclusively for a short period of
time, then publish our customizations for further enhancement by the open
source development community.

 Cross platform compatibility

   Our products employ an internet standards-based architecture that enables
them to function with other networked computers that operate on a variety of
operating systems, including Windows NT and UNIX. By being cross platform
compatible, our products enable our customers to realize the benefits of our
products as part of their existing network infrastructure.

Products

   All of our products are built on a common core software and hardware
architecture that enables us to develop and market new products rapidly. In
the 24 months ending with March 2000, we have introduced 24 products based on
our four principal product lines. Our products are based on the Linux
operating system, an operating system known for its high reliability,
performance, scalability, customizability and low memory requirements. We have
customized the Red Hat Linux operating system to improve the performance and
reliability of our products. We have invested in the development of
proprietary technology for our products that includes core applications,
software toolkits, management tools, system maintenance daemons and clustering
technologies. Our products include bandwidth management technology embedded in
the operating system for which we have filed for a patent.

   We also have an application developer program through which we encourage
third-party software developers to create additional software applications for
our products. Examples of those applications are electronic commerce engines,
a medical imaging file server program and a cellular telephone voicemail
server program. We believe that end users will benefit from our open source
model by having many additional applications available to them. We provide the
relevant portions of our source code to third party software developers to
assist them in creating applications that are closely integrated with our
products' operating systems, applications and hardware. We provide other
assistance to application developers including telephone support, electronic
mail bulletin boards and a web site. We believe that there are currently more
than 100 applications that have been developed and supported by third parties
for our products. We believe that other third party applications for our
products are currently in development.

                                       4
<PAGE>

   The following table reflects our product lines:

<TABLE>
<CAPTION>
                Date of First     Starting
 Product Line   Commercial Sale   List Price Function
 ------------   ---------------   ---------- --------
 <C>            <C>               <C>        <S>
 Cobalt Qube    March 1998          $  999   Small- to medium-sized
                (1st generation)             organizations can use these
                January 1999                 products for dedicated functions
                (2nd generation)             such as electronic mail, file
                                             servers and print servers or to
                                             provide internet access and web
                                             serving. We introduced a Japanese
                                             language user interface in May
                                             1998, French and German language
                                             user interfaces in September 1999
                                             and a Chinese language user
                                             interface in March 2000.

 Cobalt RaQ     September 1998      $1,299   Web hosting and application
                (1st generation)             service providers can use our
                March 1999                   Cobalt RaQ products for dedicated
                (2nd generation)             hosting services. The compact
                October 1999                 design of the product is intended
                (3rd generation)             to facilitate its use in standard
                                             size networking facility racks.
                                             We introduced a Japanese language
                                             user interface for this product
                                             in December 1998.

 Cobalt Cache   July 1998           $1,899   Customers can use our Cobalt
                (1st generation)             CacheQube and CacheRaQ products
                April 1999                   to provide faster web response
                (2nd generation)             time and eliminate redundant
                                             traffic travelling over wide area
                                             network links. These products are
                                             targeted at markets where
                                             bandwidth is at a premium and
                                             public communications networks
                                             are less developed.

 Cobalt NAS     April 1999          $1,799   Customers can use the Cobalt
                                             NASRaQ to add storage to an
                                             existing network. For users of
                                             the network, the Cobalt NASRaQ
                                             appears to be another hard drive.

 Cobalt         October 1999        $1,999   In multiple Cobalt RaQ
 Management                                  installations, several or as many
 Console                                     as one hundred systems can be
                                             configured, monitored, and
                                             managed as a block or in subsets
                                             from a single operator station
                                             with the aid of the Cobalt
                                             Management Console.
</TABLE>

Technology

   We have invested in developing proprietary technology for our products that
includes our operating system, web-based communications applications, software
toolkits, management tools, system maintenance daemons and clustering
technologies.

 Operating System

   Our products are based on the Linux operating system, an operating system
known for its high reliability, performance, scalability, customizability and
low memory requirements. We recognize the many benefits that an open source
operating system, such as Linux, provides for the development of server
appliances. Linux is open source software that is constantly being improved by
a broad base of developers without requirements for royalty obligations to the
developers. We can customize existing Linux operating system applications or
adopt different versions of Linux without lengthy product transitions. We have
free access to the entire Linux source code and have modified Red Hat's
version of the Linux operating system to optimize it for use in our products.


                                       5
<PAGE>

 Web-based Communications Applications

   Our server appliances offer web-based communications applications such as
web serving, domain name serving, file transfer protocol, electronic mail,
discussion groups and web authoring. We provide integrated and optimized
royalty-free industry standard software such as Apache, a web serving
software, Perl, a scripting language for web site development, and Sendmail,
an electronic mail program. We also provide our internally developed software
for discussion groups and web page authoring as integrated features of our
Cobalt Qube and Cobalt RaQ products. We are investing significant resources in
deploying, testing and effectively integrating these diverse applications with
consistent, user friendly interfaces.

 Software Toolkit

   We have developed and are continuing to enhance a proprietary software
toolkit that provides a consistent interface between the applications and the
operating system. Our software toolkit enables us to provide uniform browser-
based user interfaces across all server functions and applications. Our custom
software toolkit overcomes the complexity generally associated with setting
up, managing, monitoring and using various complex network daemons and
applications. We intend to continue to develop and improve interfaces to our
software to assist third parties such as web hosting and application service
providers and value added resellers to add software applications to our
platform.

 System Maintenance Daemons

   To improve reliability and reduce cost of ownership of our server
appliances, we have developed a set of software daemons, which are software
programs that continuously monitor the state of the various software and
hardware functions on the server to permit troubleshooting. Our system
maintenance daemons automatically inform the user of excessive server resource
utilization and recommend corrective action. Our system maintenance daemons
also attempt to fix any problems automatically that the software detects and
proactively inform the user if an attempted solution was unsuccessful. The
proactive problem resolution enhances the overall reliability of the server
appliance while reducing management overhead. Our products also support
industry standards including Simple Network Management Protocol.

 Clustering Technologies

   Our products incorporate our proprietary clustering technologies that
distribute network usage across a number of server appliances for improved
network performance. These technologies allow our server appliances to be
clustered without using expensive load balancing equipment. For example, these
technologies enable a user to deploy additional Cobalt CacheRaQ units as
needed to support increased network usage.

 Management Tools

   We have several management tools, such as our maintenance and restore
toolkit, that assist the user to perform maintenance and administrative tasks
on our server appliances. In addition, we have developed a web-based remote
management tool for monitoring the status and configurations of a large number
of our server appliances on a single network. In addition, this management
software allows system administrators to provide software upgrades to multiple
server appliances and configure multiple machines from a single management
console in an easy-to-use and cost-effective manner.

 Embedded Processor Hardware Platform

   We enable our products to deliver high performance cost-effectively through
our proprietary hardware and motherboards that leverage standard components
including hard disk drives, memory and processors. We have eliminated
unnecessary components, thus reducing cost and power consumption and
increasing reliability. With the compact size of our Cobalt RaQ products, our
service provider customers are able to achieve three to four times the server
density of general purpose servers, a key advantage in the web hosting and
application service provider market where rack space is at a premium.

                                       6
<PAGE>

Customers

   As of December 31, 1999, we had sold over 25,000 of our server appliance
products to more than 1,900 end user customers in over 70 countries. Our
direct customers include regional and national web hosting and application
service providers in the United States, in addition to our channel partners.
Our indirect customers are primarily composed of small- to medium- sized
organizations and web hosting and application service providers. With respect
to both our direct and indirect sales, customers often buy for a single
location, department or division, and then, based upon the initial success of
the products, later expand their use of our products into other parts of the
organization. In 1999 and 1998, no single end user customer accounted for more
than 10% of our revenues. Indirect sales were 79% and 54% of our net revenues
in 1999 and 1998, respectively. In 1999, sales to two of our distributors,
Nissho Electronics and Tech Data, accounted for 14% and 11% of our net
revenues, respectively.

Sales and Marketing

   We sell our products through our direct sales force and channel partners
including distributors, resellers and system integrators. Historically our
direct sales efforts have focused on regional and national web hosting and
application service providers in the United States. We intend to continue and
expand our sales efforts to web hosting and application service providers. We
also intend to pursue sales to the growing number of web hosting and
application service providers outside of the United States. We have relied on
original equipment manufacturers for only a limited number of sales, but we
intend to explore opportunities to work with additional original equipment
manufacturers in the future.

 Direct Sales

   The primary function of our direct sales force is to generate demand for
our products that is fulfilled either directly or through channel partners. We
encourage our direct sales staff to work with potential web hosting and
application service provider customers regardless of whether the customer
ultimately purchases our product from us or one of our channel partners. We
believe this model enables us to encourage proliferation of our products in
this key customer group. Our direct sales force uses a team approach, which we
believe enables us to achieve better control of the sales process and respond
more rapidly to customer needs. Our direct sales force for North America is
distributed throughout the United States. In 1999 and 1998, respectively, 21%
and 46% of our net revenues were from direct sales, substantially all of which
was from the United States.

   We opened sales offices in Japan, the United Kingdom and Germany in 1998.
During 1999, we established direct sales activities in the Netherlands and
France. In 1999 and 1998 respectively, 52% and 44% of our net revenues were
from outside the United States.

 Channel Partners

   As the server appliance market has matured, we have developed a multi-tier
sales channel that is comprised of distributors, resellers and system
integrators. We believe that as the market for server appliances matures,
sales through channel partners will represent an increasing percentage of our
sales.

   Sales to our channel partners represented 79% of our net revenues in 1999.
Channel partner sales in the United States and outside the United States were
approximately 25% and 54% of net revenues, respectively, in 1999. Our top five
channel partners based on net revenues in 1999 were:

<TABLE>
     <S>             <C>
     Ingram Micro    Nissho Electronics (Japan)
     Merisel         Tech Data
     Mitsui (Japan)
</TABLE>

   In addition to delivering our server appliances to small web hosting and
application service providers and small- to medium-sized organizations,
distributors enable us to more effectively pursue a number of vertical
markets. Vertical markets and applications such as branch offices of large
organizations, government, education and web-based direct resellers are
targets of our channel partners.

                                       7
<PAGE>

 Original Equipment Manufacturer Relationships

   We recently began to sell our products through original equipment
manufacturer relationships. As part of these relationships, we design and
manufacture products that are customized to meet the end users' needs and
which are branded and sold under that company's label. We have initiated
several original equipment manufacturer relationships for our Cobalt Qube
products. We plan to expand our selling efforts through original equipment
manufacturer relationships and are currently evaluating opportunities,
particularly with respect to sales of our Cobalt Qube products.

   In 1999, we established OEM relationships with several partners, including
NTT DoCoMo and France Telecom.

   NTT DoCoMo sells a customized version of the Cobalt Qube as the server
appliance technology branded by NTT DoCoMo for its wireless electronic mail
system. This technology enables subscribers to access e-mail from network
computer systems via handheld wireless telephone and personal digital
assistant devices. Using the wireless technology, customers can establish low
cost e-mail connections.

   France Telecom sells the Cobalt Qube to the French public schools to
provide students with network services and internet access. The France Telecom
branded version of the Cobalt Qube includes a specially developed collection
of education-oriented software, including internet content filtering software
from third party software developers. Cobalt developed the education package
for France Telecom in conjunction with third party software developers. France
Telecom plans to install one or more Cobalt Qubes in public schools over the
next several years. We believe the software technology Cobalt developed with
France Telecom and third party developers could lead to additional business in
the education market.

 Marketing Programs

   To support our growing sales organization and channel, we have devoted
significant resources in the past year to building and launching a series of
marketing campaigns. Our marketing efforts have included a number of programs,
such as seminars, industry trade shows, mailings to resellers, analyst and
press tours, print and online advertising, and public relations. We believe
these marketing programs have resulted in better awareness of our Cobalt
brand.

   In March 1999, we announced the launch of a two-tier distribution-marketing
program. Our True Blue Partner and True Blue Sapphire Partner programs are for
web hosting and application service providers that resell a specified number
of Cobalt products. These web hosting and application service providers resell
our products for dedicated web hosting with our marketing support. We have
similar True Blue and True Blue Sapphire programs for value added resellers.
In addition to partner development activities, we also actively work on end
user education. As of December 31, 1999, more than 500 partners had registered
in our True Blue programs.

 Customer Advocacy and Support

   We believe that high quality customer service and support is critical to
the successful marketing and sale of our products. We are developing a
comprehensive service and support organization to manage customer accounts and
expect to provide an increasing level of support as our products are deployed
across a range of customers. We provide support for our products and services
primarily from our Mountain View, California location. We plan to establish
additional service and support sites internationally commensurate with
customer needs.

   Our products are designed to be deployed quickly and effectively by our
customers and to require minimal support from us. We offer various levels of
service and support programs to meet pre- and post-sale technical
requirements. Our CobaltCare program offers extended warranties, advanced
product replacement, telephone and electronic mail trouble shooting assistance
and other support and services. We price our CobaltCare variably depending on
the level of support selected by the customer. We also offer a variety of
services specifically tailored for web hosting and application service
providers and resellers that provide immediate access to the latest support
information, white papers and answers to frequently asked questions.

                                       8
<PAGE>

Manufacturing

   We use contract vendors to manufacture our products, and they perform tasks
that include material procurement, assembly, test, packaging, warehousing and
shipment. Utilizing a contract manufacturer enables us to reduce investment in
manufacturing capital and inventory warehousing costs. Our internal
manufacturing expertise is primarily focused on product testability,
manufacturability and the transfer of products from development to
manufacturing. However, we also manage the evaluation and selection of key
components.

   Since August 1999, Surface Mount Technology Centre (SMTC) has been our
primary contract manufacturer. Our agreement with SMTC requires us to submit a
six month rolling forecast the first month of which is binding. In any given
month we have the ability to double our forecast and require them to fill
those orders. However, if we inaccurately forecast demand for our products,
SMTC may be unable to provide us with adequate manufacturing capacity.
Purchase prices will fluctuate based on changes in component prices throughout
the one-year contract period. SMTC provides warranties on workmanship and
pass-through warranties on component parts.

   SMTC purchases most of the key components used to manufacture our products.
Some of these key components, such as sheet metal parts and chassis, are
obtained directly from sole sources. Other industry standard components, such
as our processors and power supplies, are obtained from sole or limited
sources. SMTC may not be able to obtain adequate supplies of components to
meet our customers' delivery requirements. Alternatively, SMTC may accumulate
excess inventories for our account.

   In order to reduce the costs of sales, we anticipate that we may relocate a
portion of our manufacturing operations from SMTC's manufacturing facility in
Milpitas, California to one of its offshore manufacturing facilities during
2000. Additionally, we may consider moving the outsourced manufacturing to
other new locations or to a new contract manufacturer. These relocations could
be time consuming and expensive and there can be no assurance that such moves
would not disrupt the manufacturing of our products. Such disruptions could
cause us to lose net revenues and damage our customer relationships.

   As our needs and the needs of our customers continue to evolve, we plan to
reassess our manufacturing requirements periodically and effect changes as
necessary.

Research and Development

   Our research and development expenses were $6.0 million in 1999, up from
$3.5 million in 1998 and $1.1 million in 1997. We believe that our research
and development efforts are essential to our ability to deliver innovative
products that address the needs of the market and help evolve the capabilities
of server appliances. As of December 31, 1999, our 38 person research and
development staff included personnel with expertise in several key areas,
including software-related development, hardware-related activities, and other
research and development activities.

   We recognize the need to integrate new and enhanced technologies into our
products and to continue to extend the open architecture of our products'
Linux operating system. In addition to the development of proprietary core
technologies, we plan to continue partnerships with other leading providers of
Linux technologies, products and services to jointly develop architectures and
industry standards.

Competition

   We compete in markets that are new, intensely competitive, highly
fragmented and rapidly changing. We face competition primarily from server
vendors that provide solutions for distributed computing systems.

   Companies offering competitive products vary in scope and breadth of
products and services offered and include:

  . general purpose server manufacturers such as Compaq Computer, Dell
    Computer, Gateway Computer, Hewlett-Packard, IBM, Sun Microsystems and VA
    Linux, some of which have recently begun manufacturing versions of their
    general purpose server products for sale as server appliances;

                                       9
<PAGE>

  . server appliance vendors such as Encanto Networks, Freegate (recently
    acquired by Tut Systems), Intel and Whistle Communications (recently
    acquired by IBM);

  . network caching companies such as CacheFlow and Novell; and

  . network attached storage vendors such as Meridian (recently acquired by
    Quantum) and Maxtor.

   We believe we compete favorably on the principal factors that will draw end
users to a server appliance product, which include:

  . depth of product functionality;

  . ability to work with network components utilizing other operating systems
    such as Windows NT;

  . scalability;

  . product quality and performance;

  . open systems architecture;

  . strength of channel;

  . brand name recognition;

  . competitive pricing; and

  . customer support.

   We expect competition in the server appliance market to increase
significantly as new companies enter the market and current competitors expand
their product lines and services. Many of these potential competitors are
likely to enjoy substantial competitive advantages including:

  . greater resources that can be devoted to the development, promotion and
    sale of their products;

  . more established sales channels;

  . greater software development experience; and

  . greater name recognition.

Intellectual Property

   We have invested significantly in the development of proprietary technology
for our products. Key areas of intellectual property development relate to the
tight integration of embedded software with industry standard platforms and
components, intuitive user interfaces that provide easy to use appliance
functionality and clustering technology. Our success depends significantly
upon our proprietary technology. Additionally, we have integrated third party
intellectual property into our products. We may occasionally reach agreements
with third parties to provide additional functionality for our products and
may offer third parties our technology for integration into products on an
original equipment manufacturer or other basis. We have also trademarked the
Cobalt name as well as our individual product names in the United States.

   We currently rely on a combination of patent, copyright, trademark laws,
and trade secret laws, confidentiality procedures and contractual provisions
to protect our proprietary rights. We protect our software, documentation and
other written materials under copyright and trade secret laws, which afford
only limited protection. We have applied for one patent. We cannot be certain
that any patents we seek will be issued or that, if issued, those patents will
not be challenged. We have registered and applied for registration of some of
the service marks and trademarks we use with the United States Patent and
Trademark Office. We will continue to analyze whether we should register
additional service marks and trademarks.

   We generally enter into confidentiality agreements with our employees,
consultants, business partners and major customers. Despite our efforts to
protect our proprietary rights and other intellectual property, unauthorized

                                      10
<PAGE>

parties may attempt to copy aspects of our products, obtain and use
information that we regard as proprietary or misappropriate our copyrights,
trademarks, trade dress and similar proprietary rights. In addition, the laws
of some foreign countries do not protect proprietary rights to as great an
extent as do the laws of the United States. Our means of protecting our
proprietary rights may not be adequate. In addition, our competitors might
independently develop similar technology or duplicate our products or
circumvent any patents or our other intellectual property rights.

   Cobalt, Cobalt Networks, the Cobalt logo, Cube, Cobalt Qube, Cobalt RaQ,
Cobalt NASRaQ, Cobalt CacheRaQ and RaQ are trademarks of our company. This
annual report on Form 10-K also contains brand names, trademarks or service
marks of companies other than Cobalt, and these brand names, trademarks and
service marks are the property of their respective holders.

Employees

   As of December 31, 1999, we had 140 full time employees, of whom 38 were
engaged in research and development, 66 in sales and marketing and 36 in
finance, administration and operations. None of our employees is represented
by a labor union. We have not experienced any work stoppages and consider our
relations with our employees to be good.

Executive Officers

   Cobalt's officers and their ages as of December 31, 1999 were as follows:

<TABLE>
<CAPTION>
Name                       Age Position
----                       --- --------
<S>                        <C> <C>
Stephen W. DeWitt.........  33 Chief Executive Officer, President and Director
Vivek Mehra...............  35 Chief Technology Officer and Vice President,
                               Products
Gary A. Martell...........  37 Chief Operating Officer
Kenton D. Chow............  35 Chief Financial Officer, Vice President, Finance,
                               and Secretary
Patrick J. Conte..........  41 Vice President, Sales, Americas and Asia Pacific
Kelly M. Herrell..........  34 Vice President, Marketing
George M. Korchinsky......  58 Vice President, EMEA Operations
Sharon E. McCorkle........  42 Vice President, Operations
Mark H. Orr...............  50 Vice President, Business Development
</TABLE>

   Stephen W. DeWitt has served as our President and Chief Executive Officer
since February 1998. Prior to joining Cobalt, Mr. DeWitt was Vice President
and General Manager of the Enterprise Network Management Business Unit at
Cisco Systems, a network infrastructure company, from January 1997 to February
1998. Mr. DeWitt also served as Vice President of Enterprise Marketing for
Cisco from January 1996 to February 1997. From September 1994 to January 1996,
he was Vice President of Marketing for Symantec Corporation, a system
utilities, development tools and contact management software company. From
June 1992 to September 1994, Mr. DeWitt served as General Manager of
Symantec's Canadian subsidiary. Mr. DeWitt holds a Bachelor of Science in
Finance and Economics from Babson College in Wellesley, Massachusetts.

   Vivek Mehra, one of our co-founders, has served as our Chief Technology
Officer since September 1999 and as our Vice President of Products since
November 1996. Mr. Mehra also served as one of our directors from October 1996
to August 1999. From January 1992 to November 1996, Mr. Mehra was a senior
architect and systems engineering manager at Apple Computer, a computer design
and manufacturing company. From March 1991 to January 1992, Mr. Mehra was a
developer and a member of Technical Staff at Silicon Graphics, a high
performance workstation company. From July 1988 to March 1991 Mr. Mehra served
as a principal engineer for ASIC and Board Design at Digital Equipment
Corporation, a computer maker that is now a division of Compaq Computer. Mr.
Mehra holds a Bachelor of Science in Electronics and Electrical Communications
from Punjab University, India and a Master of Science in Computer Engineering
from Iowa State University.

   Gary A. Martell has served as our Chief Operating Officer since July 1999.
From February 1988 to July 1999, Mr. Martell served as Chief Financial Officer
and Senior Vice President of Operations at Wyse

                                      11
<PAGE>

Technology, a computer hardware company. Mr. Martell holds a Bachelor of
Science in Finance and Computer Science from the University of Massachusetts
at Amherst.

   Kenton D. Chow has served as our Chief Financial Officer and Vice President
of Finance since April 1998 and as our Secretary since September 1999. From
October 1996 to January 1998, Mr. Chow served as the Director of Finance at
OpenTV, Inc., an interactive software developer for digital television. From
January 1995 to October 1996, Mr. Chow served as Controller, Worldwide Sales
of Symantec Corporation. Mr. Chow served as Senior Manager, Financial
Reporting at Bay Networks, Inc., a networking company, now part of Nortel
Networks, from November 1991 to January 1995. Prior to that time, Mr. Chow
held various positions at PricewaterhouseCoopers LLP. Mr. Chow is a certified
public accountant. He holds both a Bachelor of Science in Finance and a
Masters of Business Administration from Santa Clara University.

   Patrick J. Conte has served as our Vice President of Sales Americas and
Asia Pacific since July 1999. From October 1998 to June 1999, Mr. Conte served
as our Vice President of Sales and Marketing. Mr. Conte served as Vice
President of Sales and Channel Marketing for Dynamic Pictures, a graphics
company, from January 1997 to September 1998. From April 1995 to December
1996, Mr. Conte served as Vice President of Sales, Americas for Wyse
Technology. Prior to that time, Mr. Conte was Director, OEM Sales with Wyse
Technology from October 1994 to March 1995. Mr. Conte holds a Bachelor of
Science in Political Science and History from James Madison University and a
Masters of Arts in Political Science from Northern Illinois University.

   Kelly M. Herrell has served as our Vice President of Marketing since July
1999. Prior to joining our company, Mr. Herrell served as Vice President of
Marketing at CacheFlow, Inc., a caching products company, from September 1997
to May 1999. Mr. Herrell served as a Senior Director of Marketing at Oracle
Corporation from September 1996 to September 1997. Prior to that time, Mr.
Herrell acted as Director of Strategy for NCR Corporation from January 1995 to
September 1996. Mr. Herrell was also a Senior Marketing Manager at AT&T Global
Information Systems from January 1993 to January 1995. Mr. Herrell holds a
Bachelor of Arts from Washington State University and a Masters of Business
Administration from Cornell University.

   George M. Korchinsky has served as our Vice President of EMEA Operations
since July 1998 and is based in our offices in the Netherlands. Mr. Korchinsky
served as a vice president of EMEA Operations for Europe, the Middle East and
Africa at Aurora Electronics, from October 1996 to May 1998. From May 1991 to
October 1996, Mr. Korchinsky served as a vice president of EMEA Operations for
Europe, the Middle East and Africa at Symantec. Prior to that time, Mr.
Korchinsky served in various capacities at Cognos Limited, Paradyne
Corporation and IBM. Mr. Korchinsky is currently a member of the board of
DataCore Ltd., a United Kingdom software company. Mr. Korchinsky holds a
Bachelor of Science in Mechanical Engineering from University of Alberta.

   Sharon E. McCorkle has served as our Vice President of Operations since
October 1999. From August 1995 to September 1999, Ms. McCorkle was Director of
Operations at Wyse Technology, where she was responsible for a multi-national
manufacturing and planning organization. Prior to joining Wyse, from July 1979
to July 1995, Ms. McCorkle spent 16 years with IBM during which she held
various staff and management roles in Industrial Engineering and Finance. Ms.
McCorkle holds Bachelor of Science in Biological Sciences and Master of
Science in Industrial Engineering & Engineering Management degrees from
Stanford University.

   Mark H. Orr, a co-founder of our company, has served as our Vice President
of Business Development since October 1998. Mr. Orr served as our Vice
President of Marketing and Business Development from March 1997 to September
1998. From August 1994 to February 1997, Mr. Orr served in various capacities
at Apple Computer, including most recently as a business development manager.
Mr. Orr holds a Bachelor of Science in Mathematics from the University of
Washington.

                                      12
<PAGE>

ITEM 2. PROPERTIES

   Our principal offices are located in a 29,500 square foot facility in
Mountain View, California. Our lease on the Mountain View facility expires in
December 2003. In September 1999, we entered into a lease for an approximately
30,000 square foot building on property contiguous to our current headquarters
to expand our Mountain View operations. This lease extends through March 2004.
We have sublet approximately one-third of this building to a third party
through February 2001. We also have sales and marketing offices in Germany,
Japan, the Netherlands and the United Kingdom.

ITEM 3. LEGAL PROCEEDINGS

   In December 1998, CUBE Computer Corporation filed a lawsuit against the
company in the United States District Court for the Southern District of New
York for trademark infringement. CUBE, an original equipment manufacturer of
personal computers, argued that this alleged infringement resulted from our
use of "Qube" in connection with our products. In December 1999, we entered
into a settlement agreement with Cube Computer. We acquired certain trademark
rights from CUBE for a one-time payment of $4.1 million, not including related
legal costs.

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

   At a special meeting of stockholders of Cobalt held on October 19, 1999,
the stockholders took the following actions:

  1. Election of Stephen W. DeWitt as an at large Director of Cobalt:

<TABLE>
     <S>        <C>
     For:       17,078,161
     Withhold:  0
</TABLE>

  2. Election of Gordon A. Campbell as a Series A Director of Cobalt:

<TABLE>
     <S>        <C>
     For:       3,467,087
     Withhold:  0
</TABLE>

  3. Election of Jordan A. Levy as a Series C Director of Cobalt:

<TABLE>
     <S>        <C>
     For:       7,640,018
     Withhold:  0
</TABLE>

  4. Ratification of PricewaterhouseCoopers LLP as independent public
     accountants of Cobalt for the year ending December 31, 1999:

<TABLE>
     <S>       <C>
     For:      17,006,711
     Against:  5,000
     Abstain:  66,450
</TABLE>

  5. Approval of an amendment to Cobalt's Restated Articles of Incorporation
     to increase the authorized number of shares of Common Stock from
     26,000,000 shares to 120,000,000:

<TABLE>
     <S>       <C>
     For:      16,905,854
     Against:  0
     Abstain:  164,385
</TABLE>

  6. Approval of a change in Cobalt's state of incorporation from California
     to Delaware:

<TABLE>
     <S>       <C>
     For:      16,905,854
     Against:  0
     Abstain:  172,307
</TABLE>


                                      13
<PAGE>

  7. Ratification and approval of the following on the closing of Cobalt's
     initial public offering of common stock and, with respect to certain
     items, the time at which the Company is no longer subject to Section
     2115 of the California Corporations Code: (i) a restatement of Cobalt's
     Certificate of Incorporation to provide that the Company will have
     authorized 10,000,000 shares of Preferred Stock; and (ii) the
     effectiveness of certain provisions of the Bylaws of the Company:

<TABLE>
     <S>       <C>
     For:      16,779,301
     Against:  0
     Abstain:  272,492
</TABLE>

  8. Approval and ratification of a form of Indemnification Agreement to be
     entered into between Cobalt and its directors, officers and agents:

<TABLE>
     <S>       <C>
     For:      16,892,104
     Against:  0
     Abstain:  186,057
</TABLE>

  9. Approval and ratification of the amendment of the 1997 Employee Stock
     Plan and the reservation of additional shares for issuance thereunder:

<TABLE>
     <S>       <C>
     For:      16,876,417
     Against:  20,859
     Abstain:  180,885
</TABLE>

  10. Approval and ratification of the 1999 Employee Stock Purchase Plan and
      the reservation of shares for issuance thereunder:

<TABLE>
     <S>       <C>
     For:      17,022,961
     Against:  0
     Abstain:  55,200
</TABLE>

  11. Approval and ratification of the 1999 Director Option Plan and the
      reservation of shares for issuance thereunder:

<TABLE>
     <S>       <C>
     For:      16,979,352
     Against:  20,859
     Abstain:  77,950
</TABLE>

  12. Waiver of the notice required for the meeting pursuant to the Restated
      Articles of Incorporation with respect to the holders of Preferred
      Stock:

<TABLE>
     <S>       <C>
     For:      13,693,546
     Against:  0
     Abstain:  106,470
</TABLE>

                                      14
<PAGE>

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

                      PRICE RANGE OF COBALT COMMON STOCK

   Cobalt's common stock has been traded on the Nasdaq National Market under
the symbol "COBT" since November 5, 1999. The following table sets forth for
the period indicated the high and low sale prices for our common stock, as
reported by the Nasdaq National Market.

<TABLE>
<CAPTION>
       Year Ended December 31, 1999                                    High Low
       ----------------------------                                    ---- ---
       <S>                                                             <C>  <C>
       Fourth Quarter (from November 5, 1999)......................... $172 $22
</TABLE>

   On March 29, 2000, the last reported sale price of our common stock on the
Nasdaq National Market was $54.38 per share. As of December 31, 1999 there
were 191 holders of record of our common stock.

                                DIVIDEND POLICY

   We have never paid any cash dividends on our common stock and do not
anticipate paying cash dividends in the foreseeable future. We currently
intend to retain any future earnings for use in the operation and expansion of
our business.

                    SALES OF SECURITIES AND USE OF PROCEEDS

   On November 10, 1999, we completed the sale of 5,750,000 shares of Common
Stock at a per share price of $22.00 in a firm commitment underwritten public
offering. The offering was effected pursuant to a Registration Statement on
From S-1 (Registration No. 333-86759), which the United States Securities and
Exchange Commission declared effective on November 4, 1999. Goldman, Sachs &
Co., Merrill Lynch & Co., Robertson Stephens and SoundView Technology Group
underwrote the offering.

   Of the $126,500,000 in aggregate proceeds raised by Cobalt in connection
with the November 1999 offering, (i) approximately $8,855,000 was paid to the
underwriters in connection with the underwriting discounts, and (ii)
approximately $2,000,000 was paid by us in connection with offering expenses,
including legal, printing and filing fees. There were no direct or indirect
payments to directors or officers of the Company or any other person or
entity. None of the offering proceeds have been used for the construction of
plant, building or facilities or the purchase or installation of machinery or
equipment or for purchases of real estate or the acquisition of other
businesses. We are currently investing the net offering proceeds for further
use as additional working capital. Such net proceeds have been invested in
short-term, interest-bearing, investment grade securities. A portion of the
net proceeds may be used for the acquisition of technologies, businesses or
products that are complementary to those of Cobalt.

   Between October 1, 1999 and December 31, 1999, we issued 35,126 shares of
unregistered common stock upon the exercise of outstanding warrants to 4
persons and entities at an average exercise price of $2.89 per share. The sale
of the above securities was deemed to be exempt from registration under the
Securities Act of 1933, as amended (the "Securities Act"), in reliance on
Section 4(2) of the Securities Act, as transactions not involving a public
offering. Each recipient had adequate access, through his or her relationship
with Cobalt, to information about Cobalt.

   Between October 1, 1999 and December 31, 1999, we issued 78,000 shares of
unregistered common stock upon the exercise of outstanding options of 13
employees at an average exercise price of $5.61 per share. The sale of the
above securities was deemed to be exempt from registration under the
Securities Act of 1933, as amended (the "Securities Act"), in reliance on Rule
701 promulgated under Section 3(b) of the Securities Act, as transactions not
involving a public offering or transactions pursuant to compensatory benefit
plans and contracts relating to compensation as provided under Rule 701. Each
recipient had adequate access, through his or her relationship with Cobalt, to
information about Cobalt.

                                      15
<PAGE>

ITEM 6: SELECTED CONSOLIDATED FINANCIAL DATA

   The selected consolidated financial data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our consolidated financial statements and notes
thereto. The selected consolidated statement of operations data for the years
ended December 31, 1999, 1998, and 1997, and the selected consolidated balance
sheet data as of December 31, 1999 and 1998, are derived from, and are
qualified by reference to, the audited consolidated financial statements
included elsewhere in this annual report on Form 10-K. The selected
consolidated statement of operations data for the period from October 18, 1996
(inception) to December 31, 1996 and the selected consolidated balance sheet
data as of December 31, 1997 and 1996 are derived from our audited
consolidated financial statements that are not included in this annual report
on Form 10-K. The historical results presented below are not necessarily
indicative of future results.

<TABLE>
<CAPTION>
                                                                    Period from
                                                                    October 18,
                                                                       1996
                                       Year Ended December 31,      (Inception)
                                     -----------------------------  to Dec. 31,
                                       1999       1998      1997       1996
                                     ---------  ---------  -------  -----------
                                       (in thousands except share and per
                                                   share data)
<S>                                  <C>        <C>        <C>      <C>
Consolidated Statement of
 Operations Data:
Net revenues.......................  $  22,814  $   3,537  $    --    $   --
Cost of revenues...................     14,461      3,123       --        --
                                     ---------  ---------  -------    ------
  Gross profit.....................      8,353        414       --        --
                                     ---------  ---------  -------    ------
Operating expenses:
  Research and development.........      6,013      3,483    1,067        22
  Sales and marketing..............     14,772      5,581      245        --
  General and administrative.......      4,070      1,895      445        60
  Amortization of stock
   compensation....................      2,970         --       --        --
  Litigation settlement............      4,200         --       --        --
                                     ---------  ---------  -------    ------
    Total operating expenses.......     32,025     10,959    1,757        82
                                     ---------  ---------  -------    ------
Loss from operations...............    (23,672)   (10,545)  (1,757)      (82)
Interest and other income
 (expense), net....................      1,366         67      (12)       --
                                     ---------  ---------  -------    ------
  Net loss.........................    (22,306)   (10,478)  (1,769)      (82)
Accretion of Mandatorily Redeemable
 Convertible Preferred Stock.......     (1,377)      (828)      --        --
                                     ---------  ---------  -------    ------
Net loss attributable to holders of
 Common Stock......................  $ (23,683) $ (11,306) $(1,769)   $  (82)
                                     =========  =========  =======    ======
Basic and diluted net loss per
 share attributable to holders of
 Common Stock......................  $   (3.43) $   (5.48) $ (4.09)
                                     =========  =========  =======
Basic and diluted weighted average
 shares outstanding................  6,901,000  2,065,000  432,000
                                     =========  =========  =======
</TABLE>

<TABLE>
<CAPTION>
                                                     December 31,
                                            ---------------------------------
                                              1999     1998     1997    1996
                                            -------- --------  -------  -----
                                                    (in thousands)
<S>                                         <C>      <C>       <C>      <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents.................. $141,777 $  2,090  $ 1,738  $  15
Working capital (deficit)..................  129,111   (1,912)   1,542   (105)
Total assets...............................  151,857    6,145    1,998     42
Notes payable, less current portion........       40       84       --     70
Mandatorily Redeemable Convertible
 Preferred Stock...........................       --   12,339    3,551     --
Total stockholders' equity (deficit).......  130,756  (13,073)  (1,847)   (82)
</TABLE>

                                      16
<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

   Certain statements in this "Management's Discussion and Analysis of
Financial Condition and Results of Operations" are forward looking statements.
These statements relate to future events or our future financial performance
and involve known and unknown risks, uncertainties and other factors that may
cause our or our industry's actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by the forward-
looking statements. These risks and other factors include those listed under
"Factors Affecting Future Operating Results" and elsewhere in this annual
report on Form 10-K. In some cases, you can identify forward-looking
statements by terminology such as "may", "will", "should", "expects", "plans",
"anticipates", "believes", "estimates", "predicts", "potential", "continue" or
the negative of these terms or other comparable terminology. These statements
are only predictions. Actual events or results may differ materially. In
evaluating these statements, you should specifically consider various factors,
including the risks outlined under "Factors Affecting Future Operating
Results". These factors may cause our actual results to differ materially from
any forward-looking statement.

Overview

   Since our inception in 1996, we have incurred substantial costs to develop
our technology and products, to recruit and train personnel for our
engineering, sales and marketing and technical support departments, and to
establish an administrative organization. As a result, we had an accumulated
deficit of $36.8 million as of December 31, 1999. We anticipate that our
operating expenses will increase substantially in the future as we increase
our sales and marketing operations, develop new channels, fund greater levels
of research and development, broaden our technical support and improve our
operational and financial systems. Accordingly, we will need to generate
significant revenues to achieve profitability. In addition, our limited
operating history makes it difficult for us to predict future operating
results and, accordingly, there can be no assurance that we will sustain
revenue growth or achieve profitability in future quarters.

   We currently derive substantially all of our net revenues from sales of a
limited number of products. During 1999 and 1998, respectively, 87% and 83% of
our net revenues were derived from sales of our Cobalt Qube and Cobalt RaQ
products. Although we began selling our Cobalt Cache products in 1998 and
Cobalt NAS products in 1999, we expect that a substantial majority of our
revenues in 2000 will continue to be generated from sales of our Cobalt Qube
and Cobalt RaQ products.

   We sell our products directly through our sales force and indirectly
through channel partners that include distributors, resellers and system
integrators. Indirect sales are a majority of our total sales and account for
substantially all of our sales outside of the United States. In 1999 and 1998,
respectively, 21% and 46% of our net revenues were from direct sales. The
decrease in direct sales as a percentage of net revenues reflected the more
rapid growth of sales through channel partners relative to the growth of
direct sales. However, the absolute dollar amount of direct sales rose to $4.8
million in 1999 from $1.6 million in 1998.

   Indirect sales were 79% and 54% of our net revenues in 1999 and 1998,
respectively. In 1999, sales to two of our distributors, Nissho Electronics
and Tech Data, accounted for 14% and 11% of our net revenues, respectively. In
1998, approximately 12% of our net revenues came from sales to Nissho
Electronics. While we are seeking to diversify our customer base and expand
the portion of our net revenues which is derived from sales through various
channels, we anticipate that our operating results will continue to depend on
volume sales to a relatively small number of channel partners.

   For direct sales and sales to resellers and system integrators, we record
revenues upon shipment. We recognize revenues on sales to distributors at the
time products are sold through to end-users. As a result, we defer recognition
of gross profit, captioned on our balance sheet as "deferred margin on
distributor inventory"

                                      17
<PAGE>

until we record the revenues and cost of revenues on a sell-through basis.
Revenues from service obligations are deferred and recognized on a straight-
line basis over the contractual period.

   Our customers and distributors are generally able to cancel their orders at
any time prior to shipment without penalty. In addition, Cobalt is typically
able to fulfill a majority of orders in less than seven days. Consequently,
backlog measured on any given day is not a meaningful predictor of our
prospects in the ensuing weeks and months.

   We provide allowances for estimated sales returns and warranty costs at the
time of revenue recognition based on our historical results. To date, our
actual sales returns and warranty expenditures have each been less than 5% of
net revenues in any quarter. However, our past product return and warranty
experience may not be indicative of future product return rates and warranty
costs.

   Although we enter into general sales contracts with our channel partners,
none of our channel partners is obligated to purchase any amount of our
products pursuant to these contracts. We rely on our channel partners to
submit purchase orders for specific quantities of our products.

   Our gross profit is affected by:

  . fluctuations in demand for our products;

  . the mix of products sold;

  . the mix of sales channels through which our products are sold;

  . the mix of sales within and outside North America;

  . the timing and size of customer orders;

  . new product introductions by us and our competitors;

  . changes in our pricing policies;

  . changes in component costs; and

  . the volume manufacturing prices we are able to obtain from our contract
    manufacturers.

   We recorded unearned stock compensation on our balance sheet of $8.9
million in connection with stock options granted to our employees between July
1, 1998 and October 1, 1999. We are amortizing this stock compensation over
the vesting period of the related options. During 1999, we amortized $2.4
million of stock compensation. During 2000, we expect to amortize stock
compensation of:

<TABLE>
<CAPTION>
                                                           Expected Amortization
Fiscal Quarter Ending                                      of Stock Compensation
---------------------                                      ---------------------
                                                              (in thousands)
<S>                                                        <C>
March 31, 2000............................................        $1,300
June 30, 2000.............................................        $1,280
September 29, 2000........................................        $  940
December 29, 2000.........................................        $  690
</TABLE>

   We then expect aggregate per quarter stock compensation amortization of
between $533,000 and $318,000 during 2001, between $262,000 and $116,000
during 2002 and between $78,000 and $10,000 during 2003. The amount of stock
compensation expense to be recorded in future periods could decrease in the
event of the forfeiture of options for which accrued but unvested compensation
has been recorded.

   As of December 31, 1999, we had approximately $26 million of federal and
$18 million of state net operating loss carryforwards for tax reporting
purposes available to offset future taxable income. These net

                                      18
<PAGE>

operating loss carryforwards expire beginning in 2014 and 2004, respectively.
We have not recognized any benefit from the future use of loss carryforwards
for these periods or for any other period since inception because of
uncertainty surrounding their realization. The amount of net operating losses
that we can utilize may be limited under tax regulations in circumstances
including a cumulative stock ownership change of more than 50% over a three-
year period. It is possible that such a change may have already occurred.

   Our net loss attributable to holders of common stock includes accretion
charges to increase over time the carrying amount of our mandatorily
redeemable convertible preferred stock to the amount we would be required to
pay if the preferred stock were to be redeemed. As of April 26, 1999, we
stopped recording these charges because we changed the terms of the preferred
stock to limit the redemption amount to its original issue price plus accrued
dividends.

   We had 140 employees as of December 31, 1999, a substantial increase from
68 as of December 31, 1998 and 14 as of December 31, 1997. This rapid growth
has placed significant demands on our management and operational resources. In
order to manage our growth effectively, we must implement and improve our
operational systems, procedures and controls on a timely basis. We could
experience a decline in our revenues and operating results if:

  . our total revenues do not increase relative to our operating expenses;

  . our management systems do not expand to meet increasing demands;

  . we fail to attract, assimilate and retain qualified personnel, or

  . our management otherwise fails to manage our expansion effectively.

   Until January 1, 1999, we operated on calendar fiscal quarters and a fiscal
year ending December 31. Beginning in 1999, we began to operate on thirteen
week fiscal quarters ending on a Friday. Therefore, in 2000 our fiscal
quarters end on March 31, June 30, September 29 and December 29. Fiscal 2000
will also end on December 29, 2000.

Results of Operations

Years Ended December 31, 1999 and 1998

 Net Revenues

   Net revenues increased to $22.8 million in 1999 from $3.5 million in 1998.
The 551% increase in net revenues was primarily the result of an increase in
sales to new and existing customers of our Cobalt Qube and Cobalt RaQ product
lines, which together represented 87% and 83% of net revenue in 1999 and 1998,
respectively. The remaining increase was due to the introduction of our Cobalt
Cache products and Cobalt NAS products in July 1998 and April 1999,
respectively, and an expansion of our sales through our direct sales force and
channel partners. We expect that the majority of our revenues in the future
may continue to be generated from sales of our Cobalt Cube and Cobalt RaQ
products.

   Net revenues from sales to international customers increased to $11.9
million, or 52% of net revenue, in 1999 from $1.6 million, or 44% of net
revenue in 1998. The increase in absolute dollars was due to expansion of our
operations in Japan, Europe and other countries. One factor relating to the
increase in net revenues from sales outside the United States was our
introduction of various local language user interfaces including Japanese,
German, and French. Our net revenues from sales outside the United States were
primarily denominated in U.S. dollars. The effect of foreign exchange
fluctuations did not have a significant impact on our results.

   Revenue in past periods may not be indicative of future revenue, which may
be affected by the other factors discussed in "Factors Affecting Future
Operating Results", as well as other factors.

                                      19
<PAGE>

 Cost of Revenues and Gross Profit

   Cost of revenues includes technology license fees, manufacturing costs,
manufacturing personnel expenses, packaging and shipping costs and warranty
expenses. We have outsourced our manufacturing and repair operations.
Accordingly, in 1999 approximately 76% and in 1998 approximately 65% of our
cost of revenues consists of payments to our contract manufacturers. Cost of
revenues increased to $14.5 million in 1999 from $3.1 million in 1998. The
increase in cost of revenues was primarily due to increased sales volume and
the introduction of new products. We believe that our cost of revenues will
increase in absolute dollars in future periods but may continue to fluctuate
as a percentage of net revenues due to factors including changes in product
mix, and material and labor costs.

   Gross profit increased to $8.4 million in 1999 from $414,000 in 1998. Gross
profit as a percentage of net revenues increased to 36.6% in 1999 from 11.7%
in 1998. The increase in gross profit was primarily due to increased sales
volume and the introduction of new products. We believe that the rate of
growth of the increase in gross profit will not be sustainable in future
quarters.

 Research and Development

   Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development including the
development of application and server management software, material costs for
prototype and test units and other expenses related to the design,
development, testing and enhancements of our products. We expense all of our
research and development costs as they are incurred. Research and development
expenses increased to $6.0 million in 1999 from $3.5 million in 1998. The
increase resulted from the hiring of additional research and development
personnel and the cost of consulting services and materials. As net revenues
increased, research and development expenses declined as a percentage of net
revenues to 26% in 1999 from 98% in 1998. We believe that a significant level
of investment in product research and development is required to remain
competitive. Accordingly, we expect to continue to devote substantial
resources to product research and development such that research and
development expenses will increase in absolute dollars but may continue to
fluctuate as a percentage of net revenues.

 Sales and Marketing

   Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and customer
support functions, as well as costs associated with trade shows, promotional
activities, advertising and public relations. Sales and marketing expenses
increased to $14.8 million in 1999 from $5.6 million in 1998. The increase in
sales and marketing expenses was due to the expansion of our international
sales and marketing efforts, our branding campaign, advertising and tradeshows
and the hiring of additional sales and marketing personnel in the United
States. As net revenues increased, sales and marketing expenses declined as a
percentage of net revenues to 65% in 1999 from 158% in 1998. We intend to
expand our sales and marketing operations and efforts substantially, both
domestically and internationally, in order to increase market awareness and to
generate sales of our products. Accordingly, we expect our sales and marketing
expenses to increase in absolute dollars but may continue to fluctuate as a
percentage of net revenues.

 General and Administrative

   General and administrative expenses consist primarily of salaries and
related expenses for executive, finance, accounting, information technology,
facilities and human resources personnel, recruiting expenses, professional
fees and costs associated with expanding our information systems. General and
administrative expenses increased to $4.1 million in 1999 from $1.9 million in
1998. The increase was due to hiring of additional administrative personnel
and increased rent. As net revenues increased, general and administrative
expenses declined as a percentage of net revenues to 18% in 1999 from 54% in
1998. We expect these expenses to increase in absolute dollars but may
continue to fluctuate as a percentage of net

                                      20
<PAGE>

revenues as we add personnel and incur additional costs related to the growth
of our business, expansion of our information infrastructure and our operation
as a public company.

 Amortization of Stock Compensation

   In connection with the grant of stock options to employees for the period
from July 1, 1998 to October 1, 1999, we recorded unearned stock compensation
within stockholders' equity of approximately $8.9 million, representing the
difference between the estimated fair value of the common stock for accounting
purposes and the option exercise price of these options at the date of grant.
We recorded $2.4 million of stock compensation amortization during 1999 and no
stock compensation amortization in 1998. The amount of stock compensation
expense to be recorded in future periods could decrease if options for which
accrued but unvested compensation has been recorded are forfeited. During
1999, unearned stock compensation costs of $64,000 were reversed upon
cancellation of options.

 Litigation Settlement

   In December 1998, CUBE Computer Corporation filed a lawsuit against the
Company in the United States District Court for the Southern District of New
York for trademark infringement. CUBE, an original equipment manufacturer of
personal computers, argued that this alleged infringement resulted from the
Company's use of "Qube" in connection with its products. In December 1999, the
Company entered into a settlement agreement with CUBE Computer resulting in a
one-time payment of $4.1 million, excluding related legal fees.

 Interest Income (Expense), Net

   Interest income (expense), net includes income from our cash investments
net of expenses related to our debt and lease financing obligations. We had
net interest income of $1.5 million in 1999 and $67,000 in 1998. The growth in
net interest income from 1998 was primarily due to an increase in interest
income earned on proceeds from issuance of our stock.

Years Ended December 31, 1998 and 1997

 Net Revenues

   We had net revenues of $3.5 million in 1998, principally related to sales
of the Cobalt Qube and Cobalt RaQ. We had no net revenues in 1997. Net
revenues from sales outside of the United States were approximately 44% of net
revenues in 1998, primarily in Japan and Europe.

 Cost of Revenues and Gross Profit

   Cost of revenues was $3.1 million in 1998 and gross profit totaled
$414,000. There were neither cost of revenues nor gross profit in 1997.

 Research and Development

   Research and development expenses increased to $3.5 million in 1998 from
$1.1 million in 1997. The increase in research and development expenses was
due to expanded technology development efforts related to our new products,
user interfaces, Linux operating system customization and application
software.

 Sales and Marketing

   Sales and marketing expenses increased to $5.6 million in 1998 from
$245,000 in 1997. The increase in sales and marketing expenses during 1998 was
due to the addition of new sales, marketing, and customer support personnel
and product launches, sales channel growth, and our expansion of our global
selling efforts, which emphasizes the support of sales and service through
distributors and resellers.

 General and Administrative

   General and administrative expenses increased to $1.9 million in 1998 from
$445,000 in 1997. The increase in general and administrative expenses in each
period was due to the hiring of additional personnel and to expansion of our
facilities to support the growth of our business.

                                      21
<PAGE>

 Interest Income (Expense), Net

   We had net interest income of $67,000 in 1998 and net interest expense of
$12,000 in 1997. The net change from 1997 to 1998 was due to interest income
on the increased average cash and cash equivalents balances as a result of our
issuances of capital stock.

Liquidity and Capital Resources

   Since inception, we have financed our operations primarily through private
sales of mandatorily redeemable convertible preferred stock, proceeds from our
initial public offering of common stock, the issuance of convertible notes,
equipment financings and net revenues generated from product sales. As of
December 31, 1999, we had cash and cash equivalents of $141.8 million, an
accumulated deficit of $36.8 million and working capital of $129.1 million.

   Our operating activities used cash of $8.4 million in 1999, $7.5 million in
1998 and $1.6 million in 1997. Cash used in operating activities during 1999
was attributable to a net loss of $22.3 million and increases in accounts
receivable of $4.1 million and inventory of $200,000 but was offset in part by
increases in accounts payable of $10.9 million, accrued expenses of $3.5
million and deferred margin on distributor inventory of $1.0 million, as well
as depreciation, amortization of stock compensation and other non-cash
expenses aggregating $4.1 million. Cash used in operating activities for 1998
and 1997 was primarily attributable to net losses of $10.5 million and $1.8
million, respectively. In 1998, cash used in operating activities was also
attributable to increases in accounts receivable and inventories of $2.0
million and $500,000, respectively, offset in part by increases in accounts
payable of $4.0 million and accrued expenses of $1.1 million.

   Our investing activities used cash of $1.8 million 1999, $1.4 million in
1998 and $157,000 in 1997. Our investing activities primarily reflect
purchases of computer equipment and other fixed assets.

   Our financing activities provided cash of $149.9 million in 1999, $9.3
million in 1998 and $3.5 million in 1997. The increases in each period
resulted primarily from the net proceeds from the issuances of preferred
stock, and the issuance of common stock in our November 1999 initial public
offering.

   From inception, we have made capital expenditures of $2.9 million to
support our research and development, sales and marketing and administrative
activities. We expect to have capital expenditures of approximately $1.5
million for 2000. We also anticipate that our capital expenditures will
increase over the next several years as we expand our facilities and acquire
equipment to support expansion of our sales and marketing and research and
development activities.

   In September 1998, we entered into an equipment lease financing agreement
with available borrowings of up to $1.0 million at an interest rate of 10.95%
per annum secured by our equipment, machinery and fixtures. We are required to
repay advances under the line in 34 equal installments. As of December 31,
1999 and December 31, 1998, respectively, we had outstanding borrowings of
$84,000 and $123,000 under this lease line.

   We intend to continue to invest heavily in the development of new products
and enhancements to our existing products. Our future liquidity and capital
requirements will depend upon numerous factors, including:

  . the costs and timing of expansion of sales and marketing activities;

  . the costs and timing of expansion of product development efforts and the
    success of these development efforts;

  . the extent to which our existing and new products gain market acceptance;

  . the level and timing of license revenues;

                                      22
<PAGE>

  . the costs involved in maintaining and enforcing intellectual property
    rights;

  . market developments;

  . available borrowings under line of credit arrangements; and

  . other factors.

   We believe that our current cash and investment balances and any cash
generated from operations and future debt financing, will be sufficient to
meet our operating and capital requirements for at least the next 12 months.
However, it is possible that we may require additional financing within this
period. We have no current plans, and we are not currently negotiating, to
obtain additional financing. The factors described above will affect our
future capital requirements and the adequacy of our available funds. In
addition, even if we raise sufficient funds to meet our anticipated cash needs
during the next 12 months, we may need to raise additional funds beyond this
time. We may be required to raise those funds through public or private
financings, strategic relationships or other arrangements. We cannot assure
you that such funding, if needed, will be available on terms attractive to us,
or at all. Furthermore, any additional equity financing may be dilutive to
stockholders, and debt financing, if available, may involve restrictive
covenants. If we fail to raise capital when needed, our failure could have a
negative impact on our ability to pursue our business strategy and achieve and
maintain profitability.

Recent Accounting Pronouncements

   In December 1999, the staff of the Securities and Exchange Commission
issued Staff Accounting Bulletin ("SAB") 101, "Revenue Recognition," which
outlines the basic criteria that must be met to recognize revenue and provides
guidance for presentation of revenue and for disclosure related to revenue
recognition policies in financial statements filed with Securities and
Exchange Commission. The effective date of this pronouncement is the second
quarter of the fiscal year beginning after December 15, 1999. The Company
believes that adopting SAB 101 will not have a material impact on the
Company's financial position and results of operations.

   In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes
methods of accounting for derivative financial instruments and hedging
activities related to those instruments as well as other hedging activities.
In July 1999, the FASB issued SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities--Deferral of the Effective Date of FASB
Statement No. 133." SFAS No. 137 deferred the effect of SFAS No. 133 until
fiscal year beginning after June 15, 2000. Cobalt will adopt SFAS No. 133 in
2001. To date, Cobalt has not engaged in derivative or hedging activities.
Cobalt is unable to predict the impact of adopting SFAS No.133 if it were to
engage in derivative and hedging activities in the future.

Risk Factors That May Affect Future Operating Results

 We only began selling our products in March 1998 and, as a result, you may
 have difficulty evaluating our business and operating results.

   Our company was founded in October 1996, and we did not begin selling our
products until March 1998. You should consider the risks and difficulties we
may encounter as an early stage company in the new and rapidly evolving server
appliance market. Our limited historical financial performance may make it
difficult for you to evaluate the success of our business to date and to
assess its future viability. We cannot be certain that our business strategy
will be successful.

 We have a history of losses and may experience losses in the future, which
 could result in the market price of our common stock declining.

   Since our inception, we have incurred significant net losses including net
losses of $22.3 million in 1999 and $10.5 million in 1998. In addition, we had
an accumulated deficit of $36.8 million as of December 31, 1999.

                                      23
<PAGE>

We expect to continue to incur significant product development, sales and
marketing and administrative expenses. As a result, we will need to generate
significant revenues to achieve profitability. We cannot be certain that we
will achieve profitability in the future or, if we achieve profitability, to
sustain it. If we do not achieve and maintain profitability, the market price
for our common stock may decline, perhaps substantially.

   We anticipate that our expenses will increase substantially in the next 12
months as we:

  . increase our direct sales and marketing activities, particularly by
    expanding our direct sales forces;

  . develop our technology, expand our existing product lines and create and
    market additional server appliance products;

  . make additional investments to develop our brand;

  . expand our distribution and reseller channels;

  . pursue original equipment manufacturing relationships; and

  . implement additional internal systems, develop additional infrastructure
    and hire additional management to keep pace with our growth.

   Any failure to significantly increase our revenues as we implement our
product and distribution strategies would also harm our ability to achieve and
maintain profitability and could negatively impact the market price of our
common stock.

 We may not be able to sustain our current revenue growth rates, which could
 cause our stock price to decline.

   Although our revenues grew rapidly in 1999 and 1998, we do not believe that
we will maintain this rate of revenue growth because we started from a small
base of revenue, and it is difficult to maintain high percentage increases
over a larger revenue base. In addition, growing competition, the incremental
manner in which customers implement server appliances and our inexperience in
selling our products to small- to medium-sized organizations could also affect
our revenue growth. Any significant decrease in our rate of revenue growth
would likely result in a decrease in our stock price.

 Because our ability to accurately forecast our quarterly sales is limited,
 our costs are relatively fixed in the short term and we expect our business
 to be affected by seasonality, our quarterly operating results and our stock
 price may fluctuate.

   Because of our limited operating history and the new and rapidly evolving
market for our server appliances, our ability to accurately forecast our
quarterly sales is limited, which makes it difficult to predict the quarterly
revenues that we will recognize. In addition, we cannot forecast operating
expenses based on historical results, and most of our costs are for personnel
and facilities, which are relatively fixed in the short term. If we have a
shortfall in revenues in relation to our expenses, we may be unable to reduce
our expenses quickly enough to avoid lower quarterly operating results. We do
not know whether our business will grow rapidly enough to absorb the costs of
these employees and facilities. As a result, our quarterly operating results
could fluctuate, and such fluctuation could adversely affect the market price
of our common stock.

   In addition, we expect to experience seasonality in the sales of our
products. For example, we expect that sales may decline during summer months,
particularly in Asian and European markets. We also anticipate that sales may
be lower in our first fiscal quarter due to patterns in the capital budgeting
and purchasing cycles of our current and prospective customers. These
seasonable variations in our sales may lead to fluctuations in our quarterly
operating results. It is difficult for us to evaluate the degree to which this
seasonality may affect our business because our growth may have largely
overshadowed this seasonality in recent periods.

                                      24
<PAGE>

 We have relied and expect to continue to rely on sales of our Cobalt Qube and
 Cobalt RaQ products for our revenues, and a decline in sales of these
 products could cause our revenues to fall.

   Historically, we have derived substantially all of our revenues from sales
of our Cobalt Qube and Cobalt RaQ products. During 1999 and 1998, sales of
Cobalt Qube and Cobalt RaQ products accounted for approximately 87% and 83% of
our total revenues. We expect that these products will continue to account for
a large portion of our total revenues for at least the next two fiscal years.
Any factors adversely affecting the pricing of or demand for our Cobalt Qube
and Cobalt RaQ products, including competition or technological change, could
cause our revenues to decline and our business to suffer. Factors that may
affect the market acceptance of our products, some of which are beyond our
control, include the following:

  . the growth and changing requirements of the server appliance market;

  . the performance, quality, price and total cost of ownership of our
    products;

  . the availability, price, quality and performance of competing products
    and technologies; and

  . the successful development of our relationships with original equipment
    manufacturer customers and existing and potential channel partners.

 We may not succeed in developing and marketing new server appliance products,
 and our operating results may decline as a result.

   We are developing additional server appliance products that use the Linux
operating system, particularly for use by web hosting and application service
providers. Developing new products that meet the needs of web hosting and
application service providers requires significant additional expenses and
development resources. If we fail to successfully develop and market new
products, our operating results will decline.

   We introduced our caching products in July 1998 and network attached
storage products in May 1999. To date, these products have accounted for only
a limited portion of our revenues. However, our future growth and
profitability could be affected by our ability to increase sales of our
caching and network attached storage products.

 If we experience any increase in the length of our sales cycle, our quarterly
 operating results could become more unpredictable and our stock price may
 decline as a result.

   We experience sales cycles ranging from three weeks to four months for our
products depending on the identity of the end user and whether the sale is
direct or indirect. If we experience any increase in the length of our sales
cycle, our quarterly operating results could become more unpredictable and our
stock price could decline as a result. Sales of our Cobalt Qube products are
generally limited to one unit per end user and do not involve a lengthy
evaluation cycle, if any. We rely heavily for sales of this product on
indirect selling, where our product is recommended by a reseller or
distributor. If the sales cycle for our Cobalt Qube products becomes longer,
our revenues could become less predictable. Our Cobalt RaQ and Cobalt Cache
products are generally sold to customers who evaluate the products before
committing to purchase them. In addition, for these products, a typical
customer may purchase a small number of units and then incrementally increase
the size of the installation over time. If customers were to implement
enterprise-wide evaluation programs or purchase products for the entire
organization at once, our sales cycle could lengthen and our revenues could be
erratic from quarter to quarter. We do not have enough historical experience
selling our Cobalt NAS products to determine how the sales cycle for these
products will affect our revenues.

 If we cannot increase our sales volumes, reduce our costs or introduce higher
 margin products to offset anticipated reductions in the average unit price of
 our products, our operating results may suffer.

   We have not experienced an overall decrease in the average selling prices
of our products. However, we anticipate that as products in the server
appliance market become more commoditized, the average unit price of our
products may decrease in the future. The average unit price of our products
may also decrease in response to

                                      25
<PAGE>

changes in product mix, competitive pricing pressures, new product
introductions by us or our competitors or other factors. If we are unable to
offset the anticipated decrease in our average selling prices by increasing
our sales volumes, our revenues will decline. Changes in the mix of our sales,
including the mix between higher margin Cobalt RaQ products and somewhat lower
margin Cobalt Qube products, could adversely affect our operating results for
future quarters. In addition, our margins could be affected if we invest
additional resources in our lower margin Cobalt NAS products. To maintain our
gross margins, we also must continue to reduce the manufacturing cost of our
products. Further, as average unit prices of our current products decline, we
must develop and introduce new products and product enhancements that sell at
higher margins.

 Our business is dependent on the adoption of server appliances to perform
 discrete tasks for corporate and internet-based computer networks and a
 decrease in their rates of adoption could cause the market price for our
 common stock to decline as a result of lower revenues or more limited
 investor expectations of the size of the market for our products.

   We expect that substantially all of our revenues will continue to come from
sales of our server appliance products. As a result, we depend on the growing
use of server appliances to perform discrete tasks for corporate and internet-
based networks. If the role of server appliances does not increase as we
anticipate, or if it in any way decreases, our revenues would decline. We
believe that our expectations for the growth of the server appliance market
may not be fulfilled if customers continue to use general purpose servers. The
role of our server appliances could, for example, be limited if general
purpose servers become better at performing the functions currently being
performed by our server appliances or are offered at a lower cost. This could
force us to lower the prices of our products or result in fewer sales of our
products. In addition, if corporate information technology organizations do
not accept Linux-based operating systems, or if there is a wide acceptance of
alternative operating systems that provide enhanced capabilities, the market
price of our stock could decline due to our lower operating results or
investors' assessment that the growth potential for sales of our products is
limited.

 The server appliance market for web hosting and application service providers
 in which we compete is new and unpredictable, and if this market does not
 develop and expand as we anticipate, our revenues may not grow. In addition,
 consolidation in this market could result in our clients being absorbed into
 larger organizations which might not be as receptive to our products.

   The market for server appliance products, particularly those for use
primarily by web hosting and application service providers--companies that
provide internet, intranet, extranet and application hosting services to
others--has only recently begun to develop and is evolving rapidly. Because
this market is new, we cannot predict its potential size or future growth
rate. Our revenues may not continue to grow and the market price for our
common stock could decline if the server appliance market does not grow
rapidly over a number of years.

   Our Cobalt RaQ products are used primarily by web hosting and application
service providers. Recently, consolidation has begun to occur in the web
hosting and application service provider market, and many large web hosting
and application service providers are acquiring the smaller and the regional
companies. For example, Verio, Inc. recently acquired our customer,
digitalNation. Large web hosting and application service providers that
provide hosting services may not be as receptive to our products, because
their buying programs are more likely to be based on established, proprietary
operating systems and general purpose servers. In addition, we expect that
internet service providers that specialize in providing internet access and
non-hosting services to consumers will not be substantial purchasers of our
products.

   Small- to medium-sized organizations may not accept server appliances
because they are less likely to be early adopters of new technologies due to
their need for minimal service disruptions. As a result, we believe the rates
of adoption of server appliances for small- to medium-sized organizations are
unpredictable. Our success in generating net revenues in this emerging market
will depend on, among other things, our ability to:

  . educate potential end users, original equipment manufacturers and channel
    partners about the benefits of server appliances;

                                      26
<PAGE>

  . establish and maintain relationships with leading original equipment
    manufacturers and maintain and enhance our relationships with our other
    channel partners; and

  . predict and base our products on technology that ultimately becomes
    industry standard.

 Because our products use Linux as their operating system, the failure of
 Linux developers to enhance and develop the Linux kernel could impair our
 ability to release major product upgrades and maintain market share.

   We may not be able to release major upgrades of our Cobalt Qube, Cobalt
RaQ, Cobalt Cache and Cobalt NAS products on a timely basis because our
products use Linux as their operating system. The heart of Linux, the Linux
kernel, is maintained by third parties. Linus Torvalds, the original developer
of the Linux kernel, and a small group of independent engineers are primarily
responsible for the development and evolution of the Linux kernel. If this
group of developers fails to further develop the Linux kernel or if Mr.
Torvalds or other prominent Linux developers were to no longer work on the
Linux kernel, we would have to either rely on another party to further develop
the kernel or develop it ourselves. To date we have optimized our Linux-based
operating system based on a version of Red Hat Linux, which we have licensed
for a nominal price. If we were unable to access Red Hat Linux, or Red Hat
Linux were to become substantially more expensive to obtain, we would be
required to spend additional time to obtain a tested, recognized version of
the Linux kernel from another source or develop our own operating system
internally. We cannot predict whether enhancements to the kernel would be
available from reliable alternative sources. We could be forced to rely to a
greater extent on our own development efforts, which would increase our
development expenses and might delay our product release and upgrade
schedules. In addition, any failure on the part of the kernel developers to
further develop and enhance the kernel could stifle the development of
additional Linux-based applications for use with our products.

 We may not succeed if Linux fragments, and application developers do not
 develop software for our products.

   Our products utilize a version of the Red Hat Linux operating system that
we have optimized for our server appliances. If Linux becomes a proprietary
operating system model, like UNIX or Windows NT, and our products do not use
the predominant Linux operating system, we may not be able to encourage third
party developers to write software applications for use with our products. If
this were to occur, our sales might be limited and our revenues could suffer.

 We may be unable to manufacture the targeted volume of our products, or any
 products at all, if our outside manufacturers are unable to meet our
 manufacturing needs because we have no internal manufacturing capacity.

   We rely on contract manufacturers to produce our products. In the future,
we may need to find a new outside manufacturer that can manufacture our
products in higher volume and at lower costs. We may not find a outside
manufacturer that meets our needs. Additionally, qualifying a new outside
manufacturer and commencing volume production is expensive and time consuming.
If we are required or choose to change outside manufacturers, we may lose
sales and our customer relationships may suffer.

 We may experience transitional problems if we switched outside manufacturers,
 including delays and quality control issues that could cause us to lose sales
 and impair our ability to achieve profitability.

   Prior to August 1999, almost all of our products were manufactured for us
by a single manufacturer that also provided supply chain management for our
products' components. In the quarter ended July 2, 1999, we experienced
problems getting our products manufactured by this contractor in a timely
fashion due in part to the increase in our volume requirements. In response to
these problems, in August 1999 we switched the majority of our manufacturing
to SMTC Corp. Although we believe that SMTC will be capable of satisfying our
manufacturing needs in 2000, we cannot be certain that we will not face
similar problems in the future. If we

                                      27
<PAGE>

face similar problems in the future, we could lose sales and may not achieve
profitability. If SMTC does not meet our volume and quality requirements, we
may experience increased costs or lose sales to other vendors.

   SMTC is only obligated to supply products to us until August 2000 and only
up to a quantity based on our forecasts. If SMTC experiences delays,
disruptions, capacity constraints or quality control problems in its
manufacturing operations, then product shipments to our customers could be
delayed, which would negatively impact our net revenues, competitive position
and reputation.

 We may experience production delays or disruptions if we relocate our
 manufacturing to offshore facilities, which could result in lost revenues.

   We anticipate that we may relocate our manufacturing operations for sales
outside North America to one of SMTC's offshore manufacturing facilities
during 2000. Additionally, we may consider moving our manufacturing to other
locations or to a different contract manufacturer. We could experience
difficulties and disruptions in the manufacture of our products while we
transition to a new facility. Manufacturing disruption could prevent us from
achieving timely delivery of products and could result in lost revenues.

 Because we depend on sole source and limited source suppliers for key
 components, we are susceptible to supply shortages that could prevent us from
 shipping customer orders on time, if at all, and result in lost sales.

   We depend upon single source suppliers for our industry standard processors
and power supplies and our custom printed circuit boards, chassis and sheet
metal parts. We also depend on limited sources to supply several other
industry standard components. We have in the past experienced and may in the
future experience shortages of, or difficulties in acquiring, these
components. If we are unable to buy these components, we will not be able to
manufacture our products on a timely basis or deliver our products to our
customers.

 Because we order components and materials based on rolling forecasts, we may
 overestimate or underestimate our component and material requirements, which
 could increase our costs or prevent us from meeting customer demand.

   We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components.
As a result, our component requirement forecasts may not be accurate. If we
overestimate our component requirements, we may have excess inventory, which
would increase our costs. If we underestimate our component requirements, we
may have inadequate inventory, which could interrupt our manufacturing and
delay delivery of our products to our customers. Any of these occurrences
would negatively impact our business and operating results.

 Because we rely on channel partners to sell a majority of our products, our
 revenues could decline substantially if our existing channel partners do not
 continue to purchase products from us.

   We rely on our channel partners who are distributors, such as Ingram Micro,
Merisel and Tech Data, resellers and system integrators to sell a majority of
our products in the United States. A substantial majority of our sales outside
of the United States are through other channel partners, and we rely on Nissho
Electronics to sell a majority of our products in Japan. Sales to distributors
accounted for 79% of our net revenues in 1999 and 54% of our net revenues in
1998. If we fail to sell our products through our existing channel partners,
we would experience a material decline in revenues. Even if we are successful
in selling our products through new channel partners, the rate of growth of
our net revenues could be materially and adversely affected if our existing
channel partners do not continue to sell a substantial number of our products.
We cannot be certain that we will be able to attract channel partners that
market our products effectively or provide timely and cost-effective customer

                                      28
<PAGE>

support and service. None of our current channel partners are obligated to
continue selling our products. We cannot be certain that any channel partner
will continue to represent our products or that our channel partners will
devote a sufficient amount of effort and resources to selling our products in
their territories.

 We may incur significant costs to promote our brand that may not result in
 the desired brand recognition by customers or increased sales.

   We believe that we need a strong brand to compete successfully. In order to
attract and retain customers, we believe that our brand must be recognized and
viewed favorably by end user customers. Although we intend to advertise and
promote our brand, we cannot be certain that these strategies will be
successful. If we are unable to design and implement effective marketing
campaigns or otherwise fail to promote and maintain our brand, our sales could
decline. Our business may also suffer if we incur excessive expenses in an
attempt to promote and maintain our brand without a corresponding increase in
revenues.

 We need to expand our direct and indirect sales channels, and if we fail to
 do so, our growth could be limited.

   In order to increase market awareness and sales of our products, we will
need to substantially expand our direct and indirect sales operations, both
domestically and internationally. If we fail in this endeavor, our growth will
be limited. To date, we have relied primarily on our direct sales force to
generate demand for our products by regional and national web hosting and
application service providers. Our products require a sophisticated sales
effort targeted at our prospective customers' information technology
departments. We have recently expanded our direct sales force and plan to hire
additional sales personnel. Competition for qualified sales people is intense,
and we might not be able to hire the quality and number of sales people we
require.

 Our expansion to international markets will result in higher personnel costs
 and could reduce our operating margins due to the higher costs of
 international sales.

   We must expand the number of channel partners who sell our products or our
direct international sales presence to significantly increase our
international sales. We may incur higher personnel costs by hiring direct
sales staff that may not result in an increase in our revenues. We may not
realize corresponding increases in operating margins from increases in
international sales, due to the higher costs of these sales. Our sales outside
of the United States represented 52% of our total revenues in 1999 and 44% of
our total revenues in 1998. To date, we have relied primarily on international
channel partners and have only recently begun to employ direct sales staff
outside of the United States. Even if we are able to successfully expand our
direct and indirect international selling efforts, we cannot be certain that
we will be able to create or increase international market demand for our
products.

 If we are unable to expand our customer service and support organization, we
 may not be able to retain our existing customers and attract new customers.

   We currently have a small customer service and support organization and
will need to increase our staff to support new customers and the expanding
needs of our existing customers. If we are unable to expand our customer
service and support organization, we may not be able to retain our existing
customers and attract new customers. Hiring customer service and support
personnel is very competitive in our industry due to the limited number of
people available with the necessary technical skills and understanding of the
Linux operating environment.

 We do not have a consulting staff, and our revenues may suffer if customers
 demand extensive consulting or other support services.

   Our products are designed to require little or no support from us and to be
deployed quickly and easily by our customers. Many of our competitors offer
extensive consulting services in addition to server appliance

                                      29
<PAGE>

products. If we introduced a product that required extensive consulting
services for installation and use or if our customers wanted to purchase from
a single vendor a menu of items that included extensive consulting services,
we would be required to change our business model. We would be required to
hire and train consultants, outsource the consulting services or enter into a
joint venture with another company that could provide those services. If these
events were to occur, our future profits would likely suffer because customers
would choose another vendor or we would incur the added expense of hiring and
retaining consulting personnel.

 We may not be able to effectively compete against providers of general
 purpose servers or limited purpose servers as a result of their greater
 financial resources and brand awareness.

   In the market for server appliances, we face significant competition from
larger companies who market general purpose servers or limited purpose servers
and have greater financial resources and name recognition than we do. We
believe that Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems, VA
Linux or other server manufacturers, each of which is also currently competing
with us by manufacturing and selling general purpose servers or limited
purpose servers, could also introduce server products that include the
functionality that we currently provide in our products at lower prices. If
these vendors provide lower cost server appliances that perform comparable
functions to our products coupled with the broader applications of their
existing product lines, our products could become obsolete. Even if the
functionality of the standard features of these products is equivalent to
ours, we face a substantial risk that a significant number of customers would
elect to pay a premium for similar functionality rather than purchase products
from a less well-known vendor.

   We may face competition in the future from established companies that have
only recently entered the server appliance market, such as Intel, Novell or
Oracle or from emerging software companies. Barriers to entry in the server
appliance market are relatively low. Increased competition may negatively
affect our business and future operating results by leading to price
reductions, higher selling expenses or a reduction in our market share.

 Our revenues could be reduced if general purpose server manufacturers make
 acquisitions in order to join their extensive distribution capabilities with
 our smaller competitors' products.

   Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems and other
server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships
with our other current competitors, including smaller private companies.
Because general purpose server manufacturers have significant financial and
organizational resources available, they may be able to quickly penetrate the
server appliance market by leveraging the technology and expertise of smaller
companies and utilizing their own extensive distribution channels. We expect
that the server appliance industry will continue to consolidate. For example,
Whistle Communications was recently acquired by IBM. It is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share.

 We may sell fewer products if other vendors' products are no longer
 compatible with ours or other vendors bundle their products with those of our
 competitors and sell them at lower prices.

   Our ability to sell our products depends in part on the compatibility of
our products with other vendors' software and hardware products. Developers of
these products may change their products so that they will no longer be
compatible with our products. These other vendors may also decide to bundle
their products with other server appliances for promotional purposes and
discount the sales price of the bundle. If that were to happen, our business
and future operating results could suffer if we were no longer able to offer
commercially viable products.

 Server appliance products are subject to rapid technological change due to
 changing operating system software and network hardware and software
 configurations, and our products could be rendered obsolete by new
 technologies.

   The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, uncertain product life
cycles, changes in customer demands and evolving

                                      30
<PAGE>

industry standards. Our products could be rendered obsolete if products based
on new technologies are introduced or new industry standards emerge. For
example, sales of our products may be limited if customers widely adopt
Windows 2000-based server appliances, and our products, which do not currently
operate on the Windows 2000 platform, fail to provide comparable
functionality.

   Computer networks in which servers perform functions for other computers,
such as a personal computer on an employee's desk, are inherently complex. As
a result, we cannot accurately estimate the life cycles of our server
appliance products. New products and product enhancements can require long
development and testing periods, which requires us to hire and retain
increasingly scarce, technically competent personnel. Significant delays in
new product releases or significant problems in installing or implementing new
products could seriously damage our business. We have, on occasion,
experienced delays in the scheduled introduction of new and enhanced products
and cannot be certain that we will avoid similar delays in the future.

   Our future success depends upon our ability to enhance existing products,
develop and introduce new products, satisfy customer requirements and achieve
market acceptance. We cannot be certain that we will successfully identify new
product opportunities and develop and bring new products to market in a timely
and cost-effective manner.

 We may not be able to preserve the value of our products' intellectual
 property because we do not have any patents and other vendors could challenge
 our other intellectual property rights.

   Our products are differentiated from those of our competitors by our
internally developed technology that is incorporated into our products. If we
fail to protect our intellectual property, other vendors could sell products
with features similar to ours, and this could reduce demand for our products.
We protect our intellectual property through a combination of copyright, trade
secret and trademark laws. We have only recently commenced a patent program
and to date have only filed one patent application. We generally enter into
confidentiality or license agreements with our employees, consultants and
corporate partners, and generally control access to our intellectual property
and the distribution of our server appliances, integrated software,
documentation and other proprietary information. We believe that such measures
afford only limited protection. Others may develop technologies that are
similar or superior to our technology or design around the copyrights and
trade secrets we own. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use our
products or technology. Policing unauthorized use of our products is
difficult, and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology, particularly in foreign countries where
the laws may not protect our proprietary rights as fully as those in the
United States. Our means of protecting our proprietary rights may be
inadequate.

 We have invested substantial resources in developing our products and our
 brand, and our operating results would suffer if we were subject to a
 protracted infringement claim or one with a significant damages award.

   Substantial litigation regarding intellectual property rights and brand
names exists in our industry. We expect that server appliance products may be
increasingly subject to third-party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products
employ technology that infringes any proprietary rights of third parties.
However, third parties may claim that we infringe their intellectual property
rights. Any claims, with or without merit, could:

  . be time consuming to defend;

  . result in costly litigation;

  . divert our management's attention and resources;

  . cause product shipment delays; or

  . require us to enter into royalty or licensing agreements.

                                      31
<PAGE>

   These royalty or licensing agreements may not be available on terms
acceptable to us, if at all. A successful claim of product infringement
against us or our failure or inability to license the infringed or similar
technology could adversely affect our business because we would not be able to
sell the impacted product without redeveloping it or incurring significant
additional expenses.

   If we were named in a trademark infringement suit in the future, we could
be forced to pay significant monetary damages, a royalty for continuing use of
a trademark or be barred from using certain product names altogether. This
could result in us losing brand equity.

 Our recent growth has placed a significant strain on our management systems
 and resources and we may be unable to effectively control our costs and
 implement our business strategies as a result.

   We continue to increase the scope of our operations and have grown our
headcount substantially. As of December 31, 1999 we had a total of 140
employees, and as of December 31, 1998, we had a total of 68 employees. Our
productivity and the quality of our products may be adversely affected if we
do not integrate and train our new employees quickly and effectively. We also
cannot be sure that our revenues will continue to grow at a sufficient rate to
absorb the costs associated with a larger overall headcount, as well as
recruiting-related expenses.

   This growth has placed, and we expect that any future growth we experience
will continue to place, a significant strain on our management, systems and
resources. To manage the anticipated growth of our operations, we may be
required to:

  . improve existing and implement new operational, financial and management
    information controls, reporting systems and procedures;

  . hire, train and manage additional qualified personnel; and

  . establish relationships with additional suppliers and partners while
    maintaining our existing relationships.

 Because our strategy to expand our international operations is subject to
 uncertainties, we may not be able to enter new international markets or
 generate a significant level of revenues from those markets outside of the
 United States in which we currently operate.

   Customers outside of the United States accounted for $11.9 million of our
net revenues in 1999 and $1.6 million of our net revenues in 1998. Although
international sales represented a majority of our sales in 1999, the absolute
dollar amount of our international sales was relatively small and must grow
substantially in order for us to achieve and maintain profitability. We plan
to increase our international sales activities, but we have limited experience
in developing foreign language translations of our products and little direct
experience marketing and distributing our products internationally.

   We conduct direct sales activities in Japan, the United Kingdom, Germany
and the Netherlands and indirect sales activities in Asia, elsewhere in Europe
and Mexico. Our international operations are subject to other inherent risks,
including:

  . the impact of recessions in economies outside the United States;

  . greater difficulty in accounts receivable collection and longer
    collection periods;

  . 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.

                                      32
<PAGE>

 Latent Year 2000 problems could have an uncertain impact on our internal
 systems or products.

   Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. As a result, software
that records only the last two digits of the calendar year may not be able to
determine whether "00" means 1900 or 2000. This may result in software
failures or the creation of erroneous results.

   Computer industry experts and US government officials were particularly
concerned that electronic systems would demonstrate unpredictable behavior
when internal electronic clocks rolled over to January 1, 2000. Since the New
Year has arrived with minimal date related problems in electronic systems
worldwide, the risk of Year 2000 errors appears to have largely passed.
However, a risk of latent Year 2000 related problems continues to exist that
applies to both our internal systems and our products.

   We are not aware of any Year 2000 related problems with its internal
computer and electronics related systems on or since January 1of this year,
but Year 2000 related problems in installed equipment could potentially still
transpire. We are unable to predict to what extent our core business functions
may be affected if our internal systems or software experience a material Year
2000 failure.

   In December 1999, we learned that Year 2000 errors existed in the InfoPlace
Document Organizer, a third-party program included under license in the
standard software configuration of the Cobalt Qube 2 product. InfoPlace
developed a patch to resolve the problem, which we provide to users from our
website at no cost. This patch enables the InfoPlace Document Organizer to
display dates correctly after January 1, 2000. It also fixes the "Find
Document" interface to allow searches with the year specified as "00." We
notified usergroups for our product of the error and the patch via electronic
mail in December. Since December 1999, the software correction has been part
of the standard software configuration of the Cobalt Qube 2.

   To date, we have not received complaints or comments from customers
concerning Year 2000 problems with the InfoPlace Document Organizer or any of
our products. Nonetheless, our server appliance products operate in complex
system environments and directly and indirectly interact with a number of
other hardware and software systems. Despite the investigation and testing by
us and our partners, our server appliance products and the underlying systems
and protocols running our products may contain latent errors or defects
associated with Year 2000 date functions. We are unable to predict to what
extent our business may be affected if our software or the systems that
operate in conjunction with our software experience a material Year 2000
failure. Known or unknown errors or defects that affect the operation of our
server appliances could result in:

  . delay or loss of revenues;

  . cancellation of customer contracts;

  . diversion of development resources;

  . damage to our reputation;

  . increased maintenance and warranty costs; or

  . litigation costs;

any of which could adversely affect our business, financial condition and
results of operations.

 We rely on the services of our founders and other key personnel, and those
 persons' knowledge of our business and technical expertise would be difficult
 to replace.

   Our products and technologies are complex and we are substantially
dependent upon the continued service of our existing engineering personnel,
and especially Stephen DeWitt, our President and Chief Executive Officer,

                                      33
<PAGE>

and Vivek Mehra, our Chief Technology Officer and one of our founders. The
loss of any of our key employees could adversely affect our business and slow
our product development processes. Although we maintain key person life
insurance policies on our key employees, the amount of this insurance may be
inadequate to compensate us for their loss.

 Errors in our products or the failure of our products to conform to
 specifications could result in our customers demanding refunds from us or
 asserting claims for damages against us.

   Because our server appliance products are complex, they could contain
errors or bugs that can be detected at any point in a product's life cycle. In
the past we have discovered errors in some of our products and have
experienced delays in the shipment of our products during the period required
to correct these errors. These delays have principally related to new product
releases. To date none of these delays has materially affected our business.
While we continually test our products for errors and work with customers
through our customer support services to identify and correct bugs in our
software and other product problems, errors in our products may be found in
the future. Although many of these errors may prove to be immaterial, any of
these errors could be significant. Detection of any significant errors may
result in:

  . the loss of or delay in market acceptance and sales of our products;

  . diversion of development resources;

  . injury to our reputation; or

  . increased maintenance and warranty costs.

   These problems could harm our business and future operating results.
Product errors or delays could be material, including any product errors or
delays associated with the introduction of new products or the versions of our
products that support operating systems other than Linux. Occasionally, we
have warranted that our products will operate in accordance with specified
customer requirements. If our products fail to conform to these
specifications, customers could demand a refund for the purchase price or
assert claims for damages.

   Moreover, because our products are used in connection with critical
distributed computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers
typically contain provisions intended to limit our exposure to liability
claims. However, these limitations may not preclude all potential claims.
Liability claims could require us to spend significant time and money in
litigation or to pay significant damages. Any such claims, whether or not
successful, could seriously damage our reputation and our business.

 Our stock has been and will likely continue to be subject to substantial
 price and volume fluctuations due to a number of factors, many of which will
 be beyond our control, that may prevent our stockholders from reselling our
 common stock at a profit.

   The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market
price of our common stock in spite of our operating performance. In addition,
our operating results could be below the expectations of public market
analysts and investors, and in response the market price of our common stock
could decrease significantly. The market price of our common stock ranged from
a low of $22 to a high of $172 from November 5, 1999 to March 29, 2000.
Investors may be unable to resell their shares of our common stock for a
profit. In the past, companies that have experienced volatility in the market
price of their stock have been the object of securities class action
litigation. If we were the object of securities class action litigation, it
could result in substantial costs and a diversion of management's attention
and resources.

                                      34
<PAGE>

 The provisions of our charter documents may inhibit potential acquisition
 bids that a stockholder may believe are desirable, and the market price of
 our common stock may be lower as a result.

   Our board of directors has the authority to issue up to 10,000,000 shares
of preferred stock at any time. The board of directors can fix the price,
rights, preferences, privileges and restrictions of the preferred stock
without any further vote or action by our stockholders. The issuance of shares
of preferred stock may delay or prevent a change in control transaction. As a
result, the market price of our common stock and the voting and other rights
of our stockholders may be adversely affected. The issuance of preferred stock
may result in the loss of voting control to other stockholders. We have no
current plans to issue any shares of preferred stock.

   Our charter documents contain anti-takeover devices including:

  . only one of the three classes of directors is elected each year;

  . the ability of our stockholders to remove directors without cause is
    limited;

  . the right of stockholders to act by written consent has been eliminated;

  . the right of stockholders to call a special meeting of stockholders has
    been eliminated; and

  . a requirement of advance notice to nominate directors or submit proposals
    for consideration at stockholder meetings.

   These provisions could discourage potential acquisition proposals and could
delay or prevent a change in control transaction. They could also have the
effect of discouraging others from making tender offers for our common stock.
As a result, these provisions may prevent the market price of our common stock
from increasing substantially in response to actual or rumored takeover
attempts. These provisions may also prevent changes in our management.

 Delaware law may inhibit potential acquisition bids; this may adversely
 affect the market price of our common stock, discourage merger offers and
 prevent changes in our management.

   Section 203 of the Delaware General Corporation Law may inhibit potential
acquisition bids for our company. We are subject to the antitakeover provision
of the Delaware General Corporation Law, which regulates corporate
acquisitions. Under Delaware law, a corporation may opt out of the
antitakeover provisions. We have not and do not intend to opt out of the
antitakeover provisions of Delaware Law.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   We do not engage in any foreign currency hedging transactions and
therefore, do not believe we are subject to exchange rate risk. Our exposure
to market risk for changes in interest rates relates primarily to our cash and
cash equivalents. We are subject to fluctuating interest rates that may
impact, adversely or otherwise, our results of operations or cash flows for
our cash and cash equivalents.

   The table below presents the principal amounts and related average interest
rates by year of maturity for our cash and cash equivalents.

   As of December 31, 1999:

<TABLE>
<CAPTION>
                                                             Expected Maturity
                                                                   2000
                                                           ---------------------
                                                           (in thousands, except
                                                              interest rates)
<S>                                                        <C>
Assets
Cash and cash equivalents.................................       $141,777
 Average interest rates...................................          5.41%
</TABLE>

   The estimated fair value of our cash and cash equivalents approximates the
principal amounts reflected above based on the short maturities of these
financial statements.

                                      35
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   Our consolidated financial statements required by Item 8 are included on
pages F-1 to F-17 of this annual report on Form 10-K. The supplemental data
called for by Item 8 is not applicable.

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

   Not applicable.

                                      36
<PAGE>

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   The information required by this item concerning our directors is
incorporated by reference to the sections captioned "Election of Directors"
and "Section 16(a) Beneficial Ownership Reporting Compliance" contained in
Cobalt's Proxy Statement related to its 2000 Annual Meeting of Stockholders,
to be filed by Cobalt with the Securities and Exchange Commission within 120
days of the end of Cobalt's fiscal year pursuant to General Instruction G(3)
of Form 10-K (the "Proxy Statement"). Certain information required by this
item concerning executive officers is set forth in Part I of this Report in
"Business--Executive Officers" and certain other information required by this
item is incorporated by reference from the section captioned "Section 16(a)
Beneficial Ownership Reporting Compliance" contained in the Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

   The information required by this item is incorporated by reference to the
section captioned "Executive Compensation and Other Matters" contained in the
Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

   The information required by this item is incorporated by reference to the
sections captioned "Security Ownership of Certain Beneficial Owners and
Management" and "Record Date; Outstanding Shares" contained in the Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information required by this item is incorporated by reference to the
sections captioned "Compensation Committee Interlocks and Insider
Participation" and "Certain Transactions" contained in the Proxy Statement.

                                      37
<PAGE>

                                    PART IV

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

   (a)(1) Financial Statements

   The following consolidated financial statements are incorporated by
reference in Item 8 of this Report:

    Report of Independent Accountants

    Consolidated Balance Sheet, December 31, 1999 and 1998

    Consolidated Statement of Operations for the years ended December 31,
    1999, 1998 and 1997

    Consolidated Statement of Stockholders' Equity (Deficit) for the years
    ended December 31, 1999, 1998 and 1997

    Consolidated Statement of Cash Flows for the years ended December 31,
    1999, 1998 and 1997

    Notes to Consolidated Financial Statements

   (a)(2) Financial Statement Schedules.

   All financial statement schedules have been omitted because the information
required to be set forth therein is not applicable or is shown in the
financial statements or notes thereto.

   (a)(3) Exhibits

<TABLE>
   <C>     <S>
    3.1.2* Certificate of Incorporation of the Registrant

    3.2*   Bylaws of the Registrant

    4.1*   Specimen Common Stock Certificate

    4.2*   Second Amended and Restated Investors' Rights Agreement, dated April
           30, 1999, by and among the Registrant and certain stockholders of
           the Registrant

   10.1*   Form of Indemnification Agreement between the Registrant and each of
           its directors and officers

   10.2*   Amended and Restated 1997 Employee Stock Plan

   10.2.1* Form of Option Agreement under the Employee Stock Plan

   10.3*   1999 Employee Stock Purchase Plan

   10.3.1* Form of Subscription Agreement under the 1999 Employee Stock
           Purchase Plan

   10.4*   1999 Director Option Plan

   10.4.1* Form of Option Agreement under 1999 Director Plan

   10.5*   Form of Executive Officer Employment Agreement

   10.6*   Consulting Agreement dated August 30, 1996 by and between the
           Registrant and Techfarm Management, Inc.

   10.7*   Lease Agreement dated August 5, 1998 between Registrant and Renault
           & Handley Solar Ellis Joint Venture for 555 Ellis Street, Mountain
           View, California office.

</TABLE>

                                      38
<PAGE>

<TABLE>
   <C>     <S>
   10.7.1* Assignment of lease dated September 2, 1998 between Registrant and
           Netscape Communications, Inc.

   10.7.2* Sublease dated October 28, 1996 between Netscape Communications,
           Inc. and Banta Corporation

   10.7.3* Addendum One to sublease dated November 6, 1996 between Netscape
           Communications, Inc. and Banta Corporation

   10.7.4* Lease dated August 10, 1993 ("Master Lease") between Banta Digital
           Services, Inc. and Renault & Handley Solar Ellis Joint Venture

   10.8*   Employee Option Agreement dated July 15, 1998 between the Registrant
           and George M. Korchinsky

   10.9*   Employment Offer Letter dated July 20, 1999 from the Registrant to
           Gary Martell

   10.10*  Separation Agreement dated July 28, 1999 by and between the
           Registrant and Robin Porter

   10.11+* Turnkey Service and Purchase Agreement dated August 31, 1999 by and
           among the Registrant and SMTC Corporation

   10.12*  Promissory Note and Security Agreement dated August 20, 1999 between
           the Registrant and Stephen W. DeWitt

   10.13+* Gateway Master Supply Agreement dated September 16, 1999 between the
           Registrant and Gateway, Inc.

   10.14*  Employment Agreement dated August 31, 1999 between the Registrant
           and Vivek Mehra

   10.15   Lease Agreement dated September 28, 1999 between Registrant and
           Kifer Investment Company for 515 Ellis Street, Mountain View,
           California office and related documents.

   10.16   Sublease Agreement dated February 26, 2000 between Registrant and
           PMC-Sierra for 515 Ellis Street, Mountain View, California office
           and related documents.

   21.1*   Subsidiaries

   23.1    Consent of PricewaterhouseCoopers LLP, Independent Accountants

   24.1    Power of Attorney (see Page 41)

   27.1    Financial Data Schedule
</TABLE>
--------
+ Confidential treatment has been requested or granted with respect to certain
  portions of this exhibit. Omitted portions have been filed separately with
  the Securities and Exchange Commission.
* Filed as an exhibit to the Registrant's Registration Statement on Form S-1
  (File No. 333-86759) as declared effective by the Securities and Exchange
  Commission on November 4, 1999.

   (b) Reports on Form 8-K. The Company did not file any reports on Form 8-K
during the three months ended December 31, 1999.

   (c) Exhibits. See Item 14(a)(3) above.

   (d) Financial Statement Schedules. See Item 14(a)(2) above.

                                       39
<PAGE>

                                  SIGNATURES

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

                                          Cobalt Networks, Inc.

                                                 /s/ Stephen W. DeWitt
                                          By: _________________________________
                                                     Stephen W. DeWitt
                                                 Chief Executive Officer,
                                                  President, and Director

Date: March 30, 2000

                               POWER OF ATTORNEY

   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Stephen W. DeWitt and Kenton D. Chow,
his true and lawful attorney-in-fact and agent, with full power of
substitution and resubstitution, to sign any and all amendments (including
post-effective amendments) to this Annual Report on Form 10-K and to file the
same, with all exhibits thereto and other documents in connection therewith,
with the Securities and Exchange Commission, granting unto said attorney-in-
fact and agent, full power and authority to do and perform each and every act
and thing requisite and necessary to be done in connection therewith, as fully
to all intents and purposes as he or she might or could do in person, hereby
ratifying and confirming all that said attorney-in-fact and agent, or his
substitute or substitutes, or any of them, shall do or cause to be done by
virtue hereof.

   Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this Report has been signed below by the following persons on behalf
of the Registrant and in the capacities and on the dates indicated:

<TABLE>
<CAPTION>
             Signature                           Title                    Date
             ---------                           -----                    ----

<S>                                  <C>                           <C>
     /s/ Stephen W. DeWitt           Chief Executive Officer,        March 30, 2000
____________________________________ President, and Director
         Stephen W. DeWitt           (Principal Executive
                                     Officer)

       /s/ Kenton D. Chow            Chief Financial Officer,        March 30, 2000
____________________________________ Vice President Finance and
           Kenton D. Chow            Secretary (Principal
                                     Accounting Officer)

     /s/ Gordon A. Campbell          Chairman of the Board of        March 30, 2000
____________________________________ Directors
         Gordon A. Campbell

      /s/ Gary F. Bengier            Director                        March 30, 2000
____________________________________
           Gary F. Bengier

       /s/ Jordan A. Levy            Director                        March 30, 2000
____________________________________
           Jordan A. Levy

      /s/ Stephen J. Luczo           Director                        March 30, 2000
____________________________________
          Stephen J. Luczo

    /s/ Carl F. Pascarrella          Director                        March 30, 2000
____________________________________
        Carl F. Pascarrella

      /s/ Mark F. Spagnolo           Director                        March 30, 2000
____________________________________
          Mark F. Spagnolo
</TABLE>

                                      40
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of Cobalt Networks, Inc.

   In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, of stockholders' equity (deficit) and
of cash flows present fairly, in all material respects, the financial position
of Cobalt Networks, Inc. and its subsidiaries at December 31, 1999 and 1998
and the results of their operations and their cash flows for each of the three
years in the period end December 31, 1999, in conformity with accounting
principles generally accepted in the United States. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States, which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for the
opinion expressed above.

/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP

San Jose, California
January 14, 2000, except as to Note
 12 which is as of March 22, 2000.

                                      F-1
<PAGE>

                             COBALT NETWORKS, INC.

                           CONSOLIDATED BALANCE SHEET
                (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1999      1998
                                                            --------  --------
<S>                                                         <C>       <C>
Assets
Current assets:
  Cash and cash equivalents................................ $141,777  $  2,090
  Accounts receivable, net of allowance for doubtful
   accounts of $572 and $335...............................    6,187     2,040
  Inventories..............................................      714       514
  Other current assets.....................................    1,494       239
                                                            --------  --------
    Total current assets...................................  150,172     4,883
Property and equipment, net................................    1,685     1,262
                                                            --------  --------
                                                            $151,857  $  6,145
                                                            ========  ========
Liabilities, mandatorily redeemable convertible preferred
 stock and stockholders' equity (deficit)
Current liabilities:
  Notes payable, current................................... $     44  $     39
  Borrowings under line of credit..........................       --       600
  Advance from related party...............................       --       500
  Accounts payable.........................................   15,101     4,179
  Accrued liabilities......................................    4,611     1,183
  Deferred margin on distributor inventory.................    1,305       294
                                                            --------  --------
    Total current liabilities..............................   21,061     6,795
Notes payable..............................................       40        84
                                                            --------  --------
                                                              21,101     6,879
                                                            --------  --------
Mandatorily Redeemable Convertible Preferred Stock (Note
 5)........................................................       --    12,339
                                                            --------  --------
Commitments and contingencies (Notes 10 and 11)

Stockholders' equity (deficit)
  Preferred Stock: $0.001 par value; 10,000,000 shares
   authorized, none issued and outstanding.................       --        --
  Common Stock: $0.001 par value; 120,000,000 shares
   authorized; 28,317,000 and 4,750,000 shares issued and
   outstanding at December 31, 1999 and 1998...............       28         5
  Additional paid-in capital...............................  174,462        79
  Unearned stock compensation..............................   (6,444)       --
  Notes receivable from stockholders.......................     (450)       --
  Accumulated deficit......................................  (36,840)  (13,157)
                                                            --------  --------
    Total stockholders' equity (deficit)...................  130,756   (13,073)
                                                            --------  --------
                                                            $151,857  $  6,145
                                                            ========  ========
</TABLE>

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

                                      F-2
<PAGE>

                             COBALT NETWORKS, INC.

                      CONSOLIDATED STATEMENT OF OPERATIONS
                (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                 -----------------------------
                                                   1999       1998      1997
                                                 ---------  ---------  -------
<S>                                              <C>        <C>        <C>
Net revenues...................................  $  22,814  $   3,537  $    --
Cost of revenues...............................     14,461      3,123       --
                                                 ---------  ---------  -------
  Gross profit.................................      8,353        414       --
                                                 ---------  ---------  -------
Operating expenses:
  Research and development.....................      6,013      3,483    1,067
  Sales and marketing..........................     14,772      5,581      245
  General and administrative...................      4,070      1,895      445
  Amortization of stock compensation...........      2,970         --       --
  Litigation settlement........................      4,200         --       --
                                                 ---------  ---------  -------
    Total operating expenses...................     32,025     10,959    1,757
                                                 ---------  ---------  -------
Loss from operations...........................    (23,672)   (10,545)  (1,757)
Interest and other income, net.................      1,587         82       17
Interest expense...............................       (221)       (15)     (29)
                                                 ---------  ---------  -------
Net loss.......................................    (22,306)   (10,478)  (1,769)
Accretion of Mandatorily Redeemable Convertible
 Preferred Stock...............................     (1,377)      (828)      --
                                                 ---------  ---------  -------
Net loss attributable to holders of Common
 Stock.........................................  $ (23,683) $ (11,306) $(1,769)
                                                 =========  =========  =======
Basic and diluted net loss per share
 attributable to holders of Common Stock.......  $   (3.43) $   (5.48) $ (4.09)
                                                 =========  =========  =======
Basic and diluted weighted average shares
 outstanding...................................  6,901,000  2,065,000  432,000
                                                 =========  =========  =======
</TABLE>


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

                                      F-3
<PAGE>

                             COBALT NETWORKS, INC.

            CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
                       (in thousands, except share data)

<TABLE>
<CAPTION>
                                                                        Note
                            Common Stock     Additional   Unearned   Receivable
                          ------------------  Paid-in      Stock        From     Accumulated
                            Shares    Amount  Capital   Compensation Stockholder   Deficit    Total
                          ----------  ------ ---------- ------------ ----------- ----------- --------
<S>                       <C>         <C>    <C>        <C>          <C>         <C>         <C>
Balance at December 31,
 1996...................          --   $ --   $     --    $    --       $  --     $    (82)  $    (82)
Issuance of Common
 Stock..................   4,763,000      5         --         --          --           --          5
Repurchase of Common
 Stock..................    (570,000)    (1)        --         --          --           --         (1)
Net loss................          --     --         --         --          --       (1,769)    (1,769)
                          ----------   ----   --------    -------       -----     --------   --------
Balance at December 31,
 1997...................   4,193,000      4         --         --          --       (1,851)    (1,847)
Issuance of Common
 Stock..................     812,000      1         79         --          --           --         80
Repurchase of Common
 Stock..................    (255,000)    --         --         --          --           --         --
Accretion of Mandatorily
 Redeemable Convertible
 Preferred Stock........          --     --         --         --          --         (828)      (828)
Net loss................          --     --                                        (10,478)   (10,478)
                          ----------   ----   --------    -------       -----     --------   --------
Balance at December 31,
 1998...................   4,750,000      5         79         --          --      (13,157)   (13,073)
Issuance of Common
 Stock..................   6,199,000      6    116,216         --         (50)          --    116,172
Issuance of warrants....          --     --        532         --          --           --        532
Stock compensation......          --     --        568         --          --           --        568
Unearned stock
 compensation (Note 7)..          --     --      8,910     (8,910)         --           --         --
Amortization of stock
 compensation...........          --     --         --      2,402          --           --      2,402
Reversal of unearned
 stock compensation on
 termination of
 employment.............          --     --        (64)        64          --           --         --
Accretion of Mandatorily
 Redeemable Convertible
 Preferred Stock........          --     --         --         --          --       (1,377)    (1,377)
Issuance of notes
 receivable to
 stockholder............          --     --         --         --        (400)          --       (400)
Conversion of
 Mandatorily Redeemable
 Preferred Stock to
 Common Stock...........  17,368,000     17     46,356         --          --           --     46,373
Adjustments to
 redemption value of
 Mandatorily Redeemable
 Preferred Stock........          --     --      1,865         --          --           --      1,865
Net loss................          --     --         --         --          --      (22,306)   (22,306)
                          ----------   ----   --------    -------       -----     --------   --------
Balance at December 31,
 1999...................  28,317,000   $ 28   $174,462    $(6,444)      $(450)    $(36,840)  $130,756
                          ==========   ====   ========    =======       =====     ========   ========
</TABLE>


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

                                      F-4
<PAGE>

                             COBALT NETWORKS, INC.

                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                     Year Ended December 31,
                                                    ---------------------------
                                                      1999      1998     1997
                                                    --------  --------  -------
<S>                                                 <C>       <C>       <C>
Cash flows from operating activities:
Net loss..........................................  $(22,306) $(10,478) $(1,769)
Adjustments to reconcile net loss to net cash used
 in operating activities:
  Depreciation and amortization...................       897       323       18
  Stock compensation..............................     2,970        --       --
  Non-cash interest expense.......................       130         2       20
  Other non-cash expense..........................       100        --       --
  Changes in assets and liabilities:
    Accounts receivable...........................    (4,147)   (2,040)      --
    Inventories...................................      (200)     (494)     (20)
    Other current assets..........................    (1,255)     (161)     (74)
    Accounts payable..............................    10,922     3,970      164
    Accrued liabilities...........................     3,478     1,096       76
    Deferred margin on distributor inventory......     1,011       294       --
                                                    --------  --------  -------
      Net cash used in operating activities.......    (8,400)   (7,488)  (1,585)
                                                    --------  --------  -------
Cash flows used in investing activities:
Acquisition of property and equipment.............    (1,320)   (1,423)    (157)
Loans to shareholder..............................      (500)       --       --
                                                    --------  --------  -------
      Net cash used in investing activities.......    (1,820)   (1,423)    (157)
                                                    --------  --------  -------
Cash flows from financing activities:
Proceeds from issuance of Mandatorily Redeemable
 Convertible Preferred Stock, net.................    30,124     7,210    2,992
Proceeds from issuance of Common Stock............   116,172        80        4
Proceeds from advance from related party..........        --       500       --
Proceeds from borrowings under line of credit.....        --       600       --
Principal payments on line of credit..............      (600)       --       --
Proceeds from borrowings under notes payable......        --       431       --
Principal payments on notes payable...............       (39)     (308)    (130)
Proceeds from borrowings under convertible
 promissory notes.................................     4,250       750      599
                                                    --------  --------  -------
      Net cash provided by investing activities...   149,907     9,263    3,465
                                                    --------  --------  -------
Net increase in cash and cash equivalents.........   139,687       352    1,723
Cash and cash equivalents at beginning of period..     2,090     1,738       15
                                                    --------  --------  -------
Cash and cash equivalents at end of period........  $141,777  $  2,090  $ 1,738
                                                    ========  ========  =======
Supplemental disclosure of cash flow information:
Cash paid for interest............................  $     91  $     13  $     9
                                                    ========  ========  =======
Conversion of notes payable and accrued interest
 into Mandatorily Redeemable Convertible Preferred
 Stock............................................  $  4,800  $    750  $   559
                                                    ========  ========  =======
Issuance of warrants..............................  $    532  $     --  $    --
                                                    ========  ========  =======
Issuance of Common Stock for promissory note......  $     50  $     --  $    --
                                                    ========  ========  =======
Conversion of Mandatorily Redeemable Convertible
 Preferred Stock to Common Stock..................  $ 46,373  $     --  $    --
                                                    ========  ========  =======
</TABLE>

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

                                      F-5
<PAGE>

                             COBALT NETWORKS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

 The Company

   Cobalt Networks, Inc., (formerly ViavisionSystems Inc. and Cobalt
Microserver, Inc.) (the "Company"), was incorporated in California in October
1996. Effective October 19, 1999, Cobalt reincorporated in the State of
Delaware. The par value and shares of Common Stock and Preferred Stock
authorized, issued and outstanding at each balance sheet date presented, and
for each period presented in the consolidated statement of stockholders'
deficit have been retroactively adjusted to reflect the reincorporation.

   The Company is a leading provider of server appliances. Server appliances
are a new category of network infrastructure devices that are optimized to
deliver one or a few network-based applications well. The Company markets and
sells its products globally through its direct sales force and its channel
partners. The Company operates in one business segment.

 Fiscal Year

   Through December 31, 1998 the Company operated on a calendar quarter-end
and year-end basis. Beginning in 1999 the Company changed its accounting
periods to thirteen-week fiscal quarters ending on the Friday closest to the
end of the month.

 Principles of Consolidation

   The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All material intercompany transactions and
balances have been eliminated in consolidation.

 Use of estimates

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

 Revenue recognition

   Revenue from product sales to other than distributors is generally
recognized at the time the product is shipped. Provisions for estimated future
product returns and exchanges are recognized upon product shipment. The
Company grants distributors limited rights of return on unsold inventory held
by such distributors. The Company has limited control over the extent to which
products sold to distributors are sold through to end users. Accordingly, the
Company recognizes revenues on sales to distributors at the time its products
are sold through to end users. The recognition of the gross profit on the
products held by distributors is deferred until the sale to the end user
occurs. The deferred gross profit is captioned as "deferred margin on
distributor inventory" on the Company's balance sheet. Upon shipment, the
Company also provides for the estimated cost that may be incurred for product
warranties.

 Cash equivalents

   The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. The majority of
the Company's cash equivalents consist of money market funds.

                                      F-6
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Fair value of financial instruments

   The Company's financial instruments, including cash, cash equivalents,
accounts receivable, accounts payable, notes payable and capital lease
obligations are carried at cost, which approximates their fair value because
of the short-term maturity of these instruments.

 Concentration of credit risk

   Financial instruments which potentially subject the Company to a
concentration of credit risk consist principally of cash equivalents and
accounts receivable. The Company places its cash and cash equivalents
primarily in market rate accounts with high credit financial institutions. The
Company's accounts receivable are derived from revenue earned from customers
located in the United States, Europe and Asia. Sales to foreign customers in
1999 and 1998, which are denominated in U.S. dollars, accounted for 52 % and
44%, respectively of total revenue. Sales in the United States, Japan, Europe
and other foreign countries were 48%, 21%, 21% and 10%, respectively, of total
revenues in 1999, and were 44%, 25%, 22% and 9%, respectively of total
revenues in 1998. The Company performs ongoing credit evaluations of its
customers' financial condition and generally requires no collateral from its
customers. The Company maintains an allowance for doubtful accounts receivable
based upon the expected collectibility of accounts receivable.

   For the year ended December 31, 1999, two customers accounted for
approximately 14% and 11%, respectively, of net revenues. As of December 31,
1999, these two customers accounted for 13% and 11%, respectively, of total
accounts receivable. For the year ended December 31, 1998, one customer
accounted for approximately 12% of net revenues. As of December 31, 1998, this
customer accounted for 15% of total accounts receivable.

 Inventories

   Inventories are stated at the lower of cost or market. Cost is determined
using standard cost which approximates the first-in, first-out method.

 Property and equipment

   Property and equipment are stated at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the assets,
generally twelve months to five years. Leasehold improvements are amortized
using the straight-line method over their estimated lives or the remaining
term of the lease, whichever is shorter.

 Long-lived assets

   The Company periodically evaluates the recoverability of its long-lived
assets based upon expected undiscounted cash flows and recognizes impairment
from the carrying value of long-lived assets, if any, based on the fair value
of such assets.

 Research and development

   Research and development costs are charged to operations as incurred.
Software development costs incurred prior to the establishment of
technological feasibility are included in research and development and are
expensed as incurred. After technological feasibility is established, material
software development costs are capitalized. The capitalized cost is then
amortized on a straight-line basis over the estimated product life, or on the
ratio of current revenues to total projected product revenues, whichever is
greater. To date, the period between achieving technological feasibility,
which the Company has defined as the establishment of a working model which

                                      F-7
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

typically occurs when the beta testing commences, and the general availability
of such software has been short and software development costs qualifying for
capitalization have been insignificant. Accordingly, the Company has not
capitalized any software development costs.

 Income taxes

   Income taxes are computed using the asset and liability method. Deferred
income tax assets or liabilities are established for the expected future
consequences resulting from the temporary differences between the financial
reporting and income tax bases of assets and liabilities and from net
operating loss and tax credit carryforwards. The Company records a valuation
allowance against deferred tax assets when it is more likely than not that
such assets will not be realized.

 Stock-based compensation

   The Company accounts for stock-based employee compensation arrangements in
accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees," and complies with the
disclosure provisions of Statement of Financial Accounting Standards ("SFAS")
No. 123 "Accounting for Stock-Based Compensation."

   The Company accounts for stock issued to non-employees in accordance with
the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18,
"Accounting for Equity Instruments That are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services."

 Foreign currency translation

   The Company uses the U.S. dollar as its functional currency for all of its
worldwide operations. All sales worldwide are billed in U.S. dollars. Foreign
currency assets and liabilities are remeasured into U.S. dollars at the end-
of- period exchange rates. Expenses are translated at average exchange rates
in effect during each period, except for those expenses related to balance
sheet amounts which are translated at historical exchange rates. Gains or
losses from foreign currency remeasurements and transactions are included in
net loss and were not material for all periods presented.

 Comprehensive income

   Effective January 1, 1998, the Company adopted the provisions of SFAS No.
130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for
reporting comprehensive income and its components in financial statements.
Comprehensive income, as defined, includes all changes in equity (net assets)
during a period from nonowner sources. To date, the Company has not had any
transactions that are required to be reported in comprehensive income (loss)
as compared to its reported net loss.

 Net loss per share

   The Company computes net loss per share in accordance with SFAS No. 128,
"Earnings per Share" and SEC Staff Accounting Bulletin ("SAB") No. 98. Under
the provisions of SFAS No. 128 and SAB 98, basic net loss per share is
computed by dividing the net loss available to holders of Common Stock for the
period by the weighted average number of shares of Common Stock outstanding
during the period. Weighted average shares exclude shares of Common Stock
subject to repurchase ("restricted shares"). Diluted net loss per share is
computed by dividing the net loss available to holders of Common Stock for the
period by the weighted average number of shares of Common Stock and Potential
Common Stock outstanding during the period, if dilutive.

                                      F-8
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Because the inclusion of Potential Common Stock would be anti-dilutive,
diluted net loss per share is the same as basic net loss per share. Potential
Common Stock includes unvested restricted shares of Common Stock and
incremental shares of Common Stock issuable upon the exercise of stock options
and warrants and upon conversion of Series A, B, and C Mandatorily Redeemable
Convertible Preferred Stock.

   The following table sets forth the computation of basic and diluted net
loss per share for the periods indicated (in thousands, except share and per
share data):

<TABLE>
<CAPTION>
                                                Year Ended December 31,
                                            ----------------------------------
                                               1999        1998        1997
                                            ----------  ----------  ----------
<S>                                         <C>         <C>         <C>
Numerator:
  Net loss attributable to holders of
   Common Stock............................ $  (23,683) $  (11,306) $   (1,769)
                                            ==========  ==========  ==========
Denominator:
  Weighted average shares outstanding......  8,226,000   4,700,000   2,519,000
  Weighted average shares of Common Stock
   subject to repurchase................... (1,325,000) (2,635,000) (2,087,000)
                                            ----------  ----------  ----------
  Denominator for basic and diluted
   calculation.............................  6,901,000   2,065,000     432,000
                                            ==========  ==========  ==========
  Basic and diluted net loss per share
   attributable to holders of Common
   Stock................................... $    (3.43) $    (5.48) $    (4.09)
                                            ==========  ==========  ==========
</TABLE>

   The effects of options to purchase 4,041,000, 1,622,000 and 238,000 shares
of Common Stock at an average exercise price of $6.77, $0.26 and $0.03 per
share at December 31, 1999, 1998 and 1997, respectively, and warrants to
purchase 204,000 and 164,000 shares of Preferred Stock at an average exercise
price of $1.24 and $1.00 per share; and 7,271,000 and 3,572,000 shares of
Mandatorily Redeemable Convertible Preferred Stock for the years ended
December 31, 1998 and 1997, respectively, and warrants to purchase 243,000
shares of Common Stock at $3.70 per share at December 31, 1999, have not been
included in the computation of diluted net loss per share as their effect
would have been anti-dilutive.

 Segment information

   In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 131, "Disclosures about Segments of an Enterprise and Related
Information." This statement establishes standards for the way companies
report information about operating segments in annual financial statements. It
also establishes standards for related disclosures about products and
services, geographic areas and major customers. During each period presented,
the Company operated in a single business segment, primarily in the United
States, Japan and Europe.

 New accounting pronouncements

   In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") 101, "Revenue Recognition," which outlines the
basic criteria that must be met to recognize revenue and provides guidance for
presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with Securities and Exchange
Commission. The effective date of this pronouncement is the second quarter of
the fiscal year beginning after December 15, 1999. The Company believes that
adopting SAB 101 will not have a material impact on the Company's financial
position and results of operations.

   In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 established methods of
accounting for derivative financial instruments and hedging

                                      F-9
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

activities related to those instruments as well as other hedging activities.
In July 1999, the FASB issued SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities- Deferral of the Effective Date of FASB
Statement No. 133." SFAS No. 137 deferred the effect of SFAS No. 133 until
fiscal year beginning after June 15, 2000. The Company will adopt SFAS No. 133
in 2001. To date, the Company has not engaged in derivative or hedging
activities. The Company is unable to predict the impact of adopting SFAS No.
133 if it were to engage in derivative and hedging activities in the future.

NOTE 2--BALANCE SHEET COMPONENTS (in thousands):

<TABLE>
<CAPTION>
                                                                 December 31,
                                                                 --------------
                                                                  1999    1998
                                                                 ------  ------
     <S>                                                         <C>     <C>
     Inventories:
       Finished goods........................................... $  517  $  498
       Raw materials............................................    197      16
                                                                 ------  ------
         Total.................................................. $  714  $  514
                                                                 ======  ======
     Property and equipment:
       Computer equipment....................................... $1,337  $  456
       Office equipment and fixtures............................    619     280
       Production equipment and tooling.........................     --     417
       Leasehold improvements...................................    485     450
                                                                 ------  ------
                                                                  2,441   1,603
       Less: Accumulated depreciation...........................   (756)   (341)
                                                                 ------  ------
                                                                 $1,685  $1,262
                                                                 ======  ======
     Accrued liabilities:
       Employee benefits........................................ $1,539  $  543
       Reserve for sales returns................................  1,817     386
       Warranty.................................................    885     181
       Other....................................................    370      73
                                                                 ------  ------
                                                                 $4,611  $1,183
                                                                 ======  ======
</TABLE>

NOTE 3--NOTES PAYABLE:

 Notes payable

   In September 1998, the Company entered into an equipment lease financing
agreement with a leasing company. The agreement provides for borrowings of up
to $1.0 million which are secured by the Company's equipment, machinery and
fixtures. As of December 31, 1999 and December 31, 1998, the Company had
outstanding borrowings under this agreement of $84,000 and $123,000,
respectively. The note balance is payable in 34 equal monthly installments and
bears interest at 10.95% per annum.

   In June 1998, the Company borrowed $300,000 from a stockholder which bore
interest at 5.5% per annum. In connection with the loan, the Company issued
warrants to purchase 7,000 shares of Series B Mandatorily Redeemable
Convertible Preferred Stock at $2.163 per share. The estimated fair value of
the warrants at the grant date was not material to the financial statements.
In July 1998, the Company repaid the loan in full.


                                     F-10
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

 Convertible promissory notes payable

   In April 1998, the Company borrowed $750,000 from various individuals under
convertible promissory notes bearing interest at 5.5% per annum. In connection
with these borrowings, the Company issued warrants to purchase 35,000 shares
of Series B Mandatorily Redeemable Convertible Preferred Stock at $2.163 per
share. The estimated fair value of the warrants at the grant date was not
material to the financial statements. These notes were converted into Series B
Mandatorily Redeemable Convertible Preferred Stock at $2.163 per share in July
1998.

   In December 1998, the Company borrowed $500,000 from an affiliate of a
member of its Board of Directors and $50,000 from an individual investor under
convertible promissory notes bearing interest at 6% per annum. These notes
were converted to Series C Mandatorily Redeemable Preferred Stock in May 1999
(See Note 5).

   In February and March 1999, the Company borrowed $4.3 million from various
investors under convertible promissory notes bearing interest at 6.0% per
annum, including $2.9 million from affiliates of the Company. These notes were
converted into Series C Mandatorily Redeemable Preferred Stock in May 1999. In
connection with the notes, the Company issued warrants to purchase 79,000
shares of Series C Mandatorily Redeemable Convertible Preferred Stock at $3.70
per share, including 61,000 of such shares to affiliates of the Company. The
estimated fair value of the warrants at the grant date was $130,000 and was
recorded as interest expense.

NOTE 4--RELATED PARTY TRANSACTION

   In August 1999, the Company advanced $500,000 to its Chief Executive
Officer. In September 1999, the advance was converted into a full recourse
non-interest bearing promissory note payable in four years and is secured by
50,000 shares of the Company's Common Stock.

NOTE 5--MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK:

   During 1997, the Company issued 3,571,000 shares of Series A Preferred
Stock at $1.00 per share for net proceeds of approximately $3.0 million and
the conversion of $559,000 of notes payable described in Note 3. In July 1998,
the Company issued 1,000 shares of Series A Preferred Stock at $1.00 per share
for net proceeds of $1,000 upon the exercise of a warrant. In September 1999,
the Company issued 77,000 shares of Series A Preferred Stock at $1.00 per
share for net proceeds of $77,000 upon the exercise of warrants.

   In July 1998, the Company issued 3,699,000 shares of Series B Preferred
Stock at $2.163 per share for net proceeds of approximately $7.2 million and
the conversion of $750,000 of notes payable described in Note 3. In September
1999, the Company issued 11,000 shares of Series B Preferred Stock at $2.163
per share for net proceeds at approximately $25,000 upon the exercise of
warrants.

   In May 1999, the Company issued 9,814,000 shares of Series C Mandatorily
Redeemable Preferred Stock at $3.70 per share for net proceeds of
approximately $29.6 million and the conversion of $4.80 million of notes
payable described in Note 3 and above. In connection with the transaction, the
Company issued a warrant to purchase 243,000 shares of Common Stock at $3.70
per share. The estimated fair value of the warrants at the date of grant was
$402,000, which was recorded as additional paid in capital. In September 1999,
the Company issued 6,000 shares of Series C Preferred stock at $3.70 per share
for net proceeds of approximately $25,000 upon the exercise of warrants.

   Upon completion of the Company's initial public offering, the holders of
warrants to purchase Preferred Stock had 90 days to exercise these warrants.
In November and December 1999, the Company issued 189,000 shares of Common
Stock for net proceeds of approximately $419,000 upon the exercise of these
warrants.


                                     F-11
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

   As of December 31, 1999, a warrant to purchase 243,000 shares of the
Company's Common Stock was outstanding.

   Upon the completion of the Company's initial public offering, 17,368,000
shares of Mandatorily Redeemable Preferred Stock, including the 189,000 shares
issued pursuant to the exercise of warrants, as described above, with a value
of $46,373,000 were converted into 17,368,000 shares of Common Stock.

NOTE 6--COMMON STOCK:

   Certain shares of Common Stock outstanding were sold under Restricted Stock
Purchase Agreements (the "Agreements"). According to the terms of the
Agreements, in the event that the purchaser ceases their relationship with the
Company, the Company has the right to repurchase shares issued at the original
purchase price ("purchase option"), subject to a declining percentage over
time. During 1998 and 1997, the Company exercised its purchase option for
255,000 shares and 570,000 shares, respectively, of Common Stock at $0.001 per
share. As of December 31, 1999, a total of 948,000 shares were subject to
repurchase by the Company.

NOTE 7--STOCK OPTION PLANS:

   In April 1997, the Company adopted the Employee Stock Option Plan ( the
"Plan"). The Plan provides for the granting of stock options and Common Stock
to employees and consultants of the Company. Options granted under the Plan
may be either incentive stock options or nonqualified stock options. Incentive
stock options ("ISO") may be granted only to Company employees (including
officers and directors who are also employees). Nonqualified stock options
("NSO") may be granted to Company employees and consultants. As of
December 31, 1999, the Company has reserved 6,100,000 shares of Common Stock
for issuance under the Plan. This reserve will be automatically increased on
the first day of the fiscal year beginning January 1, 2001, by an amount equal
to the lesser of 2,500,000 shares per year, 5% of the number of shares of
Common Stock which are issued and outstanding on the last day of the
proceeding fiscal year or a number of shares determined by the Company's board
of directors.

   Options under the Plan may be granted for periods of up to ten years and at
prices no less than 85% of the estimated fair value of the shares on the date
of grant as determined by the Board of Directors, provided, however, that (i)
the exercise price of an ISO and NSO shall not be less than 100% and 85% of
the estimated fair value of the shares on the date of grant, respectively, and
(ii) the exercise price of an ISO and NSO granted to a 10% shareholder shall
not be less than 110% of the estimated fair value of the shares on the date of
grant, respectively. Options are generally exercisable immediately, subject to
repurchase options held by the Company. The repurchase options lapse over a
maximum period of five years at such times and under such conditions as
determined by the Board of Directors. Options vest over 4 years, 25% after the
first year and ratably each month over the remaining 36 months.

                                     F-12
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes stock option activity under the Plan:

<TABLE>
<CAPTION>
                                                                       Weighted
                                                                        Average
                                                Options                Exercise
                                               Available     Options     Price
                                               for Grant   Outstanding Per Share
                                               ----------  ----------- ---------
<S>                                            <C>         <C>         <C>
Balance at December 31, 1996..................         --          --   $   --
  Authorized..................................  1,145,000          --       --
  Granted.....................................   (826,000)    826,000    0.008
  Exercised...................................         --    (110,000)   0.001
  Canceled....................................    478,000    (478,000)   0.001
                                               ----------   ---------
Balance at December 31, 1997..................    797,000     238,000
  Authorized..................................  1,405,000          --       --
  Granted..................................... (1,437,000)  1,437,000    0.500
  Exercised...................................         --     (12,000)   0.001
  Canceled....................................     41,000     (41,000)   0.190
                                               ----------   ---------
Balance at December 31, 1998..................    806,000   1,622,000
  Authorized..................................  3,550,000          --       --
  Granted..................................... (2,715,000)  2,715,000     7.49
  Exercised...................................         --    (350,000)    1.44
  Canceled....................................    271,000    (271,000)    0.75
                                               ----------   ---------
Balance at December 31, 1999..................  1,912,000   3,716,000
                                               ==========   =========
</TABLE>

 Director Option Plan

   In September 1999, the Board adopted the 1999 Director Option Plan (the
"Director Option Plan") and reserved 400,000 shares of Common Stock for
issuance thereunder. This reserve will be automatically increased on the first
day of the fiscal year beginning January 1, 2001, by an amount equal to the
lesser of 100,000 shares per year, 0.25% of the number of shares of Common
Stock which are issued and outstanding on the last day of the preceding fiscal
year or a number of shares determined by the Company's board of directors. The
option grants under the Director Option Plan are automatic and non-
discretionary, and the exercise price of the options is 100% of the fair
market value of the Common Stock on the grant date. The term of the options
granted under the Director Option Plan is ten years. Options vest over 4
years, 25% after the first year and ratably each month over the remaining 36
months.

   The following table summarizes stock option activity under the Option Plan:

<TABLE>
<CAPTION>
                                                                       Weighted
                                                                        Average
                                                 Options               Exercise
                                                Available    Options     Price
                                                for Grant  Outstanding Per Share
                                                ---------  ----------- ---------
<S>                                             <C>        <C>         <C>
Balance at December 31, 1998...................       --          --    $   --
  Authorized...................................  400,000          --        --
  Granted...................................... (325,000)    325,000     25.22
                                                --------     -------
Balance at December 31, 1999...................   75,000     325,000
                                                ========     =======
</TABLE>

                                     F-13
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes information about stock options outstanding
and exercisable as of December 31, 1999.

<TABLE>
<CAPTION>
                                                                    Options
                                    Options Outstanding at       Exercisable at
                                      December 31, 1999        December 31, 1999
                                ------------------------------ ------------------
                                           Weighted
                                            Average   Weighted           Weighted
                                           Remaining  Average            Average
                                Number of Contractual Exercise Number of Exercise
     Range of Exercise Prices    Shares      Life      Price    Shares    Price
     ------------------------   --------- ----------- -------- --------- --------
     <S>                        <C>       <C>         <C>      <C>       <C>
     $  0.001................      11,000     7.37     $0.001     11,000  $0.001
        0.100................     657,000     8.18       0.10    657,000    0.10
        0.500................     552,000     8.56       0.50    552,000    0.50
        1.00--1.40...........     154,000     9.21       1.21    154,000    1.21
        1.85--2.50...........   1,703,000     9.44       2.06  1,703,000    2.06
       10.00--10.25..........     122,000     9.71      10.16    122,000   10.16
       14.00.................     173,000     9.82      14.00    173,000   14.00
       22.00.................     614,000     9.84      22.00    614,000   22.00
      108.38--126.75.........      55,000    10.00     111.69     55,000  111.69
                                ---------                      ---------
                                4,041,000                      4,041,000
                                =========                      =========
</TABLE>

 Fair value disclosures

   Had compensation cost for the Company's stock-based compensation plan been
determined based on the fair value at the grant dates for the awards under a
method prescribed by SFAS No. 123, the Company's net loss for the years ended
December 31, 1999, 1998, and 1997 would have been increased to the pro forma
amounts indicated in the following table (in thousands, except per share
data):

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ---------------------------
                                                    1999      1998     1997
                                                  --------  --------  -------
     <S>                                          <C>       <C>       <C>
     Net loss attributable to holders of Common
      Stock:
       As reported............................... $(23,683) $(11,306) $(1,769)
                                                  ========  ========  =======
       Pro forma ................................ $(23,825) $(11,412) $(1,774)
                                                  ========  ========  =======
     Basic and diluted net loss per share
      attributable to holders of Common Stock:
       As reported............................... $  (3.43) $  (5.48) $ (4.09)
                                                  ========  ========  =======
       Pro forma ................................ $  (3.45) $  (5.53) $ (4.11)
                                                  ========  ========  =======
</TABLE>

   The Company calculated the minimum fair value of each option grant on the
date of grant using the Black-Scholes pricing model with the following
assumptions:

<TABLE>
<CAPTION>
                                                                  Year Ended
                                                                 December 31,
                                                                 --------------
                                                                  1999    1998
                                                                 ------  ------
     <S>                                                         <C>     <C>
     Expected life (years)......................................      5       5
     Risk Free interest rate....................................   5.30%   6.66%
     Expected volatility........................................     60      --
     Dividend yield.............................................     --      --
</TABLE>

                                     F-14
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The estimated weighted average fair value of options granted to purchase
shares of common stock under the Plan in 1999 and 1998 was $6.03 and $0.07,
respectively.

 Stock Compensation

   During 1998, the Company issued NSOs to an outside consultant to purchase
25,000 shares of Common Stock at $0.50 per share, the estimated grant date
fair market value. The estimated fair value of the options was not material to
the financial statements.

   In connection with two employee separation agreements in July and September
1999, the Company accelerated the vesting of options to purchase 41,000 Shares
of Common Stock. The intrinsic value of these shares amounted to $346,000 and
has been recognized as stock compensation.

   During 1999, the Company issued NSOs to two outside consultants to purchase
35,000 shares of Common Stock at $22.00 per share, the estimated fair market
value. The estimated fair value at the date of grant was $222,000, which was
recorded as stock compensation.

   In connection with certain stock option grants during the period from July
1, 1998, to October 1, 1999, the Company recorded unearned stock compensation
cost totaling $8.9 million which is being recognized over the vesting period
of the related options of four years. During 1999, unearned stock compensation
of $64,000 was reversed upon the cancellation of options. Amortization expense
associated with unearned stock compensation totaled $2.4 million for the year
ended December 31, 1999.

   The Company expects to record amortization expense associated with unearned
stock compensation of $1.3 million, $1.3 million, $940,000 and $690,000 in the
first, second, third and fourth quarters of fiscal 2000, respectively.

NOTE 8--EMPLOYEE BENEFIT PLANS:

 401(K) Plan

   The Company sponsors a 401(k) defined contribution plan (the "Plan")
covering all eligible employees. Contributions made by the Company are
determined annually by the Board of Directors. No contributions have been made
to the Plan by the Company.

 Employee Stock Purchase Plan

   In September 1999, the Board adopted the 1999 Employee Stock Purchase Plan
(the "Purchase Plan") and reserved 2,250,000 shares of Common Stock for
issuance thereunder. This reserve will be automatically increased on the first
day of the fiscal year beginning January 1, 2001, by an amount equal to the
lesser of 1,500,000 shares per year, 3% of the number of shares of Common
Stock which are issued and outstanding on the last day of the preceding fiscal
year or a number of shares determined by the Company's board of directors.
Employees generally will be eligible to participate in the Purchase Plan if
they are customarily employed by the Company for more than 20 hours per week
and more than five months in a fiscal year end. The first offering period
began on November 5, 1999, and therefore, the first Offering Period will be
less than 24 months long. Offering Periods and Purchase Periods thereafter
will begin on the first day of May and November of each year. The price at
which the Common Stock is purchased under the Purchase plan is 85% of the
lesser of the fair

                                     F-15
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

market value of the Company's Common Stock on the first day of the applicable
Offering Period or the last day of the purchase period.

NOTE 9--INCOME TAXES:

   No provision or benefit for income taxes has been recognized for any of the
periods presented as the Company has incurred net operating losses since
inception.

   As of December 31, 1999, the Company has approximately $26 million and $18
million of net operating loss carryforwards available to offset future taxable
income for Federal and California purposes, respectively, which expire
beginning in 2014 and 2004, respectively. Under the Tax Reform Act of 1986,
the amount of net operating losses that can be utilized may be limited in
certain circumstances including, but not limited to, a cumulative stock
ownership change of more than 50% over a three-year period.

   Deferred taxes comprise the following (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                                                                1999     1998
                                                              --------  -------
     <S>                                                      <C>       <C>
     Deferred tax assets:
       Depreciation.......................................... $     49  $    21
       Other accruals and liabilities........................    1,993       84
       Capitalized startup costs.............................      172      148
       Research and development credits......................      166      163
       Net operating loss and credit carryforwards...........    9,870    3,985
                                                              --------  -------
         Total deferred tax assets...........................   12,250    4,401
     Less: Valuation allowance...............................  (12,250)  (4,401)
                                                              --------  -------
     Net deferred tax assets................................. $     --  $    --
                                                              ========  =======
</TABLE>

   For financial reporting purposes, the Company has incurred a loss in each
period since its inception. Based on the available objective evidence,
including the Company's history of losses, management believes it is more
likely than not that the net deferred tax assets will not be fully realizable.
Accordingly, the Company provided for a full valuation allowance against its
net deferred tax assets for all periods presented.

   A reconciliation between the amount of income tax benefit determined by
applying the applicable U.S. statutory income tax rate to pre-tax loss is as
follows:

<TABLE>
<CAPTION>
                                                             Year Ended
                                                            December 31,
                                                           ------------------
                                                           1999   1998   1997
                                                           ----   ----   ----
     <S>                                                   <C>    <C>    <C>
     Federal statutory rate............................... (34)%  (34)%  (34)%
     State tax, net of federal impact.....................  (3)%  (  )%   (6)%
     Cheap stock amortization.............................   6%   (  )%  (  )%
     Provision for valuation allowance on deferred tax
      assets..............................................  32%    35%    44%
     Other................................................  (1)%   (1)%   (4)%
                                                           ---    ---    ---
                                                            --%    --%   --%
                                                           ===    ===    ===
</TABLE>

NOTE 10--COMMITMENTS:

   The Company leases its principal office space under a noncancelable
operating lease which expires on December 31, 2003. The Company leased a
30,000 square foot building on property contiguous to its current

                                     F-16
<PAGE>

                             COBALT NETWORKS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

headquarters to expand its Mountain View operations. This lease extends
through March 2004. The Company expects to occupy approximately two-thirds of
this new facility in March 2000, and has subleased the remainder to a tenant
through February of 2001. Rent expense was $877,000 in 1999, $316,000 in 1998,
and $73,000 in 1997.

   Future minimum lease payments under noncancelable operating leases are as
follows (in thousands):

<TABLE>
<CAPTION>
       Year Ending
       December 31,
       ------------
       <S>                                                                <C>
        2000............................................................  $1,374
        2001............................................................   1,662
        2002............................................................   1,731
        2003............................................................   1,784
        2004............................................................     237
                                                                          ------
                                                                          $6,788
                                                                          ======
</TABLE>

   In March 2000, the Company entered into a sublease agreement for 10,000
square feet of the new facility. The tenant will occupy the premises through
February of 2001. The expected rental income from this agreement is $335,000
in 2000 and $66,000 in 2001.

NOTE 11--CONTINGENCIES:

   Pursuant to the Company's turnkey service and purchase agreement with its
subcontract manufacturer, in the event that the agreement is terminated, the
Company would be required to purchase remaining surplus or obsolete inventory
which is specific to the Company's products.

   In December 1998, CUBE Computer Corporation filed a lawsuit against the
Company in the United States District Court for the Southern District of New
York for trademark infringement. CUBE, an original equipment manufacturer of
personal computers, argued that this alleged infringement resulted from the
Company's use of "Qube" in connection with its products. In December 1999, the
Company entered into a settlement agreement with Cube Computer. We acquired
certain trademark rights for a one-time payment of $4.1 million, not including
related legal costs.

NOTE 12--SUBSEQUENT EVENTS:

 Chili!Soft Acquisition

   On March 22, 2000, Cobalt entered into a definitive agreement to acquire
Chili!Soft, Inc., a provider of web page development technology. Cobalt will
acquire all outstanding stock and assume all stock options of Chili!Soft in
exchange for 1,150,000 shares of Cobalt's common stock. The transaction is
expected to be accounted for as a purchase business combination and is
expected to close during the three months ended June 30, 2000.

                                     F-17
<PAGE>

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
                                                                   Sequentially
                                                                     Numbered
 Exhibits                                                              Page
 --------                                                          ------------
 <C>      <S>                                                      <C>
  3.1.2*  Certificate of Incorporation of the Registrant

  3.2*    Bylaws of the Registrant

  4.1*    Specimen Common Stock Certificate

  4.2*    Second Amended and Restated Investors' Rights
          Agreement, dated April 30, 1999, by and among the
          Registrant and certain stockholders of the Registrant

 10.1*    Form of Indemnification Agreement between the
          Registrant and each of its directors and officers

 10.2*    Amended and Restated 1997 Employee Stock Plan

 10.2.1*  Form of Option Agreement under the Employee Stock Plan

 10.3*    1999 Employee Stock Purchase Plan

 10.3.1*  Form of Subscription Agreement under the 1999 Employee
          Stock Purchase Plan

 10.4*    1999 Director Option Plan

 10.4.1*  Form of Option Agreement under 1999 Director Plan

 10.5*    Form of Executive Officer Employment Agreement

 10.6*    Consulting Agreement dated August 30, 1996 by and
          between the Registrant and Techfarm Management, Inc.

 10.7*    Lease Agreement dated August 5, 1998 between
          Registrant and Renault & Handley Solar Ellis Joint
          Venture for 555 Ellis Street, Mountain View,
          California office.

 10.7.1*  Assignment of lease dated September 2, 1998 between
          Registrant and Netscape Communications, Inc.

 10.7.2*  Sublease dated October 28, 1996 between Netscape
          Communications, Inc. and Banta Corporation

 10.7.3*  Addendum One to sublease dated November 6, 1996
          between Netscape Communications, Inc. and Banta
          Corporation

 10.7.4*  Lease dated August 10, 1993 ("Master Lease") between
          Banta Digital Services, Inc. and Renault & Handley
          Solar Ellis Joint Venture

 10.8*    Employee Option Agreement dated July 15, 1998 between
          the Registrant and George M. Korchinsky

 10.9*    Employment Offer Letter dated July 20, 1999 from the
          Registrant to Gary Martell

 10.10*   Separation Agreement dated July 28, 1999 by and
          between the Registrant and Robin Porter

 10.11+*  Turnkey Service and Purchase Agreement dated August
          31, 1999 by and among the Registrant and SMTC
          Corporation

 10.12*   Promissory Note and Security Agreement dated August
          20, 1999 between the Registrant and Stephen W. DeWitt

 10.13+*  Gateway Master Supply Agreement dated September 16,
          1999 between the Registrant and Gateway, Inc.

</TABLE>
<PAGE>

<TABLE>
<CAPTION>
                                                                   Sequentially
                                                                     Numbered
 Exhibits                                                              Page
 --------                                                          ------------
 <C>      <S>                                                      <C>
 10.14*   Employment Agreement dated August 31, 1999 between the
          Registrant and Vivek Mehra

 10.15    Lease Agreement dated September 28, 1999 between
          Registrant and Kifer Investment Company for 515 Ellis
          Street, Mountain View, California office and related
          documents.

 10.16    Sublease Agreement dated February 26, 2000 between
          Registrant and PMC-Sierra for 515 Ellis Street,
          Mountain View, California office and related
          documents.

 21.1*    Subsidiaries

 23.1     Consent of PricewaterhouseCoopers LLP, Independent
          Accountants

 24.1     Power of Attorney (see Page 41)

 27.1     Financial Data Schedule
</TABLE>
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+ Confidential treatment has been requested or granted with respect to certain
  portions of this exhibit. Omitted portions have been filed separately with
  the Securities and Exchange Commission.
* Filed as an exhibit to the Registrant's Registration Statement on Form S-1
  (File No. 333-86759) as declared effective by the Securities and Exchange
  Commission on November 4, 1999.