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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, 2000

                                       OR

     [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
         SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

         FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .

                        COMMISSION FILE NUMBER 000-28843
                            ------------------------

                            TURNSTONE SYSTEMS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                            <C>
                   DELAWARE                                      77-0473640
       (STATE OR OTHER JURISDICTION OF                         (IRS EMPLOYER
        INCORPORATION OR ORGANIZATION)                     IDENTIFICATION NUMBER)
</TABLE>

             2220 CENTRAL EXPRESSWAY, SANTA CLARA, CALIFORNIA 95050
              (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

                                 (408) 907-1400
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                                      None

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                         Common Stock, $0.001 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 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.  [ ]

     As of February 28, 2001, there were 64,724,388 shares of the Registrant's
Common Stock outstanding. The aggregate market value of the Common Stock held by
non-affiliates of the Registrant (based on the closing price for the Common
Stock on the Nasdaq National Market on February 28, 2001) was approximately
$193,668,903.

                      DOCUMENTS INCORPORATED BY REFERENCE

     The Registrant incorporates by reference into Part III of this Form 10-K
portions of the Registrant's definitive Proxy Statement to be issued in
conjunction with the Registrant's 2001 Annual Meeting of Stockholders to be held
on May 10, 2001, which is expected to be filed not later than 120 days after the
Registrant's fiscal year ended December 31, 2000.

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                            TURNSTONE SYSTEMS, INC.

                                   FORM 10-K
                               DECEMBER 31, 2000

                               TABLE OF CONTENTS

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<CAPTION>
                                                                     PAGE
ITEM                                                                NUMBER
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<S>   <C>                                                           <C>
                                 PART I
 1.   Business....................................................     4
 2.   Properties..................................................    26
 3.   Legal Proceedings...........................................    26
 4.   Submission of Matters to a Vote of Security Holders.........    26
 4A.  Executive Officers of the Registrant........................    27

                                PART II
      Market for Registrant's Common Equity and Related
 5.   Stockholder Matters.........................................    29
 6.   Selected Consolidated Financial Data........................    30
      Management's Discussion and Analysis of Financial Condition
 7.   and Results of Operations...................................    31
      Quantitative and Qualitative Disclosures About Market
 7A.  Risk........................................................    38
 8.   Financial Statements and Supplementary Data.................    40

                                PART III
      Changes in and Disagreements with Accountants on Accounting
 9.   and Financial Disclosure....................................    63
10.   Directors and Executive Officers of the Registrant..........    63
11.   Executive Compensation......................................    63
      Security Ownership of Certain Beneficial Owners and
12.   Management..................................................    63
13.   Certain Relationships and Related Transactions..............    63

                                PART IV
      Exhibits, Financial Statement Schedules and Reports on Form
14.   8-K.........................................................    63
SIGNATURES........................................................    67
</TABLE>

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                INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

     This Annual Report on Form 10-K contains forward-looking statements. These
statements relate to future events or our future financial performance. In some
cases, you can identify forward-looking statements by terminology such as "may,"
"will," "should," "except," "plan," "anticipate," "believe," "estimate,"
"predict," "potential" or "continue," the negative of such terms or other
comparable terminology. These statements are only predictions. Actual events or
results may differ materially.

     Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Moreover, neither we nor any other person
assumes responsibility for the accuracy and completeness of the forward-looking
statements. We are under no duty to update any of the forward-looking statements
after the date of this report to conform such statements to actual results or to
changes in our expectations.

     Readers are also urged to carefully review and consider the various
disclosures made by us which attempt to advise interested parties of the factors
which affect our business, including without limitation the disclosures made
under the caption "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and under the caption "Business -- Risk Factors"
included herein and in our Registration Statement on Form S-1 (No. 333-45130)
filed with the Securities and Exchange Commission on September 1, 2000, and
thereafter amended.

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                                     PART I

ITEM 1. BUSINESS

OVERVIEW

     We are a leading provider of products that enable local exchange carriers
to rapidly deploy and efficiently maintain digital subscriber line, or DSL,
services. Our products enable the automation and remote control of installation,
qualification and maintenance of copper telephone lines. The Copper CrossConnect
CX100, our flagship product, enables local exchange carriers to rapidly and
efficiently deploy high speed digital services on existing copper telephone
lines. The CX100 is currently being installed in telephone company central
offices and remote terminals by communications service providers to speed their
deployment of DSL services. Our Smart Splitter SX500 platform, which was
introduced in November 2000, enables complete loop management for incumbent
local exchange carriers deploying residential DSL and voice services over the
same copper line, and for line sharing arrangements where different carriers
share the same copper line.

     In the fiscal year ended December 31, 2000, we achieved a number of
significant milestones. In February 2000, we completed our initial public
offering and listing on the Nasdaq National Market. In August 2000, we acquired
Paragon Solutions Limited, a New Zealand-based telecommunications equipment
design firm with twenty-five engineers. We also continued our expansion abroad
by opening offices in Australia, Germany and the United Kingdom. During the year
we shipped more than 11,000 CX100s to more than 50 customers. Our customers
include voice and data competitive local exchange carriers located in the United
States and internationally, including Covad Communications, Lucent Technologies,
McLeodUSA, Inc., Mpower Communications (formerly MGC Communications), Qwest
Communications International Inc. (formerly U.S. West), Rhythms NetConnections,
Riodata GmbH and XO Communications (formerly Nextlink).

     In the fourth quarter of 2000, however, we began to experience a high
degree of uncertainty with respect to our competitive local exchange carrier
customers. Because of their inability to obtain additional financing or generate
sufficient revenues to fund their operations, many of our customers either
reduced or discontinued the buildout of their networks and their purchases of
our products. Some of our customers also became delinquent in their payments for
our prior sales to them or filed for bankruptcy protection. The inability of our
customers to obtain financing to purchase our products and build out their
networks or to pay us for prior sales we made to them has had and is likely to
continue to have a negative impact on our business going forward.

INDUSTRY BACKGROUND

INCREASING NEED FOR HIGH SPEED ACCESS

     Internet content and the number of users accessing the Internet are
expected to continue to grow rapidly. International Data Corporation projects
the number of worldwide users conducting transactions on the Internet to grow
from approximately 240 million in 1999 to more than 600 million by 2003. In
addition, content is becoming more data-intensive as websites increasingly offer
streaming video and audio, animation and software downloads. As more users
access more Internet content, the ability to connect to the Internet at high
speeds is becoming more important. To remain competitive, businesses are using
high-speed connections to access and provide information via the Internet,
conduct transactions with customers and suppliers, and communicate more
effectively with remote employees. Consumers are also increasingly accessing the
Internet to communicate, collect and publish data-intensive information, conduct
retail purchases and access online entertainment.

     To meet this demand, a number of local exchange carriers are increasingly
offering high-speed Internet access and other services, often over existing
telephone lines. The existing lines that comprise the local loop extend from
telephone companies' central offices out to businesses and residences. Local
exchange carriers are taking advantage of the underutilized capacity of this
telephone network infrastructure to deliver high-speed Internet connections to
businesses and residences.

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EMERGING DSL SERVICES AND LOCAL EXCHANGE CARRIERS

     A number of local exchange carriers are deploying DSL to offer high-speed,
cost-effective, access services on existing copper lines. Because DSL networks
reuse the existing copper lines extending from telephone companies' central
offices to businesses and residences, they can be less expensive to deploy than
alternative access technologies. In addition, significant portions of the cost
of a DSL network can be deferred until subscribers are added, reducing the
initial fixed cost of the network. Other advantages of DSL include the ability
to leverage more of the underutilized capacity of the telephone line, offer
multiple services on the same line and operate as a dedicated, always-on
service, not requiring subscribers to initiate a dial-up connection each time
the service is used.

     Challenges to providing DSL service generally include the difficulty in
identifying, installing and determining the quality of a particular line, and
the expense of deploying and maintaining DSL service using traditional
labor-intensive procedures. The market for DSL-based services is still in a
relatively early stage of development and is rapidly evolving. Our future
success is substantially dependent upon whether DSL technology gains widespread
market acceptance by local exchange carriers, of which there are a limited
number, and by end users of their services. Our success is also dependent upon
whether we can successfully penetrate the incumbent local exchange carrier
market and whether local exchange carriers in general can obtain adequate
financing to fund the buildout of their DSL networks and the purchases of our
products. An incumbent local exchange carrier is a communications company that
held an exclusive license to offer local telephone services prior to the U.S.
Telecommunications Act of 1996 or similar legislation in other countries.
Examples include the regional Bell operating companies in the United States.

     The primary alternative methods of providing high-speed Internet access
include cable modems, wireless technology and satellite technologies. Cable
modem service targets the residential market and theoretically can provide
faster download speeds than DSL, if access is provided over a line with a single
user. However, because of the cable modems' method of data transmission and
cable layout patterns, all cable modem users in a particular neighborhood share
the same bandwidth, and download speeds decrease as the number of users in that
neighborhood increases. Both wireless and satellite technologies enable users to
transmit and receive information using radio frequencies at transmission speeds
close or comparable to DSL transmission speeds. However, neither of these
technologies provides an alternative method for incumbent local exchange
carriers to make use of their existing physical infrastructure for analog voice
services. In addition, as with DSL technology, neither wireless nor satellite
technology has achieved widespread acceptance. Technology for providing
high-speed data services is rapidly evolving, however, and our success will
depend upon DSL technology remaining competitive with these and other emerging
technologies.

     In the mid-to-late 1990's, various competitive dynamics prompted local
exchange carriers to target either the consumer or business market segments
using DSL technology. Cable operators, such as AT&T@Home and RoadRunner, began
delivering high-speed consumer services, prompting the incumbent local exchange
carriers to respond by accelerating their investments in DSL technologies. To
date, incumbent local exchange carriers have generally focused their DSL
deployments on the consumer segment by using versions of DSL that work in
conjunction with existing analog voice services as well as the associated line
maintenance procedures. However, these consumer-oriented versions of DSL
typically have limitations that make them unattractive for businesses. We
believe many incumbent local exchange carriers will gradually convert their
existing local loop equipment from analog to digital to deliver more competitive
business services as well as voice services in a more cost-effective manner.

     Deregulation under the U.S. Telecommunications Act of 1996 and similar
legislation in other countries enabled competitive local exchange carriers to
provide competing services. It also eliminated a substantial barrier to
competitive local exchange carriers by allowing access to the incumbent local
exchange carriers' facilities in order to utilize the existing local loop
network infrastructure. Many of these competitive local exchange carriers are
new companies without a significant installed base of traditional analog voice
equipment and as a result are deploying modern DSL equipment and implementing
new telephone line maintenance procedures in the incumbent carriers' facilities.
This has enabled a number of competitive local exchange carriers to use the
local loop to offer competitively priced, high-speed services to business
customers.

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     In November 1999, the Federal Communications Commission ordered that both
competitive local exchange carriers and incumbent local exchange carriers share
the same physical copper telephone line for delivering services to the customer
under an arrangement known as line sharing, by June 2000. Line sharing is
generally implemented by installing a signal splitter that offers competitive
local exchange carriers access to the higher frequency signals used to deliver
DSL services on the copper line. This arrangement leads to operational
challenges, however, because the signal splitter impairs the ability to properly
test and qualify the copper line and because competitive and incumbent local
exchange carriers require different line testing, maintenance and monitoring
capabilities. In addition, the incumbent and competitive local exchange carriers
have yet to work out many of the implementation issues relating to line sharing.
For example, it has yet to be determined whether the incumbent or the
competitive local exchange carrier will purchase, install and maintain the
signal splitter. Until these issues are resolved, we believe that implementation
of line sharing equipment will be delayed.

DSL LINE INSTALLATION AND MAINTENANCE

     Competitive local exchange carriers gain access to the local loop and
deploy DSL by leasing space in an incumbent local exchange carrier's central
office, installing network equipment in this space and leasing specific copper
telephone lines to connect subscribers. Incumbent local exchange carriers must
connect copper lines as requested from the competitive local exchange carriers'
leased space to subscriber locations, a process that tends to be labor
intensive. When a competitive local exchange carrier orders a line to be
connected from their equipment to the subscriber's site, the incumbent local
exchange carrier's personnel must manually complete one or more connections.
These include connections inside the central office, at the subscriber's site
and possibly at various points throughout the local loop.

     The process above varies somewhat if the DSL services are ordered directly
through the incumbent local exchange carrier or if the DSL services are deployed
in a line sharing arrangement. In these cases, the incumbent local exchange
carrier will not have to provision a new copper line if an existing line is
delivering voice services to the subscriber. However, the DSL service order must
still be processed, the copper line must still be connected to the appropriate
DSL access multiplexer, the existing circuit must be qualified for DSL services,
the carrier network must be configured and the necessary customer premises
equipment must be installed. A DSL access multiplexer receives signals from
multiple DSL connections and puts the signals on a larger, high-speed
transmission line.

DSL DEPLOYMENT CHALLENGES

     Despite the new revenue opportunity DSL provides for local exchange
carriers, there are several major challenges in deploying and maintaining a new
DSL infrastructure that have slowed deployment. The challenges include:

     Manual DSL Installation is Difficult, Expensive and Labor Intensive. DSL
installation requires one or more connections to the copper line in a process
that traditionally relies on manual labor and hand-held test tools. A common
problem that arises with local exchange carriers deploying DSL is human error in
installing the copper line. To ensure that the line has been correctly
connected, technicians rely on standard analog voice tools that attach to the
copper lines at any point in order to correctly identify the line. This
technique relies upon incumbent local exchange carrier voice equipment that
generates audible dial tones as well as an audible identification code
associated with a particular line. Since a competitive local exchange carrier's
DSL lines are not connected to this voice equipment, an audible dial tone is not
available. Without this line identification information, connections are often
performed incorrectly at one or more of the various points throughout the
network. Discovering and correcting these mistakes by dispatching service
personnel into the field is costly and leads to delays in establishing service.

     DSL Services are Dependent on Copper Line Length and Quality. DSL operates
at higher frequencies than traditional analog voice service and is therefore
more dependent on the length and quality of the copper line and more easily
affected by electrical interference. Because various devices connected to, or
faults occurring on, the copper line can cause problems for DSL, they must be
identified in advance so that the line

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can be properly prepared for DSL service. In addition, a greater range of
frequencies must be monitored to fully qualify the line and detect electrical
interference. For local exchange carriers to efficiently maintain DSL services,
they must be able to qualify and monitor copper lines. Where DSL and voice
services are delivered over the same line or in line sharing arrangements, local
exchange carriers face additional operational challenges such as the inability
to perform comprehensive testing from certain points in the network. To date, a
significant amount of on-site labor and expensive hand-held test equipment has
been required to install, qualify, maintain and troubleshoot lines for DSL.

     DSL Maintenance is Complex. Because DSL runs on the local loop, DSL
networks require local exchange carriers to deploy DSL equipment in a large
number of central offices or remote terminals in order to provide service in a
broad geographic region. Local exchange carriers must sometimes send technicians
to individual central offices to reconnect lines, to correct equipment failures
or to change subscriber services. For example, in the event of a DSL access
multiplexer failure, the local exchange carrier would need to either replace the
defective equipment or manually reconnect the subscriber lines around the
failure. These on-site service calls to the central office or remote terminals
can be costly and lead to delays in service availability. Given the ramp up in
the deployment of DSL technology and the need for guaranteed levels of service,
local exchange carriers are increasingly automating and remotely managing
activities related to DSL deployment and maintenance.

NEED FOR A PURPOSE-BUILT SOLUTION

     Given the historically exclusive use of the copper local loop
infrastructure by incumbent local exchange carriers for voice traffic, most
equipment vendors have focused on the needs of the incumbent local exchange
carriers and their traditional analog voice services. These vendors have not
developed products optimized for the unique requirements of new digital
services, competitive local exchange carriers and line sharing arrangements.
Traditional systems, often based on proprietary software, are difficult and
expensive to integrate with new DSL equipment and modern operational support
systems. We believe widespread deployment of competitive DSL services requires
new infrastructure equipment with standard interfaces providing for the
automation and remote management of line installation, qualification and
maintenance that would otherwise be manually implemented.

THE TURNSTONE SOLUTION

     Our products improve the efficiency of installing and managing DSL services
while delivering the high levels of reliability and scalability needed in a
large, complex network.

     We believe that our CX100 product family is the first solution designed and
built specifically to enable local exchange carriers deploying DSL to automate
and remotely control the installation, qualification and maintenance of copper
telephone lines in a local loop. Our CX100 product family consists of the Copper
CrossConnect CX100 and associated modules and the CrossWorks suite of software
applications. The CX100 product family is designed specifically to enable the
rapid and efficient deployment of high-speed digital services on the existing
local loop.

     Our Smart Splitter SX500 platform, which was introduced in November 2000,
enables loop management for incumbent local exchange carriers deploying
residential DSL and voice services over the same line, and for line sharing
arrangements. The SX500 offers signal splitting functionality, line testing
access at all points of the network and an open interface that can be compatible
with existing network operational support systems. Local exchange carriers can
interface the SX500 with any testing platform, including the CX100.

     The CX100 and SX500 are typically deployed between one or more DSL access
multiplexers and the copper subscriber lines. Additional modules can be added
over time as subscriber count increases and as more modules are added to DSL
access multiplexers. CrossWorks can operate independently or be integrated with
a local exchange carrier's operational support system, enhancing efficiency and
scalability.

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     The benefits of our solution include:

     Rapid and Efficient DSL Deployment. Our products enable carriers to
remotely perform line qualification, testing and maintenance on any line
connected through the system. Accurate line qualification and testing enable
local exchange carriers to rapidly and efficiently deploy DSL services and
reduce installation and labor costs. Our products provide local exchange
carriers with critical testing capabilities, including traditional tests
performed on analog lines as well as advanced tests that are appropriate for DSL
network environments. Our customers can remotely confirm if a particular copper
line is properly connected into the central office, and whether it can support a
specific type and speed of DSL service prior to deploying field personnel for
installation at the subscriber site. Our products can also generate audible
tones on any set of lines, providing field personnel with a convenient mechanism
for ensuring lines are correctly connected during DSL installation. These
features are also useful for performing fault isolation and maintenance on DSL
subscriber lines after service is installed and operational.

     Improved Network Reliability. Our products improve network reliability and
availability by providing local exchange carriers with remote service
modification and restoration capabilities, enabling local exchange carriers to
offer guaranteed levels of service. For example, in the event of a DSL access
multiplexer failure, our customers can rapidly restore services by remotely
reconnecting the affected lines around the problem, a process we call protection
switching. Carriers can also use the protection switching capability to remotely
modify a customer's service type quickly and cost effectively. The ability to
remotely modify a customer's services is useful for handling unforeseen
installation problems or responding quickly to service change requests without
the requirement for costly on-site labor.

     Automated Operations. Our CrossWorks software operates in conjunction with
the CX100 to automate the collection, analysis and archiving of information
regarding subscribers, line assignments, test histories and other information.
Raw test data can be automatically gathered at programmed intervals and
analyzed, generating pass/fail notifications based on user-defined thresholds
for particular services. All of the information is automatically stored and is
available for future troubleshooting or trend analysis. CrossWorks also includes
automated network administration capabilities such as software upgrades, backups
and alarm tracking. CrossWorks may be integrated with service providers'
existing operational support systems using open, standard interfaces or operated
as a stand-alone application.

     Compatible with all Services and Platforms and in Line Sharing
Arrangements. Our products are designed to be compatible with all types of local
loop services, DSL access multiplexers and in the case of the SX500, all testing
platforms. A single CX100 or SX500 may be deployed with multiple DSL access
multiplexers from a variety of vendors, including Alcatel, Cisco, Copper
Mountain, Lucent, Nokia and Paradyne. Where DSL and voice services are delivered
over the same line or in line sharing arrangements, the SX500 can be accessed by
any testing platform, including the CX100. With our solution in place, local
exchange carriers can deploy next-generation equipment to support emerging DSL
services as well as leverage existing investments in networking equipment that
support more traditional services.

STRATEGY

     Our objective is to be the leading provider of products to enable local
exchange carriers to automate and remotely control the installation,
qualification and maintenance of copper telephone lines for DSL service. Key
elements of our strategy include:

     Penetrate the Incumbent Local Exchange Carrier Market and New International
Markets as They Emerge. We believe our established position in the competitive
local exchange carrier market will better enable us to penetrate incumbent local
exchange carriers and local exchange carriers in other countries who will
gradually convert their installed base of analog voice equipment to more
efficient DSL equipment due to superior economics, demand for new services and
continued deregulation. We intend to continue to develop products specifically
targeted at incumbent local exchange carriers, such as our SX500 platform. We
also intend to add more features to make our solutions more attractive to
incumbent local exchange carriers and to local exchange carriers in other
countries. We plan to continue to expand our sales, marketing and support

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capabilities to meet the growing demand for high-speed access solutions and
increase our brand recognition both domestically and internationally.

     Increase Penetration in the Competitive Local Exchange Carrier Market. Our
initial target customers were competitive local exchange carriers specifically
focused on offering DSL services to business users. We expect that this target
market will continue to mature as new competitive local exchange carriers
emerge, as established competitive local exchange carriers supplement their
existing services with DSL service offerings for businesses and as the market
experiences consolidation. We believe our early success with competitive local
exchange carriers such as Covad Communications, McLeodUSA, Inc., Mpower
Communications (formerly MGC Communications), Qwest Communications International
Inc. (formerly U.S. West), Rhythms NetConnections, Riodata GmbH and XO
Communications (formerly Nextlink) will better enable us to market to other
competitive local exchange carriers as they deploy DSL.

     Enhance Product Offerings. We believe that our core product offerings can
be enhanced to offer better value to existing and new customers. We plan to
continue adding features and functionality to increase the utility and
applicability of our product offerings. Since our products have been deployed by
a number of our customers, we have developed an understanding of the challenges
facing these carriers. This knowledge enables us to design additional features
and capabilities into our products. We expect to invest significant development
resources in the areas of service qualifications, network management,
operational support system interfaces and manufacturing cost reductions. In
addition, we have obtained regulatory approvals and certifications so that our
products may be deployed in several European and Asian jurisdictions. We intend
to seek the necessary regulatory approvals and certifications so that our
products may be deployed widely outside of the United States.

     Develop Relationships with Original Equipment Manufacturers and
Resellers. Although we primarily market our products through our direct sales
force, we believe original equipment manufacturer relationships can enhance our
market position and make us a more attractive vendor to a broader base of
customers. We have an original equipment manufacturer relationship with Lucent
Technologies, who has chosen to resell the CX100 as a co-branded system, and
with several international resellers. We expect these relationships to expand
our distribution and customer support capacity internationally as well as
satisfy the equipment financing requirements of certain customers. In the
future, we expect to develop other original equipment manufacturer and reseller
relationships in order to penetrate additional customer segments and market our
products in international markets.

     Leverage Relationships with Complementary Vendors. Our products are
compatible with a variety of DSL equipment as well as analog telephone
equipment. The CX100 or SX500 may be used with multiple DSL access multiplexers
from a number of vendors, including Alcatel, Cisco, Copper Mountain, Lucent,
Nokia and Paradyne. Because our solution is complementary to DSL access
multiplexers, we believe DSL access multiplexer vendors are likely to recommend
our products to their customers. We intend to make our products an attractive
complement to all DSL access multiplexer vendors and to further encourage joint
sales and marketing activities. We are also working with vendors of hand-held
line test equipment in order to provide more sophisticated capabilities.

     Outsource Manufacturing. We outsource manufacturing of our products
including material procurement, board level assembly, final assembly, test and
shipment to our customers. We use automated design, manufacturing and test
processes to minimize cycle times and improve product quality. We believe that
continuing this arrangement will lower our manufacturing costs, provide us with
more flexibility to scale our operations to meet changing demand and allow us to
focus our engineering resources on new product development and product
enhancements.

PRODUCTS

     Our products are designed to be deployed in a telephone company's central
offices or remote terminals between one or more DSL access multiplexers and the
copper subscriber lines. Modules may be added over time as subscriber count
increases and as more DSL access multiplexer modules are added. With the CX100
our customers can remotely qualify and monitor copper lines as well as verify
connections to subscriber sites.
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With the SX500 our customers can implement complete loop management solutions
for delivering residential DSL and voice services over the same copper line, and
for line sharing arrangements. We also offer a suite of software modules, called
CrossWorks, which enables our customers to more efficiently control our
products, enhancing remote or automated management of the local loop. We expect
that these core technologies will serve as the basis for future generations of
products.

     Copper CrossConnect CX100. The CX100 is a modular product designed for
central office and remote terminal environments and is compliant with network
equipment building standards. The base system, which depends on customer
configuration, typically consists of one CX100 chassis, one P150 module that
provides the management and control functions of the CX100 and one or more L140
modules that provide access to copper telephone lines. The base system is
installed and fully cabled in a central office or remote terminal, with
additional modules added over time as subscriber count increases and as more DSL
access multiplexer modules are added. All modules may be inserted or removed
while the system is operational and are automatically recognized and inventoried
by the system upon insertion. All modules, indicators and switches are
accessible from the front of the system, consistent with current industry
practices. The CX100 supports dual 48-volt power feeds. In the event of loss of
power, the CX100 maintains all connections with no loss of subscriber service.
The CX100 chassis is available in 19 and 23 inch configurations. The 19 inch
version supports 425 lines, and the 23 inch version supports 550 lines. The
following modules are currently available for the CX100:

     - P150. The P150 module provides management and control functions for the
       CX100 and has line qualification functionality and the capability of
       testing lines for use of the integrated services digital network
       standard. The P150 supports Ethernet, serial port or dial-up modem access
       for management, as well as access for interfacing to external test gear.

     - L140. The L140 module provides access to the P150 and connections for up
       to 25 copper lines. Additional L140 modules may be added over time as
       subscriber count increases and as more DSL access multiplexer modules are
       added.

     - M101. The M101 module provides a six-port Ethernet hub and four contacts
       for monitoring physical alarms in central offices. This optional module
       provides a convenient management connectivity solution between multiple
       network products within the central office.

     - M120. The M120 module provides an eight-port terminal server and modem
       for remote management and monitoring of multiple network devices in
       central offices.

     Smart Splitter SX500. The Smart Splitter SX500 is a modular product that
incorporates signal splitting and test access for the efficient provisioning of
residential DSL and voice services over the same line and in line sharing
arrangements. The base system, which depends on customer configuration,
typically consists of one SX500 chassis, one SP50 module that provides
management and control functions and test access out to the subscriber and one
or more SL24 splitter modules that provide signal splitting functionality and
test access towards the voice switch or DSL access multiplexer. Additional
modules may be added over time as subscriber count increases. All modules may be
inserted or removed while the system is operational, and a continuous dial tone
is assured even during these module changes. The SX500 supports dual 48-volt
power feeds. In the event of loss of power, the SX500 functions as a passive
signal splitter and does not disrupt voice and DSL services. The SX500 is
available in the 19 inch configuration which supports 456 splitters, and the 23
inch version which supports 576 splitters. The following modules are currently
available for the SX500:

     - SP50. The SP50 module performs system management and control for the
       SX500 and enables test access for the portion of the network extending
       out to the subscriber site.

     - SL24. The SL24 module provides signal splitting functionality for up to
       24 lines and enables test access for the portion of the network extending
       towards the voice switch or the DSL access multiplexer.

     CrossWorks. CrossWorks is a suite of software products that enable service
providers to automate physical management of a large volume of copper lines when
using CX100 systems. When the CX100 and the

                                        10
<PAGE>   11

SX500 systems are deployed together, CrossWorks can be used to manage both
systems. CrossWorks employs a client-server architecture that offers flexible
integration with existing operational support systems. The CrossWorks server,
which performs most of the automation work, can be accessed via standard
interfaces, such as common object request broker architecture, commonly known as
CORBA, JAVA, remote method indication, commonly known as RMI, simple network
management protocol, commonly known as SNMP, or distributed component object
model, commonly known as DCOM, allowing a service provider to use its own user
interface. Alternatively, a service provider can use CrossWorks as a standalone
client-server application. With either of these approaches, CrossWorks is
designed to interface with the service provider's existing database through a
standard application programming interface. These options are designed to
provide the service provider with automated system capabilities while leveraging
its existing operational support systems infrastructure.

CUSTOMERS

     For the year ended December 31, 2000, our nonexclusive original equipment
manufacturer relationship with Lucent Technologies accounted for approximately
19% of our revenues and no other customers accounted for more than 10% of our
revenues. The following is a representative list of our customers as of December
31, 2000: Covad Communications, DSL.net, McLeodUSA, Inc., Mpower Communications
(formerly MGC Communications), Qwest Communications International Inc. (formerly
U.S. West), Rhythms NetConnections, Riodata GmbH and XO Communications (formerly
Nextlink). We have no long-term contracts with any of our customers, and they
may reduce or discontinue their purchases at any time.

SALES AND MARKETING

     We sell and market our products through our direct sales force, indirect
channels and through participation in affiliation programs.

     Direct Sales. As of December 31, 2000, our direct sales effort in North
America was directed by 8 account managers. We also had 6 account managers based
internationally in Australia, Germany, New Zealand and the United Kingdom. Our
direct sales efforts are primarily focused on incumbent local exchange carriers
and international carriers who are beginning to deploy DSL and competitive local
exchange carriers that are financially stable. We plan to continue to expand our
direct sales organization internationally in the future. We also have 17 systems
engineers who support our account managers and work with customers' engineering
and operations personnel to improve their ability to use and integrate our
products. Direct sales accounted for approximately 81% of our revenues for the
year ended December 31, 2000.

     Indirect Sales. We and Lucent Technologies, a leader in the global
telecommunications equipment market, are parties to an original equipment
manufacturer agreement. Under this agreement, we co-brand the CX100 with Lucent,
which resells the CX100 products. Lucent offers DSL access equipment and
services, including vendor financing, which facilitate the sale of our products
and services. Lucent generally provides first level support for our products to
its customers. Our agreement allows Lucent to sell our product on a worldwide,
nonexclusive basis. Under our agreement, Lucent provides monthly, nonbinding,
twelve-month forecasts of Lucent's anticipated orders. The contract contains no
minimum purchase requirements and is terminable by Lucent at any time. Products
are shipped against individual purchase orders. The agreement expires in August
2002 but may be renewed by agreement of both parties for an additional twelve
month period. We have also entered into nonexclusive, territory-based
arrangements with several international resellers. These arrangements typically
have one-year renewable terms, contain no minimum purchase requirements and are
terminable by either party at any time.

     Affiliation Programs. We have worked to make our hardware products
interoperable with complementary products of other equipment providers in order
to enable us to jointly offer a more comprehensive solution for deploying DSL
services. Hardware companies with which we have affiliated with are AccessLan
Communications, Inc., ADTRAN, Inc., Alcatel Alsthom S.A., Cisco Systems, Copper
Mountain Networks, Inc., Lucent, Paradyne Corporation and Sunrise Telecom Inc.
We have also initiated the CrossWorks Back Office Network Development program
whereby we work with other leading vendors and system integrators to

                                        11
<PAGE>   12

accelerate the development of next generation back office systems that enable
DSL service providers to fully automate installation, management and maintenance
of copper telephone lines. Vendors and systems integrators with which we are
currently affiliated are BusinessEdge Solutions, Cygent Inc., Cap Gemini Ernst &
Young LLP, Nightfire Software Inc., Syndesis Limited and Vitria Technology, Inc.

     Our marketing organization is responsible for sales support activities,
product presentations, documentation and pricing, as well as new product and
feature definition. Our marketing organization also performs activities such as
marketing communications, joint marketing with affiliates, marketing research,
trademark administration and other support functions.

CUSTOMER SERVICE AND SUPPORT

     We believe a high level of continuing service and support is critical to
our long-term success. We offer comprehensive hardware and software maintenance
and support programs for our products. The majority of our service and support
activities are related to training, troubleshooting and network management.
These services are provided by telephone, email and directly at customer
locations using personnel from our customer support group. We also offer various
training courses for our direct customers and original equipment manufacturers.

RESEARCH AND DEVELOPMENT

     We have assembled a team of highly skilled engineering professionals who
are experienced at designing data networking equipment and network management
software. Our engineering personnel have expertise in a number of fields,
including digital loop carrier design, voice and data switching technology,
local loop equipment design and operations support systems. During the year
ended December 31, 2000, we spent $18.7 million on research and development. As
of December 31, 2000, we had a total of 85 employees engaged in research and
development.

     We believe that our future success depends on our continued ability to
adapt to the rapidly changing local loop market, to maintain our expertise in
management of the local loop and to continue anticipating and satisfying our
customers' evolving needs. We continually review and evaluate technological and
regulatory changes affecting the local exchange carrier market and seek to offer
products and capabilities that solve customers' operational challenges and
improve their efficiency.

     Through our research and development efforts, we created our CrossWorks
suite of software products that enable more efficient integration of our CX100
systems' functions into our customers' operations support systems. We believe
that our extensive experience designing and implementing high-quality network
components has enabled us to develop high-value integrated systems solutions.

     We are currently investing significant resources in operational support
systems interfaces and capabilities, automated testing, new modules optimized
for specific applications and support for additional industry standards,
including international compliance testing for our products.

COMPETITION

     The market for telecommunications equipment is highly competitive. A number
of companies that have traditionally produced products for analog voice networks
also sell products that compete with ours. These companies include: Harris
Corporation, Hekimian Laboratories, a division of Spirent plc, Inrange
Technologies Corporation, Lucent Technologies, Nokia Corporation, Nortel
Networks, Teradyne Corporation and Tollgrade Communications. In addition, a
number of smaller companies are expected to introduce products that will compete
with ours.

     We also compete with DSL equipment providers including Lucent, Nortel,
Nokia and Alcatel, who have announced plans to incorporate competitive features
and functionality into their DSL access multiplexers. To the extent we expand
the capabilities of our products to incorporate functionality traditionally
contained in other equipment, we may also face increased competition from other
vendors.

                                        12
<PAGE>   13

     Remaining competitive in our markets will require a continued high level of
investment in research and development, marketing, and customer service. The
principal competitive factors in our market include:

     - speed of new product introductions to market;

     - depth of product functionality;

     - ease of installation, integration and use;

     - system reliability and performance;

     - price and financing terms;

     - technical support and customer service;

     - size and stability of the vendor's operations; and

     - compliance with government and industry standards.

     Due to the rapidly evolving markets in which we compete, additional
competitors with significant market presence and financial resources, including
other large telecommunications equipment manufacturers, may enter our markets,
thereby further intensifying competition. We may not have sufficient resources
to continue to make the investments or achieve the technological advances
necessary to compete successfully. The markets for high-speed telecommunications
products are characterized by rapid technological developments, frequent
enhancements to existing products and new product introductions, changes in end
user requirements and evolving industry standards. The emerging nature of these
products and services and their rapid evolution requires us to continually
improve the performance, features and reliability of our products, particularly
in response to competitive product offerings. Current or future competitors may
foresee the course of market developments more accurately than we do and may
introduce products incorporating superior or alternative technologies that could
render our products obsolete.

     Our products are primarily used in DSL-based service applications that use
copper lines. Numerous other high-speed access technologies, including cable
modems, satellite technology and wireless technologies compete with DSL-based
services. These competing technologies may ultimately prove to be superior to
DSL-based services and reduce or eliminate the demand for our products. The
properties of copper lines limit the speed and distance over which data can be
transmitted. Service levels degrade as distance from the central switching
station increases. Other competing technologies, such as wireless and cable, are
not subject to such limitations. Our products may become obsolete as a result of
the development of competing technologies that are more reliable, faster and
less expensive than DSL.

MANUFACTURING

     Our manufacturing operation is entirely outsourced. We and A-Plus
Manufacturing, a division of C-MAC Industries Inc., are parties to a contract
manufacturing agreement, under which we subcontract manufacturing of our
products. A-Plus Manufacturing, located in San Jose, California, is an
established contract manufacturer with ISO 9002 and Telecordia, formerly
Bellcore, certifications. These certifications relate to the manufacturer's
compliance with industry standards for quality control procedures and
telecommunications products. This subcontracting arrangement includes material
procurement, board level assembly, final assembly, test and shipment to our
customers. We utilize automated design, manufacturing and test processes to
minimize cycle times and improve product quality. We design and implement all of
the tests that are required to meet internal and external quality standards, and
routinely monitor product quality via on-site inspections. This arrangement
provides us with the following benefits:

     - we operate without substantial space dedicated to manufacturing
       operations;

     - we conserve a significant portion of the working capital that would be
       required for funding inventory; and

     - we can more easily adjust manufacturing volumes to meet changes in
       demand.

                                        13
<PAGE>   14

     A combination of standard parts and components are used, which are
generally available from more than one vendor, and a number of key components
are purchased from sole or limited source vendors for which alternative sources
are not currently available. In most cases, there are no guaranteed supply
arrangements with these suppliers, and we or our contract manufacturer may fail
to obtain these supplies in a timely manner in the future. Delivery delays,
supply interruptions or the discontinuation of these components could result in
delays or reduction in product shipments and revenues. In addition, the purchase
of these components on a sole source basis subjects us to risks of price
increases and potential quality assurance problems.

     Our contract manufacturer currently purchases key components for which
there are currently no substitutes available from approximately 8 suppliers. All
of these components are critical to the production of our products, and
competition exists with other manufacturers for these key components. While
alternative suppliers may be available, we must first identify these suppliers
and qualify them. Qualifying additional suppliers is time-consuming and
expensive. We cannot be certain that we will be able to qualify or identify
alternative suppliers in a timely fashion, or at all. In addition, our contract
manufacturer may not be able to obtain sufficient quantities of these components
from existing or future suppliers on the same or substantially the same terms as
are currently available. Consolidations involving suppliers could further reduce
the number of alternatives and affect the cost of components. An increase in the
cost of components could make our products less competitive and result in lower
margins. Financial or other difficulties faced by these suppliers or significant
changes in market demand for these components could limit the availability of
these components. Any interruption or delay in the supply of any of these
components, or an inability to obtain these components from alternate sources at
acceptable prices and within a reasonable amount of time, would adversely affect
our ability to meet scheduled product deliveries to our customers, cause us to
lose sales to existing and future customers and harm our operating results and
financial condition.

     In addition, lead times for some of the materials and components we use are
very long and depend on factors such as the specific supplier, contract terms
and demand for each component at a given time. Our contract manufacturer also
may experience shortages of components from time to time, which also could delay
the manufacturing of our products. Additionally, long lead times for some
materials and components have in the past, and may in the future, cause us to
attempt to mitigate these lead times by purchasing inventories of some parts
ourselves, increasing our costs, the risk of the parts' obsolescence and the
risk of incurring supply contract cancellation fees if we overestimate our
component requirements. Limited sources of supply of, and competition with other
manufacturers for, key components may increase the price we pay to obtain these
components and lower our gross margins. If we fail to carry a sufficient
inventory of long lead time items, if lead times increase or if demand for our
products increases unexpectedly, we may have insufficient access to components
necessary to meet demand for our products on a timely basis. If demand for our
products decreases unexpectedly, which we have experienced in the past and may
experience in the future, we may have excess inventory and incur supply contract
cancellations fees.

INTELLECTUAL PROPERTY

     We rely on a combination of copyright, trademark, trade secret and other
intellectual property law, nondisclosure agreements and other protective
measures to protect our intellectual property. We have filed six patent
applications to date. We attempt to protect our intellectual property rights by
limiting access to the distribution of our software, documentation and other
proprietary information. In addition, we enter into confidentiality agreements
with our employees and certain customers, vendors and strategic partners. These
steps may fail to prevent the misappropriation of our intellectual property,
particularly in foreign countries where the laws may not protect our
intellectual property as fully as in the United States. Other parties may
independently develop competing technology. Attempts may be made to copy aspects
of our products or to obtain and use information that we regard as proprietary.
Our existing and future patent applications, if any, may not be approved, any
issued patents may not protect our intellectual property, and any issued patents
may be challenged by third parties. Any failure to adequately protect our
intellectual property could result in our competitors offering similar products,
potentially resulting in loss of a competitive advantage and decreased revenues.

                                        14
<PAGE>   15

     We employ many types of intellectual property in the development and
manufacturing of our products. We believe that the loss of all or a substantial
portion of our intellectual property could have a material adverse effect on our
results of operations. Our intellectual property protection measures might not
be sufficient to prevent misappropriation of our technology. In addition, the
laws of many foreign countries do not protect our intellectual properties to the
same extent as the laws of the United States. From time to time, we may desire
or be required to renew or to obtain licenses from others in order to further
develop and market commercially viable products effectively. Any necessary
licenses might not be available on reasonable terms. To date, we have not been
notified that our products infringe the proprietary rights of third parties, but
in the future third parties might claim infringement by us with respect to our
current or future products. These claims and any resulting lawsuit, if
successful, could subject us to significant liability for damages and invalidate
our proprietary rights. These lawsuits, regardless of their success, would
likely be time-consuming and expensive to resolve and would divert management
time and attention. Any potential intellectual property litigation also could
force us to do one or more of the following:

     - cease selling, incorporating or using products or services that
       incorporate the infringed intellectual property;

     - obtain from the holder of the infringed intellectual property right a
       license to sell or use the relevant technology, which license may not be
       available on acceptable terms, if at all; or

     - redesign those products or services that incorporate the disputed
       technology.

     We may in the future initiate claims or litigation against third parties
for infringement of our proprietary rights or to determine the scope and
validity of our proprietary rights or the proprietary rights of competitors.
These claims could result in costly litigation and the diversion of our
technical and management personnel. As a result, our operating results could
suffer and our financial condition could be harmed.

     We have registered Turnstone Systems, the Turnstone Systems logo, Copper
CrossConnect CX100 and Smart Splitter SX500 as trademarks. Each trademark, trade
name or service mark of any other company appearing in this prospectus belongs
to its holder.

EMPLOYEES

     As of December 31, 2000, we had a total of 160 employees based in the
United States, 35 employees based in New Zealand and 8 employees based in
various other international jurisdictions. Of the total, 85 were engaged in
research and development, 58 were engaged in sales, marketing and customer
support, 27 were engaged in operations, and 33 were engaged in administration
and finance. None of our employees is subject to a collective bargaining
agreement and we believe that our relations with our employees are good.

RISK FACTORS

     In addition to other information in this Form 10-K, the following risk
factors should be carefully considered in evaluating Turnstone and its business
because such factors currently may have a significant impact on Turnstone's
business, operating results and financial condition. As a result of the risk
factors set forth below and elsewhere in this Form 10-K, and the risks discussed
in Turnstone's other Securities and Exchange Commission filings, actual results
could differ materially from those projected in any forward-looking statements.

WE HAVE LOST MONEY IN THE PAST, ARE CURRENTLY EXPERIENCING LOSSES AND MAY NOT
ACHIEVE PROFITABILITY IN THE FUTURE, WHICH COULD CAUSE THE MARKET PRICE OF OUR
COMMON STOCK TO DECLINE.

     We have experienced losses in the past and were not profitable on an
operating basis for the fourth quarter of fiscal 2000. Our stock price declined
substantially in the fourth quarter of fiscal 2000. If we do not succeed in
generating significant revenue growth, we will not be able to achieve
profitability and the market price of our common stock may decline further. We
expect to continue to incur significant product

                                        15
<PAGE>   16

development, sales and marketing and administrative expenses. In particular, we
anticipate that our expenses will increase substantially in the next 12 months
as we:

     - increase our sales and marketing activities, particularly by expanding
       our incumbent local exchange carrier and international sales and support
       organization;

     - develop our technology, expand our existing product lines and add new
       features to penetrate new markets; and

     - develop additional infrastructure and hire additional management.

     Our operating expenses are largely based on currently anticipated revenue
trends, which may not be realized, and a high percentage of our expenses are and
will continue to be fixed in the short term. We will need to generate
significant revenues to offset these expenses and achieve profitability.

OUR LIMITED OPERATING HISTORY AND THE LIMITED OPERATING HISTORY OF MANY OF OUR
CURRENT CUSTOMERS MAKE FORECASTING DIFFICULT, AND IF OUR OPERATING RESULTS ARE
BELOW EXPECTATIONS, THE PRICE OF OUR COMMON STOCK WILL DECLINE.

     As a result of our limited operating history, it is difficult to forecast
accurately our revenues and operating expenses. Specifically, we began
operations in January 1998, began shipping the CX100 in the first quarter of
1999 and introduced the SX500 in November 2000. The revenue and income potential
of our products and business are unproven and the market that we are addressing
is rapidly evolving. In addition, we are experiencing limited visibility and
continued uncertainty with respect to many of our competitive local exchange
carrier customers, who also have limited operating histories and who have
recently faced financial difficulties. These financial difficulties have caused
and may continue to cause our customers to cancel or reduce their orders of our
products or to become delinquent in their payments for our prior sales to them.
If our customers continue to reduce orders for our products or become unable to
pay for products already ordered, our operating results will fall below our
expectations and the expectations of investors and market analysts, and the
price of our common stock will decline.

IF DSL TECHNOLOGY FAILS TO GAIN WIDESPREAD MARKET ACCEPTANCE, THE DEMAND FOR OUR
PRODUCTS MAY DECREASE.

     If DSL technology fails to gain widespread acceptance, our revenues and
results of operations will be harmed. Our products are primarily used by local
exchange carriers who offer DSL-based services. Our future success is
substantially dependent upon whether DSL technology gains widespread market
acceptance by local exchange carriers, of which there are a limited number, and
by end users of their services. Local exchange carriers are continuously
evaluating alternative high-speed data access technologies and may at any time
adopt technologies other than DSL. Numerous other high-speed access
technologies, including cable modems, wireless technology and satellite
technologies compete with DSL-based services. Cable modem service can
theoretically provide faster download speeds than DSL. Both wireless and
satellite technologies enable users to transmit and receive information using
radio frequencies at speeds close or comparable to DSL transmission speeds.
These competing technologies may ultimately prove to be superior to DSL-based
services and reduce or eliminate the demand for our products.

IF WE FAIL TO PENETRATE THE INCUMBENT LOCAL EXCHANGE CARRIER MARKET, OUR ABILITY
TO GROW OUR BUSINESS WILL BE JEOPARDIZED.

     Previously, our sales efforts have primarily been focused on competitive
local exchange carriers. We have shifted our focus to penetrating the incumbent
local exchange carrier market and face a number of new challenges, including our
inexperience selling to incumbent carriers, a very long sales cycle, competition
from established suppliers and stringent customer service and support
requirements. In addition, the incumbent carriers may be reluctant to make
additional infrastructure investments or to purchase products from a supplier
with whom they have not previously worked. If we cannot overcome these
challenges and penetrate the incumbent local exchange carrier market, our growth
will be slowed and we may not achieve profitability.

                                        16
<PAGE>   17

SUBSTANTIALLY ALL OF OUR REVENUES COME FROM NEW AND EMERGING COMPETITIVE LOCAL
EXCHANGE CARRIERS, WHOSE INABILITY TO OBTAIN CAPITAL IS CAUSING THEM AND MAY
CONTINUE TO CAUSE THEM TO REDUCE OR DISCONTINUE THEIR PURCHASES OF OUR PRODUCTS.

     Because our current customer base consists principally of new and emerging
businesses, we will not be able to increase our revenues if their business
models, which are largely unproven, are not successful or if their financial
conditions continue to deteriorate. To date, our customers have consisted
principally of competitive local exchange carriers. These carriers require
substantial capital for the development, construction and expansion of their
networks and the introduction of their services. Recently, many of these
carriers have had difficulty in obtaining or have been unable to obtain
financing and have either reduced or discontinued their purchase of our
products. A continued reduction in the financing available to our customers, or
the inability of our customers to obtain financing, will continue to impair our
ability to make future sales as well as to collect amounts due on sales we have
already made. In addition, we may choose to provide financing to our customers,
which will subject us to additional financial risk and may cause us to incur
additional losses. The telecommunications service provider industry has recently
experienced consolidation. The loss of a customer, through industry
consolidation or otherwise, could reduce or eliminate our sales to that
customer.

IF OUR CUSTOMERS ARE UNABLE TO ACQUIRE AND RETAIN DSL SUBSCRIBERS, THEY MAY
CURTAIL THEIR DSL DEPLOYMENT PLANS AND REDUCE THEIR PURCHASES OF OUR PRODUCTS OR
CONTINUE TO HAVE PROBLEMS PAYING FOR OUR PRODUCTS.

     To date, our customers have deployed DSL equipment, including our products,
in substantially larger volumes than their current subscriber count. The
inability of our current or future customers to acquire and retain subscribers
as planned, or to respond to competition for their services or reduced demand
for their services, could cause them to reduce or eliminate their DSL deployment
plans. If our customers are forced to reduce or eliminate their DSL deployment
plans, our sales to them will decline.

     Recently, because of their inability to obtain additional financing or
generate sufficient revenues to fund their operations, a number of our customers
have become delinquent in their payments for our prior sales to them. As of
December 31, 2000, eight of our customers were experiencing financial
difficulties and were not able to stay current in their payments. As a result,
during the fourth quarter of 2000 we recorded a charge to our bad debt reserve
for the receivables of these customers. We cannot assure you that we will ever
be able to collect any payments from these customers. Two of these customers,
Digital Broadband Communications, Inc. and Vectris Communications, Inc., have
filed for bankruptcy protection. With respect to them or any of our customers
that have sought or may seek bankruptcy protection in the future, the bankruptcy
court may require us to return some or all of the payments we received from them
prior to their bankruptcy filing. The inability of our customers to pay us for
prior sales we made to them has and will continue to have a negative impact on
our operating results.

OUR CUSTOMERS HAVE AND MAY CONTINUE TO MAKE AVAILABLE FOR SALE LARGE QUANTITIES
OF OUR PRODUCTS IN THE PUBLIC MARKETPLACE AT DISCOUNTED PRICES, WHICH COULD
RESULT IN LOST SALES AND LOWER GROSS MARGINS FOR US.

     Recently, a number of our customers have decided to scale back or
discontinue their network buildouts or have filed for bankruptcy. As a result,
these customers have and may continue to make available for sale large
quantities of our products in the public marketplace, often at discounted
prices. If our prospective customers choose to purchase our products from these
customers instead of from us, our sales may decline. In addition, we may
experience pricing pressures as a result of the excess supply of our products in
the marketplace, which could force us to lower our average selling prices and
reduce our gross margins.

THE CX100 AND SX500 ARE CURRENTLY OUR ONLY VOLUME PRODUCT OFFERINGS, AND IF THEY
FAIL TO ACHIEVE MARKET ACCEPTANCE, WE WILL NOT BE ABLE TO GROW OUR REVENUES.

     Our future growth and a significant portion of our future revenue depend on
the success of our CX100 and SX500 platforms, which are the only two volume
products that we currently offer. Accordingly, failure of the CX100, SX500 or
future products to maintain meaningful levels of market acceptance and customer
satisfaction would limit our sales and our revenue growth. We only began
shipping the CX100 in the first

                                        17
<PAGE>   18

quarter of 1999, and have not yet recognized any revenue from the SX500, which
was introduced in November 2000. Many potential customers who have evaluated the
CX100 or SX500 have not yet deployed the product in production network
environments and may choose not to deploy our current products or any of our
future products. Other potential customers may have already deployed another
technology and may therefore be unwilling to deploy the CX100 or SX500.

     Even when customers do purchase and deploy our products, due to the variety
and complexity of environments in which the CX100 or SX500 is installed, the
installed product may not operate as expected. Failure of our products to
operate as expected could delay or prevent their volume deployment, which could
decrease our revenues and increase our expenses as we devote additional
development resources to improving product performance. The success and
deployment into our customers' networks of our products will also depend on
customer satisfaction with our products and numerous other factors, including:

     - the realization of operating cost efficiencies for our customers when our
       products are deployed and our customers' ability to quantify these
       operational efficiencies;

     - our successful development of systems and software that address customer
       infrastructure requirements; and

     - our customers' successful integration of our CrossWorks software into
       their operational support systems.

WE DERIVE A MAJORITY OF OUR REVENUES FROM A SMALL NUMBER OF CUSTOMERS, AND ANY
DECREASE IN REVENUES FROM A MAJOR CUSTOMER COULD PREVENT US FROM MEETING
SECURITIES ANALYSTS' EXPECTATIONS AND CAUSE OUR STOCK PRICE TO FALL.

     We began recognizing revenues from the CX100 in the quarter ended March 31,
1999. The majority of our revenues to date have been recognized from a small
number of customers. Purchases by large customers and, therefore, our revenues,
may vary significantly from quarter to quarter. The loss of any one of our major
customers or a reduction or delay in purchases of our products from any one of
these customers would cause our revenues to decline and could cause our stock
price to decline if our revenues are below analysts' expectations. Revenues from
significant customers as a percentage of our total revenues for the years ended
December 31, 2000 and 1999 were as follows:

<TABLE>
<CAPTION>
                                                            2000         1999
                                                        -------------    ----
<S>                                                     <C>              <C>
Lucent Technologies...................................            19%    15%
Rhythms NetConnections................................  Less than 10%    41%
Network Access Solutions..............................  Less than 10%    19%
Covad Communications..................................  Less than 10%    11%
</TABLE>

     We expect that the majority of our revenues will continue to depend on
sales of our products to a small number of customers. In addition, a small
number of customers may account for substantially all of our revenues in any
particular quarter, and these customers may change from quarter to quarter. We
have no long-term contracts with any customers for the purchase of our products,
and customers may reduce or discontinue purchases at any time. Customers may
also delay or cancel purchase orders without penalty.

     There are a limited number of local exchange carriers that are potential
customers, and this number may not increase in the future. Consolidation among
local exchange carriers may increase our reliance on a small number of customers
in future periods. Accordingly, our future revenues will depend significantly
upon the timing and size of future purchase orders from our largest customers.

     In addition, because we are dependent on a limited number of customers, we
expect to experience volatility relating to the budgeting cycles of our
customers and the telecommunications industry in general. For example, the
telecommunications sector recently experienced a general market downturn and
many of our customers have been unable to raise the capital necessary to fund
their budgeted buildout plans, and have ceased or significantly reduced their
purchases of our products or have been unable to pay or delayed payment for
products they had previously purchased. Adverse changes in our revenues or
operating results as a result of

                                        18
<PAGE>   19

these budgeting cycles or any other reduction in capital expenditures by our
large customers have substantially reduced and could continue to substantially
reduce the trading price of our common stock. Some of our customers are
significantly larger than us and are able to exert a high degree of influence
over us. They have sufficient bargaining power to demand low prices and other
terms and conditions that may negatively affect our business and results of
operations.

OUR OPERATING RESULTS MAY FLUCTUATE DUE TO SEASONAL BUYING PATTERNS OF OUR
CUSTOMERS.

     Based on our limited operating history, we believe that on a relative
basis, purchases by our customers tend to be lower in the fourth calendar
quarter. Many of our customers typically establish annual plans for building out
their networks at the beginning of each calendar year. To the extent they are
completed prior to the fourth calendar quarter, some of our customers may decide
to cease or significantly reduce purchases of our products. We cannot be sure,
however, that this trend will continue or that additional patterns of
seasonality will not occur in international markets as we expand our
international operations. Additionally, our customers are affected by a number
of other business factors, including capital availability, DSL adoption rates
and competition, which could greatly alter their network buildout plans and
normal seasonal buying patterns.

THE LONG SALES CYCLE FOR OUR PRODUCTS MAY CAUSE OUR REVENUES AND OPERATING
RESULTS TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER.

     Because the sales cycle for our products is long, our revenues in a given
quarter may not meet market expectations if we experience delays in customer
orders. In addition, we may have incurred substantial sales and marketing
expenses during that quarter, without offsetting revenues. As a result, delays
resulting from our lengthy sales cycle could reduce our revenues and decrease
our profits, or result in a loss. Specifically, our customers' network planning
and purchase decisions normally involve a significant commitment of resources
and a lengthy evaluation and product qualification process. The decision to
purchase our products is made as part of this network planning process, and our
sales cycle can be as long as one year or more. Throughout the sales cycle, we
often spend considerable time and resources educating and providing information
to prospective customers regarding the use and benefits of our products. Even
after making the decision to purchase our products, our customers may delay or
cancel the deployment of our products. Timing of deployment is unpredictable,
can vary widely and depends on a number of factors, many of which are beyond our
control, including:

     - customers' current network deployment procedures;

     - customers' level of expertise;

     - status and performance of customers' other network equipment;

     - degree of software development and integration necessary for the customer
       to deploy our products; and

     - financial and administrative resources of the customer.

INTENSE COMPETITION IN OUR INDUSTRY COULD RESULT IN OUR LOSING CUSTOMERS OR
BEING UNABLE TO ATTRACT NEW CUSTOMERS. AS A RESULT, OUR REVENUE COULD DECLINE OR
WE COULD EXPERIENCE LOSSES.

     The market for telecommunications equipment is highly competitive. If we
are unable to compete effectively, our revenues could decline, our expenses
could increase, and our earnings could decrease or we could experience losses. A
number of companies produce products that compete with ours, including Harris
Corporation, Hekimian Laboratories, a division of Spirent plc, Lucent
Technologies, Nokia Corporation, Nortel Networks, Teradyne Corporation and
Tollgrade Communications. Many of our current and potential competitors have
significantly greater sales and marketing, technical, manufacturing, financial
and other resources. In addition, a number of smaller companies are expected to
produce products that compete with ours. Due to the rapidly evolving market in
which we compete, additional competitors with significant market presence and
financial resources, including other large telecommunications equipment
manufacturers, may enter that market, thereby further intensifying competition.
                                        19
<PAGE>   20

     We also compete with DSL equipment providers, including Alcatel, Lucent,
Nokia and Nortel, who have each announced plans to incorporate competitive
features and functionality into their DSL access multiplexers. A DSL access
multiplexer is a network device, usually located at a telephone company's
central office, that receives signals from multiple DSL connections and puts the
signal on a larger, high-speed transmission line. Lucent has announced plans to
produce DSL access multiplexer products that will include some of the same
features and functions as our CX100 product. If our current and potential
customers choose to deploy DSL access multiplexers that include features and
functions that are competitive with our products, or delay purchases of our
products to evaluate these DSL access multiplexers, our business could be
seriously harmed. To the extent we expand the capabilities of our products to
incorporate functionality traditionally contained in other equipment, we may
also face increased competition from other vendors.

WE EXPECT AVERAGE SELLING PRICES AND GROSS MARGINS OF OUR PRODUCTS TO DECREASE,
AND WE MAY NOT BE SUCCESSFUL IN REDUCING OUR COSTS OR REDESIGNING OUR PRODUCTS
TO REMAIN COMPETITIVE.

     The market for telecommunications equipment is characterized by declining
prices due to increased competition, new products and increasing unit volumes.
Due to competition and potential pricing pressures from large customers in the
future, we expect that the average selling price and gross margins for our
products will decline over time. If we fail to reduce our production costs, our
gross margins will decline rapidly. We may not be successful in redesigning our
products or achieving cost reductions in a timely manner, particularly as we
introduce new products. In addition, redesign may not provide sufficient cost
reductions to allow us to remain competitive.

SOME KEY COMPONENTS IN OUR PRODUCTS COME FROM SOLE OR LIMITED SOURCES OF SUPPLY,
WHICH EXPOSES US TO POTENTIAL SUPPLY INTERRUPTIONS THAT COULD PREVENT OR DELAY
THE MANUFACTURE AND SALE OF OUR PRODUCTS AND COULD REDUCE GROSS MARGINS OF OUR
PRODUCTS.

     Our contract manufacturer currently purchases a number of key components
used in the manufacture of our products from sole or limited sources of supply
for which alternative sources are not currently qualified and may not be
available. In most cases we and our contract manufacturer have no guaranteed
supply arrangement with these suppliers, and we or our contract manufacturer may
fail to obtain these supplies in a timely or cost effective manner. Financial or
other difficulties faced by these suppliers or significant changes in market
demand for, or supply of, these components could limit the availability to us of
these components. We have experienced supply delays in the past and may
experience delays in the future. Such delays could:

     - significantly increase the cost of manufacturing our products and reduce
       gross margins of our products;

     - adversely affect our ability to meet scheduled product deliveries to our
       customers; and

     - cause us to lose sales to existing and future customers.

     In addition, the purchase of these components on a sole source basis
subjects us to risks of price increases and potential quality assurance
problems.

     Our contract manufacturer currently purchases key components for which
there are currently no substitutes available from approximately 8 suppliers. All
of these components are critical to the production of our products, and
competition exists with other manufacturers for these key components. We might
not be able to qualify or identify alternative suppliers in a timely fashion, or
at all. Consolidations involving suppliers could further reduce the number of
alternatives for us and affect the cost of components. An increase in the cost
of components could make our products less competitive and result in lower
margins.

IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD INCUR
ADDITIONAL COSTS AND EXCESS INVENTORY OR EXPERIENCE MANUFACTURING DELAYS AND A
SHORTAGE OF INVENTORY.

     We have a supply contract with A-Plus Manufacturing, a division of C-MAC
Industries Inc., to build our products. We provide product demand forecasts to
A-Plus Manufacturing no less than six months prior to scheduled delivery of
products to our customers. If we overestimate our requirements, A-Plus
Manufacturing may have excess inventory, which we could be obligated to
purchase. If we underestimate our requirements,
                                        20
<PAGE>   21

A-Plus Manufacturing may have inadequate inventory, which could interrupt
manufacturing of our products and result in delays in shipments and revenues, or
add additional costs to our products to expedite delivery of certain long lead
time components.

     In addition, lead times for some of the materials and components used in
our products are very long and depend on factors such as the specific supplier,
contract terms and demand for each component at a given time. If we or A-Plus
Manufacturing fail to carry a sufficient inventory of long lead time items, if
lead times increase or if demand for our products increases unexpectedly, we may
have insufficient access to components necessary to meet demand for our products
on a timely basis. Long lead times for some materials and components have in the
past, and may in the future, cause us to purchase inventories of, or enter into
supply contracts for, some parts ourselves. This may increase our costs, the
risk of the parts' obsolescence and the risk of incurring supply contract
cancellation fees if we overestimate our component requirements.

     As of December 31, 2000, we had excess inventory and purchase commitments
as a result of customer order cancellations, reductions and delays. As a result,
we recorded a charge in the fourth quarter of 2000 to write down our excess
inventory and to accrue for our estimated purchase commitments. If our customers
continue to cancel, reduce or delay their orders or we fail to attract new
customers, we may in the future have to record additional excess inventory
charges.

WE DEPEND ON A SINGLE CONTRACT MANUFACTURER THAT HAS NO OBLIGATION TO PROVIDE US
WITH FIXED PRICING OR QUANTITIES. IF WE ARE UNABLE TO OBTAIN SUFFICIENT PRODUCTS
FROM OUR CONTRACT MANUFACTURER ON ECONOMICAL TERMS, WE MAY NOT BE ABLE TO TIMELY
FILL CUSTOMER ORDERS.

     We rely on a single contract manufacturer, A-Plus Manufacturing, a division
of C-MAC Industries, Inc., to build our products. If A-Plus Manufacturing is
unable to provide us with adequate supplies of high-quality products, or
terminates its relationship with us, we may be unable to fulfill customer orders
on a timely basis, which may delay the DSL deployment schedules of our customers
and strain our relationships with them. Because we currently do not have a
long-term supply contract with A-Plus Manufacturing, they are not obligated to
supply products to us for any specific period, in any specific quantity or at
any certain price, except as may be specified in a particular purchase order.
Our current supply contract with A-Plus Manufacturing can be terminated by
either party with 120 days notice for any reason. If the contract is terminated,
we would be required to purchase any excess inventory held by A-Plus
Manufacturing, they would no longer be obligated to manufacture products for us
and our ability to supply products to our customers could be seriously harmed.
We may be unable to develop alternative manufacturing arrangements on a timely
basis, or at all. In addition, A-Plus Manufacturing may not meet our future
requirements for product quality or timely delivery.

IF WE FAIL TO ENHANCE EXISTING PRODUCTS OR DEVELOP AND SELL NEW PRODUCTS THAT
MEET CUSTOMER REQUIREMENTS, OUR SALES WILL SUFFER.

     Our failure to develop products or offer services that satisfy customer
requirements would reduce our sales and harm our operating results. Many of our
current and potential customers may require product features that our products
do not have. In addition, some potential customers have sought to use our
products for uses we have not anticipated, and we have been required to
determine whether the requested functionality could be integrated into our
product. To the extent we are required to add features to our products in order
to achieve a sale, our sales cycle will lengthen, and we will incur increased
development costs for our products. To increase our sales, we must effectively
anticipate and adapt to customer requirements and offer products and services
that meet customer demands.

IF WE DO NOT MANAGE NEW PRODUCT INTRODUCTIONS EFFECTIVELY, WE COULD EXPERIENCE
CANCELLED ORDERS OR PRODUCT RETURNS OR BE REQUIRED TO PURCHASE OBSOLETE
INVENTORY FROM OUR CONTRACT MANUFACTURER.

     The introduction of new or enhanced products requires that we manage the
transition from older products in order to minimize disruption in customer
ordering patterns and ensure that adequate supplies of new products can be
delivered to meet anticipated customer demand. Our inability to effectively
manage a product transition may cause material delays in the deployment of DSL
services by our customers, which could cause

                                        21
<PAGE>   22

our customers to cancel orders or return our products. The introduction of new
and enhanced products may cause certain customers to defer or cancel orders for,
or to return, existing products. Although we maintain reserves for product
returns, these reserves may not be adequate. In addition, the development of new
or enhanced products could cause inventory held by our contract manufacturer,
A-Plus Manufacturing, to become obsolete. In that event, we could be obligated
to purchase that inventory from A-Plus Manufacturing.

FCC REGULATIONS REGARDING LINE SHARING MAY REDUCE THE DEMAND FOR OUR PRODUCTS IF
INCUMBENT AND COMPETITIVE LOCAL EXCHANGE CARRIERS DECIDE TO SHARE THEIR LINE
MAINTENANCE SYSTEMS.

     On November 18, 1999, the Federal Communications Commission, or FCC,
ordered that line sharing, a network arrangement in which incumbent local
exchange carriers must share the existing subscriber line with competitive local
exchange carriers, be made available to competitive local exchange carriers by
June 6, 2000. To the extent that competitive local exchange carriers elect to
provide DSL services on shared lines that they would have otherwise deployed on
separate lines, the demand for our products could be significantly reduced or
eliminated.

     Adjustments to the FCC's regulations regarding line sharing, new FCC
regulations or regulations set forth by other regulatory bodies may also reduce
demand for our products. Because the competitive local exchange carriers do not
have access to the incumbent local exchange carriers' line maintenance systems,
the competitive local exchange carriers have typically implemented an
independent line maintenance system and several have deployed the CX100 as a key
component of this system. In the future, the FCC may expand line sharing to give
competitive local exchange carriers access to incumbent local exchange carriers'
line maintenance infrastructure, which would eliminate or reduce the need for
our products.

BECAUSE OUR PRODUCTS ARE DEPLOYED IN COMPLEX ENVIRONMENTS, THEY MAY HAVE ERRORS
OR DEFECTS THAT ARE FOUND ONLY AFTER FULL DEPLOYMENT, WHICH COULD RESULT IN
LIABILITY CLAIMS AGAINST US.

     Errors or other problems in our products could result in:

     - loss of or delay in revenues and loss of customers or market share;

     - failure of our products to achieve market acceptance;

     - diversion of development resources;

     - increased service and warranty costs;

     - legal actions by our customers; and

     - increased insurance costs.

     Because our products are designed to provide critical services, if errors,
defects or failures are discovered in our current or future products, or as new
versions are released, we may be exposed to significant legal claims. Any
claims, with or without merit, could damage our reputation and our business,
increase our expenses and impair our operating results. Although we maintain
product liability insurance covering some damages arising from implementation
and use of our products, our insurance may not fully cover claims sought against
us. Liability claims could require us to spend significant time and money in
litigation or to pay significant damages.

     Our products are designed for large and complex networks. To date, our
products have been deployed on a limited basis. Consequently, our customers may
discover errors or defects in our hardware or software only after it has been
fully deployed and operated as part of their infrastructure in connection with
products from other vendors, especially DSL access multiplexers and DSL modems.

WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE FAIL TO DEVELOP AND MAINTAIN
RELATIONSHIPS WITH THIRD PARTIES TO MARKET AND SELL OUR PRODUCTS.

     Our growth will largely be dependent upon relationships with third parties
who market and sell our products. In particular, we and Lucent Technologies are
parties to an original equipment manufacturer
                                        22
<PAGE>   23

agreement under which we have agreed to co-brand and sell our products to
Lucent. If Lucent reduces its purchases of our products or breaches or
terminates the agreement, our business will be harmed. Our agreement does not
require Lucent to sell specified volumes of our products. In addition to our
CX100 products, Lucent resells products manufactured by Tollgrade, a competitor.
Lucent has also introduced DSL access multiplexer products that include some of
the same features and functions as our CX100 product. Lucent may choose to sell
these alternative products or other competing products instead of our products.
We have also entered into nonexclusive, territory-based agreements with several
international resellers of our products. If these reseller arrangements are not
successful, our international growth may be slowed.

IF WE CANNOT ATTRACT EXPERIENCED SALES PERSONNEL, SPECIALIZED ENGINEERS AND
HIGHLY-TRAINED CUSTOMER SERVICE PERSONNEL, WE WILL NOT BE ABLE TO SELL AND
SUPPORT OUR PRODUCTS.

     Our products and services require a sophisticated selling effort targeted
at several key people within our prospective customers' organizations. This
process requires the efforts of experienced sales personnel as well as
specialized systems and consulting engineers. In addition, the complexity of our
products and the difficulty of configuring and maintaining them require highly
trained customer service and support personnel. We intend to hire a significant
number of engineering, sales, marketing and customer service and support
personnel in the future. We believe our success depends, in large part, upon our
ability to attract and retain these key employees. Competition for such persons
is intense, especially in the San Francisco Bay area. We may not be successful
in attracting and retaining these individuals.

WE DEPEND ON A SINGLE APPLICATION SERVICE PROVIDER FOR INFORMATION SYSTEMS AND
SERVICES. IF THOSE SERVICES ARE INTERRUPTED, OUR ABILITY TO PROCESS TRANSACTIONS
WILL BE IMPAIRED.

     We rely on a single application service provider, AristaSoft Corporation,
to provide accounting and operations software and support. If AristaSoft is
unable to provide the level and quality of service we currently anticipate, our
ability to process orders, ship products, prepare invoices and manage our
day-to-day financial transactions will be impaired. Locating and educating a new
application service provider or implementing an alternative solution would be
time consuming and would put further strain on our management personnel. In
addition, the terms of our arrangement with an alternative provider could be
less advantageous, which could increase our expenses. AristaSoft began providing
information systems and services to us on a regular basis in August 1999, at
which time we were their only customer. In December 1999, we entered into a
three year agreement with AristaSoft for access to customer service, financial,
logistics and manufacturing software. In order for us to realize our business
goals, AristaSoft must be able to provide and manage a scalable and reliable
information technology infrastructure to support the growth of our business. If
AristaSoft is unable to meet our expectations, we may be unable to obtain
alternative services on a timely or economical basis.

IF WE FAIL TO MANAGE EXPANSION EFFECTIVELY, THIS WILL PLACE SIGNIFICANT STRAIN
ON OUR MANAGEMENT AND OPERATIONAL RESOURCES.

     We have expanded our operations rapidly since our inception and intend to
continue to expand in order to pursue existing and potential market
opportunities. Our growth places a significant strain on management and
operational resources. Our customer relationships could be strained if we are
unable to devote sufficient resources to them.

WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS THAT COULD LIMIT OUR
SALES AND ADD TO OUR COST OF OPERATIONS.

     We market and sell our products in the United States and have recently
started to sell our products internationally. We intend to expand our
international operations substantially and to enter new international markets.
This expansion will require significant management attention and financial
resources. We may not be able to maintain or increase international market
demand for our products.

                                        23
<PAGE>   24

     We have limited experience in marketing and distributing our products
internationally. International operations are subject to inherent risks,
including:

     - tariffs, export controls and other trade barriers;

     - longer accounts receivable payment cycles, difficulties in collecting
       accounts receivable and foreign currency exchange exposures;

     - difficulties and costs of staffing and managing foreign operations;

     - certification and regulatory requirements with which we may be
       unfamiliar; and

     - reduced protection of intellectual property rights in some countries.

RAPID TECHNOLOGICAL CHANGE IN THE TELECOMMUNICATIONS INDUSTRY COULD RENDER OUR
PRODUCTS OBSOLETE.

     The markets for high-speed telecommunications products are characterized by
rapid technological developments, frequent enhancements to existing products and
new product introductions, changes in customer requirements and evolving
industry standards. Intense competition among numerous high-speed access
technologies has further driven innovation and increasingly complex product
requirements. We may be unable to improve the performance and features of our
products as needed to respond to these developments. The introduction or market
acceptance of products incorporating superior technologies or the emergence of
alternative technologies or new industry standards could render our existing or
potential future products less economical, obsolete and unmarketable. For
example, if semiconductor, robotic or other technologies become effective
alternatives for our product architecture, our products may become obsolete.

WE COULD LOSE OUR COMPETITIVE ADVANTAGE IF WE ARE UNABLE TO PROTECT OUR
INTELLECTUAL PROPERTY.

     If we fail to adequately protect our intellectual property, our competitors
could offer similar products relying on technologies developed by us,
potentially harming our competitive position and decreasing our revenues. We
have filed six patent applications to date. Our existing and future patent
applications, if any, may not be approved, any issued patents may not protect
our intellectual property and any issued patents could be challenged by third
parties. Furthermore, other parties may independently develop similar or
competing technology or design around any patents that may be issued to us.
Attempts may be made to copy aspects of our products or to obtain and use
information that we regard as proprietary. We attempt to protect our
intellectual property by limiting access to the distribution of our software,
documentation and other proprietary information and by relying on a combination
of copyright, trademark and trade secret laws. In addition, we enter into
confidentiality agreements with our employees and certain customers, vendors and
strategic partners. These steps may fail to prevent the misappropriation of our
intellectual property, particularly in foreign countries where the laws may not
protect our intellectual property as fully as in the United States.

IF WE BECOME INVOLVED IN A PROTRACTED INTELLECTUAL PROPERTY DISPUTE, OR ONE WITH
A SIGNIFICANT DAMAGES AWARD, OR WHICH REQUIRES US TO CEASE SELLING OUR PRODUCTS,
WE COULD BE SUBJECT TO SIGNIFICANT LIABILITY AND THE TIME AND ATTENTION OF OUR
MANAGEMENT COULD BE DIVERTED.

     In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights, including among
companies in telecommunications and Internet industries. Intellectual property
claims against us, and any resulting lawsuit, if successful, could subject us to
significant liability for damages and invalidate our intellectual property.
These lawsuits, regardless of their merit, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation also could force us to do one or more
of the following:

     - cease selling, incorporating or using products or services that
       incorporate the infringed intellectual property;

     - obtain from the holder of the infringed intellectual property right a
       license to sell or use the relevant technology, which license may not be
       available on acceptable terms, if at all; or

     - redesign those products or services that incorporate the disputed
       technology.

                                        24
<PAGE>   25

     If we are subject to a successful claim of infringement against us and fail
to develop non-infringing technology or license the infringed technology on
acceptable terms and on a timely basis, our revenues may decline or our expenses
may increase.

     We may in the future initiate claims or litigation against third parties
for infringement of our proprietary rights or to determine the scope and
validity of our proprietary rights or the proprietary rights of competitors.
These claims could result in costly litigation and the diversion of our
technical and management personnel.

CONTROL BY OUR EXISTING STOCKHOLDERS MAY LIMIT YOUR ABILITY TO INFLUENCE MATTERS
REQUIRING STOCKHOLDER APPROVAL AND COULD DELAY OR PREVENT A CHANGE IN CONTROL,
WHICH COULD PREVENT YOU FROM REALIZING A PREMIUM IN THE MARKET PRICE OF OUR
COMMON STOCK.

     The concentration of ownership of our common stock by existing stockholders
could delay or prevent a change in our control or discourage a potential
acquirer from attempting to obtain control of us, which could cause the market
price of our common stock to fall or prevent our stockholders from realizing a
premium in the market price associated with an acquisition. As of December 31,
2000, our executive officers, directors and principal stockholders and their
affiliates owned 46,200,899 shares or approximately 70.4% of the outstanding
shares of common stock. These stockholders, if acting together, would be able to
significantly influence all matters requiring approval by our stockholders,
including the election of directors and the approval of mergers or other
business combination transactions. For information about the ownership of common
stock by our executive officers, directors and principal stockholders, see
"Security Ownership of Certain Beneficial Owners and Management".

WE EXPECT TO EXPERIENCE VOLATILITY IN OUR STOCK PRICE WHICH COULD NEGATIVELY
AFFECT YOUR INVESTMENT.

     Prior to February 2000, you could not buy or sell our common stock
publicly. An active public market for our common stock may not be sustained in
the future. The market for technology stocks has been extremely volatile. The
following factors could cause the market price of our common stock to fluctuate
significantly from the original purchase prices paid by investors:

     - announcements by us or our competitors of significant contracts, new
       products or technological innovations, acquisitions, strategic
       relationships, joint ventures or capital commitments;

     - changes in financial estimates by securities analysts;

     - release of lock-up or transfer restrictions on our outstanding shares of
       common stock or sales of additional shares of common stock;

     - changes in market valuations of networking and telecommunications
       companies; and

     - fluctuations in stock market prices and volumes.

SHOULD OUR STOCKHOLDERS SELL A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK
IN THE PUBLIC MARKET, THE PRICE OF OUR COMMON STOCK COULD FALL.

     Our executive officers, directors and principal stockholders and their
affiliates hold a substantial number of shares, which they are able to sell in
the public market, subject to some restrictions under federal securities laws.
Sales of a substantial number of shares of our common stock at any time could
reduce the market price of our common stock. In addition, the sale of these
shares could impair our ability to raise capital through the sale of additional
equity securities.

WE RELY ON A CONTINUOUS POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND CALIFORNIA'S
CURRENT ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND INCREASE OUR EXPENSES.

     California is in the midst of an energy crisis that could disrupt our
operations and increase our expenses. In the event of an acute power shortage,
that is, when power reserves for the State of California fall below 1.5%,
California has on some occasions implemented, and may in the future continue to
implement, rolling blackouts throughout California. We currently do not have
backup generators or alternate sources of power in
                                        25
<PAGE>   26

the event of a blackout, and our current insurance does not provide coverage for
any damages we or our customers may suffer as a result of any interruption in
our power supply. If blackouts interrupt our power supply, we would be
temporarily unable to continue operations at our facilities. Blackouts may also
impair the operations of A-Plus Manufacturing, upon whom we depend for all our
manufacturing needs, and Aristasoft Corporation, upon whom we depend for
accounting and operations software and support. Any such interruption in our
ability to continue our operations could damage our reputation, harm our ability
to retain existing customers and to obtain new customers, and could result in
lost revenue, any of which could substantially harm our business and results of
operations.

     Furthermore, the deregulation of the energy industry instituted in 1996 by
the California government has caused power prices to increase. Under
deregulation, utilities were encouraged to sell their plants, which
traditionally had produced most of California's power, to independent energy
companies that were expected to compete aggressively on price. Instead, due in
part to a shortage of supply, wholesale prices have skyrocketed over the past
year. If wholesale prices continue to increase, our operating expenses will
likely increase, as substantially all of our facilities are located in
California.

THE LOSS OF A-PLUS MANUFACTURING, TURNSTONE'S SOLE MANUFACTURER, DUE TO
INTERRUPTION IN CALIFORNIA'S ELECTRIC POWER SUPPLY, WOULD NEGATIVELY IMPACT
TURNSTONE'S ABILITY TO MANUFACTURE AND SELL ITS PRODUCTS.

     We rely on A-Plus Manufacturing as our sole contract manufacturer. The
locations of A-Plus Manufacturing that are responsible for manufacture of our
products are located exclusively in Northern California. Recently, California
has been experiencing a shortage of electric power supply that has resulted in
intermittent loss of power in the form of rolling blackouts. While A-Plus has
not experienced any power failures to date that have prevented their ability to
manufacture our products, the continuance of blackouts may affect A-Plus's
ability to manufacture our products, meet our requirements for product quality,
and meet scheduled delivery needs.

     Furthermore, because we currently do not have a long-term supply contract
with A-Plus Manufacturing, they are not obligated to supply products to us for
any specific period, in any specific quantity or at any certain price, except as
may be specified in a particular purchase order. If wholesale prices for
electricity continue to increase, A-Plus may increase the prices they charge us
for manufacturing our products. An increase in the cost of our products could
make our products less competitive and result in lower margins.

ITEM 2. PROPERTIES

     Our principal administrative, sales, marketing and research and development
facility occupies approximately 62,500 square feet in Santa Clara, California
under a lease that expires in June 2010. We also have a lease, expiring in
January 2003, for approximately 9,400 square feet of space in Mountain View,
California, which we are currently subleasing to a third party. Our New Zealand
facility occupies approximately 1,100 square meters in Wellington, New Zealand
under a lease that expires in July 2005. We have sales offices throughout the
United States and internationally, including regional sales offices in ten
states and international sales offices in Australia, Germany and the United
Kingdom.

     The commercial real estate market in the San Francisco Bay area is volatile
and unpredictable in terms of location, availability and rental rates. We cannot
assure you that additional space will be available or affordable if and when we
require it.

ITEM 3. LEGAL PROCEEDINGS

     We are not a party to any material legal proceedings.

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

     No matters were submitted to a vote of security-holders during the fourth
quarter of the fiscal year covered by this report.

                                        26
<PAGE>   27

ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT

     Our executive officers and their ages, as of December 31, 2000, are as
follows:

<TABLE>
<CAPTION>
                NAME                   AGE                     POSITION(S)
                ----                   ---                     -----------
<S>                                    <C>    <C>
Richard N. Tinsley...................  36     President, Chief Executive Officer and
                                              Director
P. Kingston Duffie...................  40     Chief Technology Officer and Director
Terrence J. Schmid...................  37     Chief Financial Officer
Eric J. Andrews......................  35     Vice President, Marketing
Gary D. Corbin.......................  52     Chief Information Officer
Michael A. Crumlin...................  39     Vice President, Sales
John Loiacono IV(1)..................  37     Vice President, Business Development
Catherine Millet.....................  48     Vice President, Engineering
Shames S. Panahi.....................  42     Vice President, Operations
M. Denise Savoie(2)..................  45     Vice President, Business Operations
Edward S. Thompson...................  53     Vice President, Customer Service Worldwide
</TABLE>

---------------
(1) Mr. Loiacono IV has informed us that he intends to resign as an officer and
    employee of Turnstone, effective March 21, 2001.

(2) Ms. Savoie resigned as an officer and employee of Turnstone, effective
    February 19, 2001.

     RICHARD N. TINSLEY cofounded Turnstone Systems in January 1998 and has
served as President and Chief Executive Officer and as a director since that
time. From August 1997 to December 1997, Mr. Tinsley was a consultant to the
venture capital firms Institutional Venture Partners and Benchmark Capital
Partners. From September 1993 to August 1997, Mr. Tinsley held various positions
at Newbridge Networks, a designer and manufacturer of networking products, most
recently as Vice President and General Manager, VIVID Business Unit. Mr. Tinsley
holds an M.B.A. from the University of Dallas and a B.S. in electrical
engineering from Rennselaer Polytechnic Institute.

     P. KINGSTON DUFFIE cofounded Turnstone Systems in January 1998 and has
served as Chief Technology Officer and as a director since that time. From
January 1998 to April 1999, he also served as Vice President, Engineering. From
August 1997 to January 1998, Mr. Duffie was a consultant to Institutional
Venture Partners and Matrix Partners. From May 1997 to July 1997, Mr. Duffie was
Assistant Vice President, Engineering, Data Communications division, for Ascend
Communications, a developer and manufacturer of wide area networking equipment.
From March 1993 until April 1997, Mr. Duffie was Chief Technology Officer at
Whitetree, Inc., a developer and manufacturer of high-speed switching products,
which was acquired by Ascend Communications in April 1997. From April 1994 until
August 1996, he also served as Vice President, Engineering of Whitetree. Mr.
Duffie holds an M.S. in electrical engineering from McGill University in
Montreal and a B.Sc. (Eng.) in engineering physics from Queen's University in
Kingston, Ontario.

     TERRENCE J. SCHMID joined Turnstone Systems in June 2000 and has served as
Chief Financial Officer since that time. From February 1998 to June 2000 he
served as Chief Financial Officer and Vice President, Finance and Administration
of ONI Systems, an optical networking company. From April 1996 to February 1998,
Mr. Schmid was Vice President, Finance and Chief Financial Officer of The 3DO
Company, an entertainment software company. From 1993 to April 1996, he worked
in the finance division of Electronic Arts, an entertainment software company.
Mr. Schmid holds an M.B.A. from Duke University and a B.A. in Economics from the
University of San Francisco.

     ERIC J. ANDREWS joined Turnstone Systems in February 1998 and has served as
Vice President, Marketing since that time. From April 1993 to January 1998, Mr.
Andrews held various marketing positions at Newbridge Networks, most recently as
Assistant Vice President of Marketing, VIVID Business Unit. Mr. Andrews holds an
M.S. and a B.S. in computer science and electrical engineering from the
Massachusetts Institute of Technology.

                                        27
<PAGE>   28

     GARY D. CORBIN joined Turnstone Systems in January 2000 and has served as
Chief Information Officer since that time. From October 1997 to January 2000, he
was Director of Information Technology for Omnicell Technologies, a provider of
supply and pharmaceutical point-of-use systems to hospitals and clinics. From
January 1997 to August 1997 he served as Director of Business Applications for
Remedy Corporation, a software company. From May 1995 to December 1997 Mr.
Corbin served as Director of Business Applications for Acuson Corporation, a
maker of medical ultrasound devices. From December 1989 to May 1995 he served as
an information technology consultant to Acuson Corporation. Mr. Corbin holds a
B.S. in Industrial Technology from San Jose State University.

     MICHAEL A. CRUMLIN joined Turnstone Systems in March 1999 and has served as
Vice President, Sales and Customer Service since that time. From August 1998 to
February 1999, Mr. Crumlin was Vice President of Business Development for
e.spire Communications, a provider of integrated communications services. From
November 1996 to August 1998, Mr. Crumlin was Director of Marketing of Yurie
Systems, a manufacturer of telecommunications equipment, which was acquired by
Lucent Technologies, a provider of communications and networking products, in
May 1998. From April 1995 to August 1996, Mr. Crumlin was a co-founder and
Director of Marketing & Business Development of TSI TelSys, a developer of
satellite data processing systems. Mr. Crumlin holds an M.B.A. from Harvard
Business School and a B.S. in engineering from the United States Military
Academy at West Point.

     JOHN LOIACONO IV joined Turnstone Systems in September 1999 and has served
as Vice President, Business Development since that time. From September 1994 to
September 1999, Mr. Loiacono was Director of Systems Engineering, Europe,
Middle-East, Africa at Bay Networks, Inc., a provider of internetworking
solutions, which was acquired by Nortel Networks, a supplier of
telecommunications equipment products, in August 1998. Mr. Loiacono holds a B.S.
in computer science from California State University -- San Francisco.

     CATHERINE MILLET joined Turnstone Systems in April 1999 and has served as
Vice President, Engineering since that time. From December 1997 to April 1999,
Ms. Millet held various senior management positions at Advanced Fibre
Communications, a designer and manufacturer of multi-service access solutions
for telecommunications providers, most recently as Vice President of
Engineering. From September 1994 to December 1997, Ms. Millet held various
senior management positions at DSC Communications, a provider of
telecommunications products, most recently as Vice President of Advanced
Planning. Ms. Millet holds an M.S.E.E. equivalent from the Ecole Superieure d'
Electricite in Paris.

     SHAMES S. PANAHI joined Turnstone Systems in February 1998 and has served
as Vice President, Operations since that time. From October 1995 to June 1997,
Ms. Panahi was Director of Manufacturing at Whitetree. From June 1992 to October
1995, Ms. Panahi was Manufacturing Engineering Manager at Adaptive/Network
Equipment Technologies, a designer and manufacturer of wide area networks. Ms.
Panahi holds a B.S. in industrial engineering from Northwestern University.

     M. DENISE SAVOIE cofounded Turnstone Systems in January 1998 and has served
as Vice President of Business Operations since that time. She also served as
Chief Financial Officer from January 1998 until June 2000. From May 1997 to
December 1997, Ms. Savoie worked as an independent consultant. From May 1993 to
May 1997, Ms. Savoie served as Vice President of Business Operations and Chief
Financial Officer at Whitetree. Ms. Savoie holds a B.A. in economics from the
University of Michigan and a B.A. in art from Whitman College.

     EDWARD S. THOMPSON joined Turnstone Systems in December 2000 and has served
as Vice President, Customer Service Worldwide since that time. From May 2000 to
November 2000, Mr. Thompson served as Vice President, U.S. Operations at DG
Systems, Inc., a digital distributor of broadcast advertising. From August 1995
to April 2000, Mr. Thompson served as Vice President of Technical Operations at
Allied Telesyn International, Inc., a provider of networking solutions. Mr.
Thompson holds a B.S. in mathematics from University of Texas and a B.S. in
computer science from Trinity University.

                                        28
<PAGE>   29

                                    PART II

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

     Our common stock has traded on the Nasdaq National Market under the symbol
"TSTN" since February 1, 2000. The price range per share reflected in the table
below, is the highest and lowest sale price for our stock as reported by the
Nasdaq National Market during each quarter the stock has been publicly traded.
Our present policy is to retain earnings, if any, to finance future growth. We
have never paid cash dividends and have no present intention to pay cash
dividends. At February 28, 2001, there were approximately 443 stockholders of
record and the price per share of our common stock was $6.44.

<TABLE>
<CAPTION>
                                                          THREE MONTHS ENDED
                                        ------------------------------------------------------
                                        MARCH 31,    JUNE 30,    SEPTEMBER 30,    DECEMBER 31,
                                          2000         2000          2000             2000
                                        ---------    --------    -------------    ------------
<S>                                     <C>          <C>         <C>              <C>
Price range per share:
  High................................   $95.25       $94.59        $107.00          $50.13
  Low.................................   $47.75       $23.00        $ 44.50          $ 5.13
</TABLE>

     The above information has been restated to reflect the two-for-one stock
split, effected in the form of a stock dividend on August 23, 2000 to each of
our stockholders of record as of August 9, 2000.

                                        29
<PAGE>   30

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and the notes to the
consolidated financial statements and "Management's Discussion and Analysis of
Financial Condition and Results of Operations," which are included elsewhere in
this report. The consolidated statement of operations data for the years ended
December 31, 2000 and 1999 and for the period from January 2, 1998 (inception)
to December 31, 1998, and the consolidated balance sheet data as of December 31,
2000, 1999 and 1998 are derived from our audited consolidated financial
statements.

<TABLE>
<CAPTION>
                                                                                      PERIOD FROM
                                                                                       JANUARY 2,
                                                                  YEARS ENDED             1998
                                                                 DECEMBER 31,        (INCEPTION) TO
                                                              -------------------     DECEMBER 31,
                                                                2000       1999           1998
                                                              --------    -------    --------------
                                                              (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                           <C>         <C>        <C>
STATEMENT OF OPERATIONS DATA:
Net revenues................................................  $149,365    $27,196       $    --
Cost of revenues:
  Cost of products sold.....................................    61,058     12,359            --
  Write-down of inventory...................................     4,098         --            --
  Provision for purchase commitments........................     7,300         --            --
                                                              --------    -------       -------
        Total cost of revenues..............................    72,456     12,359            --
Gross profit................................................    76,909     14,837            --
Operating expenses:
  Research and development (exclusive of non-cash
    compensation expense of $3,766, $1,639 and $9 for 2000,
    1999 and 1998, respectively)............................    18,729      5,731         3,462
  Sales and marketing (exclusive of non-cash compensation
    expense of $1,885, $846 and $17 for 2000, 1999 and 1998,
    respectively)...........................................    13,268      3,912           737
  General and administrative (exclusive of non-cash
    compensation expense of $1,366, $1,099 and $3 for 2000,
    1999 and 1998, respectively)............................     6,894      1,559           713
  Amortization of intangible assets.........................       635         --            --
  Amortization of deferred stock compensation...............     7,017      3,584            29
                                                              --------    -------       -------
        Total operating expenses............................    46,543     14,786         4,941
Operating income (loss).....................................    30,366         51        (4,941)
Interest income (expense) and other, net....................     7,960        180           193
                                                              --------    -------       -------
Income (loss) before income tax expense.....................    38,326        231        (4,748)
Income tax expense..........................................    15,964        463             1
                                                              --------    -------       -------
Net income (loss)...........................................  $ 22,362    $  (232)      $(4,749)
Basic net earnings (loss) per share of common stock(1)......  $   0.45    $ (0.03)      $ (1.99)
Diluted net earnings (loss) per share of common stock(1)....  $   0.34    $ (0.03)      $ (1.99)
Weighted-average shares of common stock outstanding used in
  computing basic net earnings (loss) per share of common
  stock(1)..................................................    49,964      8,474         2,390
                                                              ========    =======       =======
Weighted-average shares of common stock outstanding used in
  computing diluted net earnings (loss) per share of common
  stock(1)..................................................    66,069      8,474         2,390
                                                              ========    =======       =======
</TABLE>

<TABLE>
<CAPTION>
                                                                      DECEMBER 31,
                                                              -----------------------------
                                                                2000       1999       1998
                                                              --------    -------    ------
                                                                     (IN THOUSANDS)
<S>                                                           <C>         <C>        <C>
BALANCE SHEET DATA:
Cash and cash equivalents...................................  $199,091    $ 8,063    $1,338
Working capital.............................................   283,182     10,969       960
Total assets................................................   345,997     19,257     1,970
Long-term obligations under capital leases, net of current
  portion...................................................        41        260       270
Total stockholders' equity..................................  $320,627    $11,891    $1,226
</TABLE>

---------------
(1) See Note 2 of our Notes to Consolidated Financial Statements for information
    concerning the computation of the shares used to compute net earnings (loss)
    per share of common stock. All share and per share data have been adjusted
    to give effect to our two-for-one stock split to holders of record on August
    9, 2000.

                                        30
<PAGE>   31

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

     The following discussion and analysis of the financial condition and
results of operations of Turnstone Systems, Inc. should be read in conjunction
with "Selected Consolidated Financial Data" and Turnstone's consolidated
financial statements and related notes appearing elsewhere in this report. This
discussion and analysis contains forward-looking statements that involve risks,
uncertainties and assumptions. The actual results may differ materially from
those anticipated in these forward-looking statements as a result of certain
factors, including but not limited to, those set forth under "Business -- Risk
Factors" and elsewhere in this report.

OVERVIEW

     From inception on January 2, 1998 through December 1998, our operating
activities consisted primarily of research and development and building our
management team. We introduced our first products in October 1998, and entered
live service trials in November 1998. In January 1999, our CX100 was certified
as being compliant with Network Equipment Building Standards (NEBS), a
telecommunications industry standard. We began shipping our products in the
first quarter of 1999. To date, we have derived substantially all of our
revenues from sales of our CX100. Revenues from our CrossWorks software have not
been material. Our success will depend on our ability to sell our CX100 to
additional customers, our ability to generate revenue from our recently
introduced SX500 as well as our ability to develop and sell additional products.

     We recognize revenue from product sales based upon shipment of products
pursuant to customer purchase orders, assuming that the price to customer is
fixed or determinable and that collectibility of the resulting receivable is
probable. When the arrangement with the customer includes future obligations for
which fair value does not exist or when customer acceptance is required, revenue
is recognized when those obligations have been met or customer acceptance has
been received. Our policy generally does not allow for product returns. We
maintain an estimated reserve for potential returns based on a minimal level of
returns on a historical basis. Revenue from services and support provided under
the our maintenance programs are deferred based upon the fair value of the
program and recognized on a straight-line basis over the period of the contract.
We provide twelve months warranty for product shipments not already covered
under maintenance programs. Costs associated with the warranty program are
estimated and accrued for at the time of product shipment. Revenue from
consulting and training are deferred based on the fair value of the services,
and recognized when such services are completed.

     We sell our products to domestic and international local exchange carriers
through our direct sales force, third-party resellers and through an indirect
original equipment manufacturer channel. A customer's network planning and
purchase decisions normally involve a significant commitment of its resources
and a lengthy evaluation and product qualification process. Since the decision
to purchase the CX100 or SX500 is made as part of this network planning process,
our sales cycle is lengthy, often as long as one year or more. Substantially all
of our sales are made on the basis of purchase orders rather than long-term
agreements. As a result, we commit resources to the development and production
of products without having received advance purchase commitments from customers.

     Based on our limited operating history, we believe that on a relative
basis, purchases by our customers tend to be lower in the fourth calendar
quarter. Many of our customers typically establish annual plans for building out
their networks at the beginning of each calendar year. To the extent they are
completed prior to the fourth calendar quarter, some of our customers may decide
to cease or significantly reduce purchases of our products. We cannot be
certain, however, that this trend will continue or that additional patterns of
seasonality will not occur in international markets as we expand our
international operations. Additionally, our customers are affected by a number
of other business factors, including capital availability, DSL adoption rates
and competition, which could greatly alter their network buildout plans and
normal seasonal buying patterns.

     To date, a significant portion of our revenues has resulted from a small
number of relatively large orders from a limited number of customers. We
anticipate that our operating results for any given period will continue to be
dependent to a significant extent on large purchase orders, which can be delayed
or cancelled by
                                        31
<PAGE>   32

our customers without penalty. In addition, we anticipate that our operating
results for a given period will continue to be dependent on a small number of
customers. If we fail to receive a significant purchase order that we expect for
a given quarter, our revenues for that quarter, and possibly following quarters,
will be adversely affected. Recently, a number of our customers have experienced
financial difficulties and have either reduced or canceled their purchases of
our products or have become delinquent in their payments for our prior sales to
them. If our customers continue to reduce orders for our products or become
unable to pay for products already ordered, our operating results will be
negatively impacted.

     We currently use A-Plus Manufacturing, a contract manufacturer, to
manufacture our products. A-Plus Manufacturing is a division of C-MAC Industries
Inc., a large international contract manufacturer. This subcontracting
arrangement includes material procurement, board level assembly, final assembly,
testing and shipment to our customers. If our contract with A-Plus Manufacturing
were terminated, we would be required to purchase any excess inventory held by
them. In addition, the development of new or enhanced products could cause
inventory held by A-Plus Manufacturing to become obsolete. In that event, we
would also be obligated to purchase that inventory from them. We use a
combination of standard parts and components that are generally available from
more than one vendor, and certain key components that are purchased from sole or
limited source vendors for which alternative sources are not currently
available. In addition, lead times for some of the materials and components we
use are very long. Further, the market for components used in telecommunications
equipment has been characterized by frequent shortages for many components.
These long lead times and component shortages have in the past caused, and may
in the future cause, us to purchase inventories of some parts ourselves ahead of
demand. Limited sources of supply of, and competition with other manufacturers
for, key components may increase the price we pay to obtain these components and
lower our gross margins. We have in the past written off components purchased in
excess of forecast demand. If we purchase or commit to purchase components in
excess of actual demand in future periods, we may have to write-off the unused
inventory and may also incur supply contract cancellation fees. Any write-off of
inventory or incurrence of cancellation fees could harm our results of
operations and financial condition.

     We continue to develop additional products and product features based on
our assessment of the needs of our customers. This has resulted in increased
research and development expenses and may result in reduced operating margins on
our products and a longer sales cycle.

     Currently, competition in our market is intense. Due to competition and
potential pricing pressures from large customers in the future, we expect that
the average selling price and gross margins for our products will decline over
time. If we fail to reduce our production costs, our gross margins will decline
rapidly.

     In connection with the granting of stock options to our employees, we
recorded deferred stock-based compensation totaling approximately $17.2 million
from inception through December 31, 2000. This amount represents the difference
between the exercise price and the deemed fair value of our common stock on the
date these stock options were granted. We are amortizing the deferred stock
compensation over the vesting periods of the applicable options and the
repurchase periods for restricted stock purchases. The service period over which
deferred stock compensation is amortized is determined separately for each 25%
portion of the total award, in accordance with Financial Accounting Standards
Board Interpretation No. 28. The result of this accounting treatment is that
approximately 52% of the unearned deferred compensation will be amortized in the
first year, 27% in the second year, 15% in the third year and 6% in the fourth
year following the date of the grant. We recorded related stock-based
compensation amortization expense of $3.6 million in 1999 and $29,000 in 1998.
We recorded $1.5 million of related stock-based compensation amortization
expense during the three months ended December 31, 2000 and $7.0 million of such
expense during the twelve months ended December 31, 2000. As of December 31,
2000, we had an aggregate of $6.7 million of related deferred compensation to be
amortized. The amortization of this amount will result in additional charges to
operations through 2004. The amortization of stock-based compensation is
presented as a separate component of operating expenses in our statements of
operations.

     In August 2000, we acquired Paragon Solutions Limited, a privately held New
Zealand company, for a total acquisition cost of a minimum of $7.5 million in
cash, and an additional $2.5 million in cash upon the first anniversary of the
acquisition if certain conditions specified in the purchase agreement are met.
We

                                        32
<PAGE>   33

accounted for the transaction using the purchase method of accounting. The
purchase price allocation includes an allocation of $6.5 million to goodwill and
other intangibles, which we are amortizing on a straight-line basis over four
years. Amortization of intangible assets totaled $0.6 million for the year ended
December 31, 2000.

STOCK SPLIT

     In July 2000, our Board of Directors approved a two-for-one stock split of
our common stock, effected in the form of a stock dividend on August 23, 2000 by
distribution to each stockholder of record as of August 9, 2000 of one share of
common stock for each share of common stock held.

RESULTS OF OPERATIONS

     The following table sets forth certain statements of operations data as a
percentage of net revenues for the periods indicated. The data has been derived
from the consolidated financial statements contained in this report. This
information should be read in conjunction with the consolidated financial
statements included in this report.

<TABLE>
<CAPTION>
                                                               YEARS ENDED
                                                               DECEMBER 31,
                                                              --------------
                                                              2000     1999
                                                              -----    -----
<S>                                                           <C>      <C>
Net revenues................................................  100.0%   100.0%
Cost of revenues:
  Cost of products sold.....................................   40.9     45.4
  Write-down of inventory...................................    2.7       --
  Provision for purchase commitments........................    4.9       --
                                                              -----    -----
          Total cost of revenues............................   48.5     45.4
Gross profit................................................   51.5     54.6
Operating expenses:
  Research and development (exclusive of non-cash
     compensation expense of $3,766 and $1,639 for 2000 and
     1999, respectively)....................................   12.5     21.1
  Sales and marketing (exclusive of non-cash compensation
     expense of $1,885 and $846 for 2000 and 1999,
     respectively)..........................................    8.9     14.4
  General and administrative (exclusive of non-cash
     compensation expense of $1,366 and $1,099 for 2000 and
     1999, respectively)....................................    4.6      5.7
  Amortization of intangible assets.........................    0.4       --
  Amortization of deferred stock compensation...............    4.7     13.2
                                                              -----    -----
          Total operating expenses..........................   31.2     54.4
Operating income (loss).....................................   20.3      0.2
Interest income (expense) and other, net....................    5.3      0.7
                                                              -----    -----
Income (loss) before income tax expense.....................   25.7      0.8
Income tax expense..........................................   10.7      1.7
                                                              -----    -----
Net income (loss)...........................................   15.0%    (0.9)%
</TABLE>

FISCAL YEARS ENDED DECEMBER 31, 2000 AND 1999

NET REVENUES

     Net revenues increased to $149.4 million for the year ended December 31,
2000 from $27.2 million for the comparable period in 1999. The increase in net
revenues is primarily the result of increased shipments of our CX100 due to the
expansion of our sales force and to a larger domestic and international customer
base. Our revenues to date have been recognized from a small number of
customers. We expect that the majority of our revenue will continue to depend on
sales of the CX100 and the recently introduced SX500 to a small number of
customers. During the three months ended December 31, 2000 revenue from
international customers totaled 16.0% of our net revenues and 12.3% for the
twelve months ended December 31, 2000. We expect revenue from international
customers to increase as a percentage of net revenues.

                                        33
<PAGE>   34

COST OF REVENUES

     Cost of revenues increased to $72.5 million, or 48.5% of net revenues, for
the year ended December 31, 2000 from $12.4 million, or 45.4% of net revenues,
in the comparable period of 1999. Cost of revenues includes amounts paid to
A-Plus Manufacturing and related overhead expenses, consisting primarily of
salary and other expenses for personnel engaged in procurement, vendor
management, quality assurance and customer support. Cost of revenues for the
year ended December 31, 2000 also includes a charge of $11.4 million taken in
the fourth quarter to write down the value of inventory in excess of forecasted
requirements. The $11.4 million charge includes a $4.1 million charge to write
down the value of inventory on-hand at December 31, 2000 and $7.3 million to
accrue a liability for commitments made for future delivery of raw materials in
excess of forecasted requirements. The increase in cost of revenues reflects the
increase in CX100 sales. Cost of revenues as a percentage of net revenues has
increased due to the $11.4 million charge taken during the fourth quarter of
2000.

RESEARCH AND DEVELOPMENT

     Research and development expenses, net of non-cash compensation expense of
$3.8 million for the year ended December 31, 2000 and $1.6 million in the
comparable period of 1999, consist primarily of salaries and related expenses
for personnel engaged in research and development, fees paid to consultants and
outside service providers, cost of certification and compliance testing and
material costs for prototype and test units. They also include 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 227% to $18.7 million for the
year ended December 31, 2000 from $5.7 million in the comparable period of 1999.
This increase in research and development expenses was due primarily to a
significant increase in personnel and related costs associated with new product
development, verification testing, certification and compliance testing and
other engineering expenses. Development of new features and products is
essential to our future success and we expect that research and development
expenses will increase in absolute dollars in future periods.

SALES AND MARKETING

     Sales and marketing expenses, net of non-cash compensation expense of $1.9
million for the year ended December 31, 2000 and $0.8 million in the comparable
period of 1999, consist primarily of salaries, commissions, and related expenses
for personnel engaged in marketing, sales and customer support functions. These
expenses also include costs associated with trade shows, promotional activities
and public relations.

     Sales and marketing expenses increased 239% to $13.3 million for the year
ended December 31, 2000 from $3.9 million in the comparable period of 1999. This
increase was primarily due to an increase in the number of sales and marketing
personnel, increased commissions associated with higher net revenues, increased
sales and sales support personnel, increased tradeshow activities and marketing
expenses, and other customer-related costs.

     We intend to expand our sales and marketing operations and efforts in order
to increase market awareness and to generate sales of our products. We expect
that sales and marketing expenses will increase in absolute dollars in future
periods.

GENERAL AND ADMINISTRATIVE

     General and administrative expenses, net of non-cash compensation expense
of $1.4 million for the year ended December 31, 2000 and $1.1 million in the
comparable period of 1999, consist primarily of salaries and related expenses
for executive, finance, accounting, professional fees, costs associated with
expanding our information systems as well as charges taken to increase our
allowance for bad debt.

     General and administrative expenses increased 331% to $6.9 million for the
year ended December 31, 2000 from $1.6 in the comparable period of 1999. This
increase was primarily due to an increase in the number of general and
administrative personnel, increased facilities costs, increased legal and
accounting
                                        34
<PAGE>   35

expenses associated with our growing business activities and a $2.1 million
charge taken in the fourth quarter of the year ended December 31, 2000 to
increase our allowance for bad debt.

     We expect to add personnel and incur additional costs related to growing
our business, expanding our information infrastructure and operating as a public
company.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

     As of December 31, 2000, deferred stock compensation for stock options
granted at prices deemed to be below fair value on the date of grant totaled
$6.7 million. We amortized approximately $7.0 million in the year ended December
31, 2000 and $3.6 million for the comparable period in 1999, of deferred stock
compensation.

INTEREST INCOME (EXPENSE) AND OTHER, NET

     Interest income (expense) and other, net includes income from our cash
investments net of expenses related to our lease financing obligations. We had
net interest and other income of $8.0 million for the year ended December 31,
2000 and net interest and other income of $0.2 million for the comparable period
in 1999. Interest income increased primarily from interest earned on the net
cash proceeds of approximately $92.1 million received in connection with the
completion of our initial public offering in February 2000 and $165.5 million
received in connection with the completion of our secondary offering in
September 2000. In future periods we expect interest income (expense) and other,
net to vary depending upon changes in the amount and mix of interest-bearing
investments and short and long-term debt outstanding during each period.

INCOME TAX EXPENSE

     We have recorded a tax provision of $16.0 million for the year ended
December 31, 2000 consisting primarily of federal and state taxes at an
effective tax rate of 41.7%. Income tax expense for the year ended December 31,
1999 was $463,000 and consisted primarily of federal and minimum state taxes.

FISCAL YEARS ENDED DECEMBER 31, 1999 AND 1998

NET REVENUES

     The quarter ended March 31, 1999 was the first quarter in which we recorded
revenue. Net revenues were $27.2 million for the year ended December 31, 1999,
resulting primarily from sales of our CX100.

COST OF REVENUES

     Cost of revenues for the year ended December 31, 1999 was $12.4 million,
attributable primarily to the commencement of manufacturing and sales of our
CX100. Because we did not generate any revenues during the period from January
2, 1998 (inception) to December 31, 1998, we incurred no cost of revenues for
that period.

RESEARCH AND DEVELOPMENT

     Research and development expenses, net of non-cash compensation expense of
$1.6 million in 1999, were $5.7 million for the year ended December 31, 1999, an
increase of $2.3 million over the comparable period of 1998. The increase was
due primarily to a significant increase in personnel and related costs
associated with new product development, verification testing, certification and
compliance testing and other engineering expenses.

SALES AND MARKETING

     Sales and marketing expenses, net of non-cash compensation expense of
$846,000 in 1999, were $3.9 million for the year ended December 31, 1999, an
increase of $3.2 million over the comparable period of 1998. This increase was
primarily due to an increase in the number of sales and marketing personnel,
increased marketing expenses and other customer-related costs.

                                        35
<PAGE>   36

GENERAL AND ADMINISTRATIVE

     General and administrative expenses, net of non-cash compensation expense
of $1.1 million in 1999, were $1.6 million for the year ended December 31, 1999,
an increase of $846,000 over the comparable period of 1998. This increase was
primarily due to an increase in the number of general and administrative
personnel, increased facilities costs, and increased legal and accounting
expenses associated with our growing business activities.

AMORTIZATION OF DEFERRED STOCK COMPENSATION

     In connection with the grant of stock options to employees, we recorded
amortization of deferred stock compensation of approximately $3.6 million for
the year ended December 31, 1999. We recorded amortization of deferred stock
compensation of $29,000 during the comparable period of 1998. The increase in
deferred stock compensation expense was attributable primarily to increased
option grants in 1999 relative to 1998. These additional option grants resulted
from our accelerated hiring activities, which corresponded to the first shipment
of our products in early 1999.

INTEREST INCOME (EXPENSE) AND OTHER, NET

     Interest income (expense) and other, net includes income from our cash
investments net of expenses related to our lease financing obligations. We had
net interest income of $180,000 for the year ended December 31, 1999 and net
interest income of $193,000 for the comparable period in 1998. The change from
the year ended December 31, 1998 was primarily due to a decrease in interest
income earned on proceeds from issuances of our preferred stock and an increase
in interest charges on capital lease obligations.

INCOME TAX EXPENSE

     Income tax expense for 1998 was comprised of minimum state taxes, and for
the year ended December 31, 1999 was comprised of federal and minimum state
taxes.

     As of December 31, 1998, we had net operating loss carryforwards and tax
credits for federal income tax purposes of approximately $3.0 million and for
state income tax purposes of approximately $1.3 million. These net operating
loss carryforwards and tax credits were used to reduce income subject to income
taxes in 1999.

     Federal and California tax laws impose substantial restrictions on the
utilization of net operating loss and credit carryforwards in the event of an
ownership change for tax purposes, as defined in Section 382 of the Internal
Revenue Code. The issuance of Series A convertible preferred stock on January
13, 1998 resulted in such a change. As a result the loss and credit
carryforwards as of January 13, 1998 of approximately $105,600 are subject to an
annual limitation approximating $300,000. The net operating losses incurred from
January 14, 1998 to December 31, 1998 are not subject to an annual limitation
and were utilized to offset taxable income in 1999.

     As of December 31, 1999, we had research and other credit carryforwards for
federal income tax purposes of approximately $17,000 available to reduce future
income taxes. The federal research credit carryforwards expire in 2019. We have
recorded these research and other credit carryforwards, together with other
temporary differences as deferred tax assets and have established a full
valuation allowance for them as their realization is uncertain.

LIQUIDITY AND CAPITAL RESOURCES

     Our principal source of liquidity as of December 31, 2000 consisted of
$199.1 million in cash and cash equivalents, $65.9 million in short-term
investments and $23.9 million in long-term investments. As of December 31, 2000,
we had $237,000 in obligations under capital leases to be repaid over a period
of three years from lease inception. Since our inception, we have financed our
operations through private and public sales of securities, cash generated from
operations and, during the period from inception through December 31, 1999,
partially through equipment lease financing. Our equipment lease financing
arrangement expired April 2000.
                                        36
<PAGE>   37

     During the year ended December 31, 2000, we generated $33.6 million from
operating activities compared to the year ended December 31, 1999 in which we
generated $328,000 from operating activities. This positive cash flow resulted
primarily from our net income for the year ended December 31, 2000, net of
non-cash charges, and from increases in accounts payable, accrued compensation
and benefits, and accrued expenses and other liabilities, and a decrease in
accounts receivable. This was partially offset by increases in our inventory,
income tax receivable, deferred tax assets, prepaid expense and other current
asset balances, and decreases in customer deposit and deferred revenue balances.
We used $4.3 million in operating activities in the period from inception to
December 31, 1998 primarily due to our net loss of $4.7 million partially offset
by non-cash charges.

     Net cash used in investing activities for the year ended December 31, 2000
was $102.1 million compared to net cash used in investing activities of $715,000
in the same period in 1999. Cash used in investing activities in the year ended
December 31, 2000 was used primarily for the purchases of available-for-sale
investments of $120.1 million, net of proceeds from sales and maturities of
similar investments in the amount of $30.3 million. There were no maturities or
sales of available-for-sale investments in the year ended December 31, 1999. Net
cash used in investing activities was $222,000 for the period from inception to
December 31, 1998. Investing activities for the year ended December 31, 1999 and
for the period from inception to December 31, 1998 consisted primarily of
purchases of fixed assets.

     Capital expenditures increased to $4.0 million for the year ended December
31, 2000 compared to $611,000 the same period in 1999 due primarily to additions
of test and lab equipment for increased research and development activities,
office equipment and computer software and hardware associated with our
increases in staffing worldwide and expansion of our information systems
infrastructure. Capital expenditures for the period from inception to December
31, 1998 were $194,000. We expect that our capital expenditures will continue to
increase in future periods. In May 2000, we entered into an operating lease
agreement for new corporate facilities. Upon execution of the lease agreement in
May 2000 and extending through the duration of the lease term, we are required
to maintain a standby letter of credit in the amount of $3.6 million. This
letter of credit requires us to hold funds in the form of a certificate of
deposit with a financial institution. Net cash used in investing activities for
the year ended December 31, 2000 included an allocation to restricted cash of
$3.6 million for the certificate of deposit associated with this standby letter
of credit.

     The lease term commenced July 1, 2000 and extends through June 30, 2010.
Lease payments will be made on an escalating basis for total minimum lease
payments of $42.7 million over the lease term. In May 2000, we were required to
make an advance lease payment for the first twelve months of the lease. As of
December 31, 2000, we had a remaining advance payment of $1.8 million included
in prepaid expenses and other current assets.

     In August 2000, we acquired Paragon Solutions Limited, a privately held New
Zealand company, for a total cash purchase price of up to $10.0 million. Upon
the closing of the acquisition we paid $5.0 million of the purchase price. An
additional cash payment of $2.5 million will be made upon the first anniversary
of the closing of the acquisition. Further, an additional $2.5 million will be
paid if conditions specified in the purchase agreement are met upon the first
anniversary of the closing of the acquisition.

     Net cash provided by financing activities for the year ended December 31,
2000 was $259.5 million compared to $7.1 million for the comparable period in
1999. Cash provided by financing activities in the year ended December 31, 2000
was primarily due to total net proceeds of $257.6 million from our initial
public offering in February 2000 and our secondary offering in September 2000.
Net cash provided by financing activities was $5.9 million for the period from
inception to December 31, 1998. Net cash generated by financing activities for
the year ended December 31, 1999 and the period from inception to December 31,
1998 was primarily from private sales of convertible preferred stock and
issuances of common stock. We had $237,000 in capitalized lease obligations
outstanding at December 31, 2000, and $489,000 at December 31, 1999.

     We expect to devote substantial capital and operating resources to continue
our research and development efforts, to hire and expand our sales, support,
marketing and product development organizations, to expand marketing programs,
to establish operations internationally, and for other general corporate
activities.
                                        37
<PAGE>   38

Although we believe that current cash and investment balances will be sufficient
to fund operations for at least the next 12 months, there can be no assurance
that we will not require additional financing within this time frame or that
such additional funding, if needed, will be available on acceptable terms. Any
additional issuance of equity or equity-related securities will be dilutive to
our stockholders.

RECENT ACCOUNTING PRONOUNCEMENTS

     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, which establishes accounting and
reporting standards for derivative instruments, including derivative instruments
embedded in other contracts, (collectively referred to as derivatives) and for
hedging activities. Through December 31, 2000, our investments in derivative
instruments has been insignificant and we have not engaged in hedging
activities. Accordingly, we have evaluated the effects of adopting SFAS No. 133
and currently do not believe that it have a material impact on our financial
position, results of operations or cash flows. We will adopt SFAS No. 133 in the
first quarter of fiscal 2001. In June 2000, the FASB issued Statement No. 138,
Accounting for Certain Derivative Instruments and Certain Hedging Activities.
SFAS 138 addresses certain issues related to the implementation of SFAS 133, but
does not change the basic model of SFAS 133 or further delay the implementation
of SFAS 133.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

FOREIGN CURRENCY RISK

     We develop our products in the United States and market our products in the
United States, Canada, Europe, Asia and Asia Pacific. Substantially all of our
sales and expenses are denominated in United States dollars. As a result, a
strengthening of the dollar could make our products less competitive in foreign
markets. We have not engaged in any foreign exchange hedging activities to date.
We may conduct transactions in foreign currencies in the future as we expand our
international operations and may engage in foreign exchange hedging activities
at that time.

INTEREST RATE RISK

     The primary objective of our investment activities is to preserve
principal. We attempt to maximize the income we receive from our investments
without significantly increasing risk. Some of the securities that we have
invested in may be subject to market risk. This means that a change in
prevailing interest rates may cause the value of the investment to fluctuate.
For example, if we hold a security that was issued with a fixed interest rate at
the then-prevailing rate and the prevailing interest rate later rises, the value
of the investment will probably decline. To mitigate this risk, we maintain our
portfolio of cash equivalents and investments in a variety of securities,
including money market funds, commercial paper and government and non-government
debt securities. In general, money market funds are not subject to market risk
because the interest paid on such funds fluctuates with the prevailing interest
rate. In addition, we invest in relatively short-term securities.

                                        38
<PAGE>   39

     The following table presents the amounts of cash equivalents, short-term
investments and long-term investments that are subject to market risk by range
of expected maturity and weighted-average interest rates as of December 31, 2000
and 1999. This table does not include money market funds because those funds are
not subject to market risk.

<TABLE>
<CAPTION>
                                                             MATURING
                                           MATURING IN       BETWEEN         MATURING
                                           THREE MONTHS    THREE MONTHS    GREATER THAN
                                             OR LESS       AND ONE YEAR      ONE YEAR       TOTAL
                                           ------------    ------------    ------------    --------
<S>                                        <C>             <C>             <C>             <C>
AT DECEMBER 31, 2000
Included in cash and cash equivalents....    $102,230        $    --         $    --       $102,230
Weighted average interest rate...........        7.11%            --              --           7.11%
Included in short-term investments.......    $ 27,968        $37,950         $    --       $ 65,918
Weighted average interest rate...........        6.78%          6.88%             --           6.84%
Included in long-term investments........    $     --        $    --         $23,939       $ 23,939
Weighted average interest rate...........          --             --            6.68%          6.68%
Total portfolio..........................    $130,198        $37,950         $23,939       $192,087
Weighted average interest rate...........        7.04%          6.88%           6.68%          6.96%
AT DECEMBER 31, 1999
Included in cash and cash equivalents....    $  2,750        $    --         $    --       $  2,750
Weighted average interest rate...........        6.76%            --              --           6.76%
</TABLE>

                                        39
<PAGE>   40

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The following consolidated financial statements, and the related notes
thereto, of Turnstone and the Report of Independent Auditors are filed as a part
of this Form 10-K.

<TABLE>
<CAPTION>
                                                               PAGE
                                                              NUMBER
                                                              ------
<S>                                                           <C>
Independent Auditor's Report................................    41
Consolidated Balance Sheets as of December 31, 2000 and
  1999......................................................    42
Consolidated Statements of Operations for the years ended
  December 31, 2000, 1999 and 1998..........................    43
Consolidated Statements of Stockholders' Equity for the
  years ended December 31, 2000, 1999 and 1998..............    44
Consolidated Statements of Cash Flows for the years ended
  December 31, 2000, 1999 and 1998..........................    45
Notes to Consolidated Financial Statements..................    46
</TABLE>

                                        40
<PAGE>   41

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Turnstone Systems, Inc.

     We have audited the accompanying consolidated balance sheets of Turnstone
Systems, Inc. and subsidiaries (the Company) as of December 31, 2000 and 1999,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for the years ended December 31, 2000 and 1999 and the period from
January 2, 1998 (inception) to December 31, 1998. In connection with our audits
of the consolidated financial statements, we have also audited the financial
statement schedule as listed in the accompanying index. These consolidated
financial statements and financial statement schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement schedule based on our
audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Turnstone
Systems, Inc. and subsidiaries as of December 31, 2000 and 1999, and the results
of their operations and their cash flows for the years ended December 31, 2000
and 1999 and the period from January 2, 1998 (inception) to December 31, 1998,
in conformity with accounting principles generally accepted in the United States
of America. Also, in our opinion, the related financial statement schedule, when
considered in relation to the consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth
therein.

                                                     /s/ KPMG LLP

Mountain View, California
January 22, 2001

                                        41
<PAGE>   42

                            TURNSTONE SYSTEMS, INC.

                          CONSOLIDATED BALANCE SHEETS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

                                     ASSETS

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              -------------------
                                                                2000       1999
                                                              --------    -------
<S>                                                           <C>         <C>
Current assets:
  Cash and cash equivalents.................................  $199,091    $ 8,063
  Short-term investments....................................    65,918         --
  Accounts receivable, net of allowance for doubtful
     accounts and sales returns of $3,076 and $276 at
     December 31, 2000 and 1999, respectively...............     1,251      6,439
  Inventory.................................................    29,502      2,939
  Income tax receivable.....................................     6,840         --
  Deferred tax asset........................................     3,616         --
  Prepaid expenses and other current assets.................     2,176        599
                                                              --------    -------
          Total current assets..............................  $308,394    $18,040
                                                              --------    -------
  Property and equipment, net...............................     4,090      1,085
  Long-term investments.....................................    23,939         --
  Restricted cash...........................................     3,639         --
  Intangible assets.........................................     5,832         --
  Other assets..............................................       103        132
                                                              --------    -------
          Total assets......................................  $345,997    $19,257
                                                              ========    =======

                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Current obligations under note payable and capital
     leases.................................................  $  2,573    $   229
  Accounts payable..........................................     8,229        783
  Accrued compensation and benefits.........................     2,087        920
  Customer deposits.........................................        --      1,328
  Other current liabilities and accrued expenses............    10,521      1,679
  Deferred revenue..........................................     1,802      2,132
                                                              --------    -------
          Total current liabilities.........................    25,212      7,071
                                                              --------    -------
Long-term obligations under capital leases, net of current
  portion...................................................        41        260
Other long-term liabilities.................................       117         35
                                                              --------    -------
          Total liabilities.................................    25,370      7,366
                                                              --------    -------
Stockholders' equity:
  Convertible preferred stock...............................        --         15
  Common stock, $.001 stated value, 200,000 shares
     authorized; 65,623 and 22,814 shares issued and
     outstanding at December 31, 2000 and 1999,
     respectively...........................................        66         22
  Additional paid-in capital................................   309,773     26,536
  Deferred stock compensation...............................    (6,651)    (9,701)
  Accumulated other comprehensive income....................        58         --
  Retained earnings (accumulated deficit)...................    17,381     (4,981)
                                                              --------    -------
          Total stockholders' equity........................   320,627     11,891
                                                              --------    -------
          Total liabilities and stockholders' equity........  $345,997    $19,257
                                                              ========    =======
</TABLE>

          See accompanying notes to consolidated financial statements.
                                        42
<PAGE>   43

                            TURNSTONE SYSTEMS, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                              ------------------------------
                                                                2000       1999       1998
                                                              --------    -------    -------
<S>                                                           <C>         <C>        <C>
Net revenues................................................  $149,365    $27,196    $    --
Cost of revenues:
  Cost of products sold.....................................    61,058     12,359         --
  Write-down of inventory...................................     4,098         --         --
  Provision for purchase commitments........................     7,300         --         --
                                                              --------    -------    -------
          Total cost of revenues............................    72,456     12,359         --
Gross profit................................................    76,909     14,837         --
Operating expenses:
  Research and development (exclusive of non-cash
     compensation expense of $3,766, $1,639 and $9 for 2000,
     1999 and 1998, respectively............................    18,729      5,731      3,462
  Sales and marketing (exclusive of non-cash compensation
     expense of $1,885, $846 and $17 for 2000, 1999 and
     1998, respectively)....................................    13,268      3,912        737
  General and administrative (exclusive of non-cash
     compensation expense of $1,366, $1,099 and $3 for 2000,
     1999 and 1998, respectively)...........................     6,894      1,559        713
  Amortization of intangible assets.........................       635         --         --
  Amortization of deferred stock compensation...............     7,017      3,584         29
                                                              --------    -------    -------
          Total operating expenses..........................    46,543     14,786      4,941
                                                              --------    -------    -------
          Operating income (loss)...........................    30,366         51     (4,941)
  Interest income (expense) and other, net..................     7,960        180        193
                                                              --------    -------    -------
Income (loss) before income tax.............................    38,326        231     (4,748)
  Income tax expense........................................    15,964        463          1
                                                              --------    -------    -------
Net income (loss)...........................................  $ 22,362    $  (232)   $(4,749)
                                                              ========    =======    =======
Basic net earnings (loss) per share of common stock.........  $   0.45    $ (0.03)   $ (1.99)
                                                              ========    =======    =======
Diluted net earnings (loss) per share of common stock.......  $   0.34    $ (0.03)   $ (1.99)
                                                              ========    =======    =======
Weighted-average shares of common stock outstanding used in
  computing basic net earnings (loss) per share.............    49,964      8,474      2,390
                                                              ========    =======    =======
Weighted-average shares of common stock outstanding used in
  computing diluted net earnings (loss) per share...........    66,069      8,474      2,390
                                                              ========    =======    =======
</TABLE>

          See accompanying notes to consolidated financial statements
                                        43
<PAGE>   44

                            TURNSTONE SYSTEMS, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                       CONVERTIBLE                                                     ACCUMULATED      RETAINED
                                     PREFERRED STOCK     COMMON STOCK     ADDITIONAL     DEFERRED         OTHER         EARNINGS
                                     ----------------   ---------------    PAID-IN        STOCK       COMPREHENSIVE   (ACCUMULATED
                                     SHARES    AMOUNT   SHARES   AMOUNT    CAPITAL     COMPENSATION      INCOME         DEFICIT)
                                     -------   ------   ------   ------   ----------   ------------   -------------   ------------
<S>                                  <C>       <C>      <C>      <C>      <C>          <C>            <C>             <C>
  Issuance of restricted common
    stock to founders..............       --    $ --    16,950    $17      $     (9)     $     --          $--          $    --
  Issuance of Series A preferred
    stock, net of issuance costs...   11,680      12        --     --         5,801            --           --               --
  Issuance of common stock pursuant
    to stock plans to employees and
    to consultants.................       --      --     3,374      3            82            --           --               --
  Issuance of convertible preferred
    stock warrants.................       --      --        --     --            40            --           --               --
  Deferred stock compensation......       --      --        --     --           195          (195)          --               --
  Amortization of deferred stock
    compensation...................       --      --        --     --            --            29           --               --
  Net loss.........................       --      --        --     --            --            --           --           (4,749)
                                     -------    ----    ------    ---      --------      --------          ---          -------
Balance at December 31, 1998.......   11,680      12    20,324     20         6,109          (166)          --           (4,749)
  Issuance of Series B preferred
    stock, net of issuance costs...    3,177       3        --     --         6,171            --           --               --
  Issuance of common stock pursuant
    to stock plans to employees and
    to consultants.................       --      --     2,490      2         1,137            --           --               --
  Deferred stock compensation......       --      --        --     --        13,119       (13,119)          --               --
  Amortization of deferred stock
    compensation...................       --      --        --     --            --         3,584           --               --
  Net loss.........................       --      --        --     --            --            --           --             (232)
                                     -------    ----    ------    ---      --------      --------          ---          -------
Balance at December 31, 1999.......   14,857      15    22,814     22        26,536        (9,701)          --           (4,981)
  Issuance of common stock pursuant
    to stock plans to employees....       --      --     2,446      2         2,196            --           --               --
  Repurchases of common stock......       --      --       (17)    --           (20)           --           --               --
  Issuance of stock pursuant to
    warrant exercises..............       --      --       266      1            (1)           --           --               --
  Conversion of preferred to common
    stock..........................  (14,857)    (15)   29,714     30           (15)           --           --               --
  Issuance of stock pursuant to
    initial public offering, net of
    offering expenses..............       --      --     6,900      7        92,104            --           --               --
  Issuance of stock pursuant to
    secondary offering, net of
    offering expenses..............       --      --     3,500      4       165,485            --           --               --
  Deferred stock compensation......       --      --        --     --         3,967        (3,967)          --               --
  Amortization of deferred stock
    compensation...................       --      --        --     --            --         7,017           --               --
  Tax benefit on stock options.....       --      --        --     --        19,521            --           --               --
  Other comprehensive income:
    Change in unrealized gain on
      available-for-sale
      securities...................       --      --        --     --            --            --           58               --
    Net income.....................       --      --        --     --            --            --           --           22,362
    Other comprehensive income.....       --      --        --     --            --            --           --               --
                                     -------    ----    ------    ---      --------      --------          ---          -------
Balance at December 31, 2000.......       --    $ --    65,623    $66      $309,773      $ (6,651)         $58          $17,381
                                     =======    ====    ======    ===      ========      ========          ===          =======

<CAPTION>

                                         TOTAL
                                     STOCKHOLDERS'
                                        EQUITY
                                     -------------
<S>                                  <C>
  Issuance of restricted common
    stock to founders..............    $      8
  Issuance of Series A preferred
    stock, net of issuance costs...       5,813
  Issuance of common stock pursuant
    to stock plans to employees and
    to consultants.................          85
  Issuance of convertible preferred
    stock warrants.................          40
  Deferred stock compensation......          --
  Amortization of deferred stock
    compensation...................          29
  Net loss.........................      (4,749)
                                       --------
Balance at December 31, 1998.......       1,226
  Issuance of Series B preferred
    stock, net of issuance costs...       6,174
  Issuance of common stock pursuant
    to stock plans to employees and
    to consultants.................       1,139
  Deferred stock compensation......          --
  Amortization of deferred stock
    compensation...................       3,584
  Net loss.........................        (232)
                                       --------
Balance at December 31, 1999.......      11,891
  Issuance of common stock pursuant
    to stock plans to employees....       2,198
  Repurchases of common stock......         (20)
  Issuance of stock pursuant to
    warrant exercises..............          --
  Conversion of preferred to common
    stock..........................          --
  Issuance of stock pursuant to
    initial public offering, net of
    offering expenses..............      92,111
  Issuance of stock pursuant to
    secondary offering, net of
    offering expenses..............     165,489
  Deferred stock compensation......          --
  Amortization of deferred stock
    compensation...................       7,017
  Tax benefit on stock options.....      19,521
  Other comprehensive income:
    Change in unrealized gain on
      available-for-sale
      securities...................          58
    Net income.....................      22,362
                                       --------
    Other comprehensive income.....    $ 22,420
                                       ========
Balance at December 31, 2000.......    $320,627
                                       ========
</TABLE>

          See accompanying notes to consolidated financial statements.

                                        44
<PAGE>   45

                            TURNSTONE SYSTEMS, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                  YEAR ENDED DECEMBER 31,
                                                              -------------------------------
                                                                2000        1999       1998
                                                              ---------    -------    -------
<S>                                                           <C>          <C>        <C>
OPERATING ACTIVITIES
Net income (loss)...........................................  $  22,362    $  (232)   $(4,749)
Adjustments to reconcile net income (loss) to net cash
  provided (used) in operating activities:
  Depreciation and amortization.............................      1,634        312        108
  Stock compensation expense................................      7,101      3,584         29
  Common stock issued for services..........................         --         13          2
  Tax benefit on stock options..............................     19,521         --         --
  Provision for doubtful accounts and sales returns.........      2,800        276         --
  Loss on disposal of property and equipment................         53         --         --
  Effect of changes in foreign currency.....................         51         --         --
  Changes in assets and liabilities:
     Accounts receivable....................................      2,829     (6,715)        --
     Income tax receivable..................................     (6,840)        --         --
     Deferred tax asset.....................................     (3,616)        --         --
     Inventory..............................................    (26,563)    (2,939)        --
     Prepaid expenses and other current assets..............     (1,562)      (503)       (56)
     Accounts payable.......................................      7,427        601        182
     Accrued compensation and benefits......................      1,117        791        129
     Accrued expenses and other liabilities.................      8,981      1,680         34
     Deferred revenue.......................................       (330)     2,132         --
     Customer deposits......................................     (1,328)     1,328         --
                                                              ---------    -------    -------
          Net cash provided (used) in operating
            activities......................................     33,637        328     (4,321)
INVESTING ACTIVITIES
Acquisition of Paragon Solutions Limited, net of cash
  acquired of $374..........................................     (4,626)        --         --
Acquisition of property and equipment.......................     (3,981)      (611)      (194)
Proceeds from disposal of property and equipment............         31         --         --
Purchases of available-for-sale investments, net............   (120,076)        --         --
Proceeds from sales and maturities of available-for-sale
  investments...............................................     30,277         --         --
Increase in other assets....................................        (72)      (104)       (28)
Increase in restricted cash.................................     (3,639)        --         --
                                                              ---------    -------    -------
          Net cash used in investing activities.............   (102,086)      (715)      (222)
FINANCING ACTIVITIES
Net proceeds from issuance of common stock..................    259,694      1,126         91
Net proceeds from issuance of convertible preferred stock...         --      6,174      5,813
Principal payments of capital lease obligations.............       (224)      (188)       (23)
                                                              ---------    -------    -------
          Net cash provided by financing activities.........    259,470      7,112      5,881
Effect of exchange rate changes on cash and cash
  equivalents...............................................          7         --         --
Net increase in cash and cash equivalents...................    191,028      6,725      1,338
Cash and cash equivalents at beginning of period............      8,063      1,338         --
Cash and cash equivalents at end of period..................  $ 199,091    $ 8,063    $ 1,338
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
  Cash paid for interest....................................  $      27    $    31    $    --
  Cash paid for income tax..................................  $   6,775    $    --    $    --
NONCASH INVESTING AND FINANCING ACTIVITIES:
  Note payable issued for acquisition of Paragon Solutions
     Limited................................................  $   2,377    $    --    $    --
  Deferred stock compensation...............................  $   3,967    $13,119    $   195
  Equipment purchases under capital leases..................  $      --    $   278    $   422
  Convertible preferred stock warrant issuances.............  $      --    $    --    $    40
</TABLE>

          See accompanying notes to consolidated financial statements
                                        45
<PAGE>   46

                            TURNSTONE SYSTEMS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2000, 1999 AND 1998

 1. DESCRIPTION OF BUSINESS

     Turnstone Systems, Inc. (the Company) develops and markets products that
enable local exchange carriers to rapidly deploy and efficiently maintain
digital subscriber line services. The Company commenced the commercial sale of
its products in the first quarter of 1999.

     During 1998, the Company was considered to be in the development stage as
the Company was engaged primarily in obtaining financing and personnel and
developing its products.

     The Company was incorporated on January 2, 1998. The period from this date
to December 31, 1998 is referred to in the accompanying consolidated financial
statements and notes as "1998" or the "Year ended December 31, 1998".

 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Basis of Presentation

     The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries located in New Zealand, the United Kingdom,
Germany and Australia. All significant intercompany accounts and transactions
have been eliminated in consolidation.

     The functional currency of the Company's subsidiaries is the U.S. dollar.
The financial statements of the subsidiaries are remeasured into U.S. dollars
for the purposes of consolidation using the historical exchange rates in effect
at the date of the transactions. Remeasurement gains and losses are included in
interest income (expense) and other, net and have not been material to date.
Foreign currency transaction gains and losses are included in interest income
(expense) and other, net and have not been material for all periods presented.

     In July 2000, the Board of Directors authorized a two-for-one stock split
of the Company's common stock effected in the form of a stock dividend on August
23, 2000 to holders of record as of the close of business on August 9, 2000. All
common shares, common options and per share amounts in the accompanying
financial statements have been adjusted to reflect the stock split.

  Use of Estimates

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

  Reclassifications

     Certain reclassifications, none of which affected net income (loss), have
been made to prior year amounts to conform to the current year presentation.

  Cash and Cash Equivalents

     The Company considers all highly liquid investments purchased with an
original maturity of less than three months at the date of purchase to be cash
equivalents. Cash equivalents at December 31, 2000 and 1999 consist primarily of
money market funds. Substantially all cash and cash equivalents are held with
three financial institutions.

                                        46
<PAGE>   47
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

  Investments

     The Company has classified its investment securities as available-for-sale.
Available-for-sale securities are carried at fair value. Unrealized gains and
losses are included in other comprehensive income (loss). Realized gains and
losses are computed using the specific identification method.

     The Company's investments comprise U.S., state, and municipal government
obligations and corporate debt securities. Investments with maturities of less
than or equal to one year are considered short-term and investments with
maturities in excess of one year are considered long-term. Management determines
the appropriate classification of securities at the time of purchase and
evaluates such designation as of each balance sheet date.

  Fair Value of Financial Instruments and Concentration of Credit Risk

     The carrying value of the Company's financial instruments, including cash
and cash equivalents, investments and accounts receivable approximates fair
market value. Financial instruments that subject the Company to concentrations
of credit risk consist primarily of cash and cash equivalents, investments and
trade accounts receivable. Management believes the financial risks associated
with these financial instruments are minimal. The Company maintains its cash and
cash equivalents and investments with high quality financial institutions. The
Company performs ongoing credit evaluations of its customers and generally does
not require collateral on accounts receivable. The Company maintains reserves
for potential credit losses.

     For the year ended December 31, 2000, 19% of net revenues were derived from
one customer. For the year ended December 31, 1999, 15% of net revenues were
derived from that same customer, and 41%, 19% and 11% of net revenues were
attributable to three additional customers. Substantially all of the Company's
revenues during 2000 and 1999 were derived from customers who are competitive
local exchange carriers. The financial condition of competitive local exchange
carriers has in the past, and may in the future, have a significant impact on
the Company's results of operations.

  Foreign Currency Risk

     The Company develops its products in the United States and markets its
products in the United States, Canada, Europe, Asia and Asia Pacific.
Substantially all revenues and expenses are denominated in United States
dollars. As a result, a strengthening of the dollar could make the Company's
products less competitive in foreign markets. The Company currently does not
conduct transactions in any foreign currencies and, therefore, does not engage
in any foreign exchange hedging activities.

  Inventories

     Inventories consist primarily of finished products and raw materials.
Finished products are manufactured by a third party manufacturer and are
included in the Company's inventory balance once testing is complete and title
passes to the Company. Raw materials included in the Company's inventory balance
consist of component parts inventory purchased by the Company. The Company
recognized a charge of $4.1 million to write down the value of finished goods
and raw materials on hand at December 31, 2000 in excess of forecast
requirements. Inventories are stated at the lower of cost (determined by the
first-in, first-out method) or market. Component parts purchased and owned by
the third party manufacturer are not included in the Company's inventory
balance. Under the contract with the third party manufacturer, the Company has
liability for component parts purchased on behalf of the Company, and
work-in-process and finished goods inventory manufactured for the Company, that
become excess or obsolete to the manufacturer as a result of certain actions.
Such actions can include the effect of product design changes or changes in the
Company's planned requirements.

                                        47
<PAGE>   48
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     Inventory consisted of the following at December 31 (in thousands):

<TABLE>
<CAPTION>
                                                             2000       1999
                                                            -------    ------
<S>                                                         <C>        <C>
Raw materials.............................................  $   295    $   85
Finished goods............................................   29,207     2,854
                                                            -------    ------
                                                            $29,502    $2,939
                                                            =======    ======
</TABLE>

  Valuation of Long-Lived Assets

     Property and equipment are stated at cost less accumulated depreciation.
Depreciation and amortization are computed using the straight-line method over
the shorter of the estimated useful lives of the assets, generally three years,
or the lease term, if applicable. Gains and losses on disposals are included in
net income at amounts equal to the difference between the net book value of the
disposed assets and the proceeds received upon disposal.

     Intangible assets consist of goodwill and assembled workforce associated
with the Company's purchase of Paragon Solutions Limited (Paragon) in August
2000. Intangible assets are being amortized on a straight-line basis over an
estimated life of four years.

     The Company periodically evaluates the carrying value of long-lived assets
and certain identifiable intangibles for impairment, when events and
circumstances indicate that the book value of an asset may not be recoverable.
An impairment loss is recognized whenever the review demonstrates that the book
value of a long-lived asset is not recoverable. Recoverability of property and
equipment to be held and used is measured by a comparison of the carrying amount
of the asset to future net cash flows expected to be generated by the asset. If
such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Recoverability of goodwill and certain identifiable
intangibles is measured by the undiscounted cash flows of the acquired business
over the remaining amortization period and, when the carrying value exceeds the
net realizable value, the value of goodwill and intangible is reduced to net
realizable value.

     Since January 2, 1998 (inception) through December 31, 2000, no impairment
losses have been identified.

  Revenue Recognition

     The Company recognizes revenue from product sales based upon shipment of
products pursuant to customer purchase orders, assuming that the price to
customer is fixed or determinable and that collectibility of the resulting
receivable is probable. When the arrangement with the customer includes future
obligations for which fair value does not exist or when customer acceptance is
required, revenue is recognized when those obligations have been met or customer
acceptance has been received. The Company generally does not allow for product
returns. The Company maintains an estimated reserve for potential returns based
on a minimal level of returns on a historical basis. Revenue from services and
support provided under the Company's maintenance programs are deferred based
upon the fair value of the program and recognized on a straight-line basis over
the period of the contract. The Company provides twelve months warranty for
product shipments not already covered under maintenance programs. Costs
associated with the warranty program are estimated and accrued for at the time
of product shipment. Revenue from consulting and training are deferred based on
the fair value of the services, and recognized when such services are completed.

     Deferred revenue represents amounts received from customers in respect of
maintenance programs, consulting and training, in advance of such services and
support being provided.

                                        48
<PAGE>   49
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     Revenue from transactions involving the Company's software application
products is recognized provided that a purchase order has been received, the
software and related documentation have been shipped, collection of the
resulting receivable is deemed probable, and the fee is fixed or determinable.
To date, revenue from such transactions has not been significant.

  Research and Development Costs

     Development costs incurred in the research and development of new products
and enhancements to existing products are expensed as incurred until the product
has been completed, tested and is ready for commercial manufacturing. To date,
hardware development projects have been completed concurrent with the
establishment of commercial manufacturing and accordingly no costs have been
capitalized. To date, software development projects have been completed
concurrent with the establishment of technological feasibility in the form of a
working model and, accordingly, no costs have been capitalized.

  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 Financial Accounting Standards
Board (FASB) Interpretation No. 44, Accounting for Certain Transactions
Involving Stock Compensation: An Interpretation of APB Opinion No. 25, and
complies with the disclosure provisions of Statement of Financial Accounting
Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. Compensation
expense on fixed stock options is based on the difference, if any, on the date
of the grant, between the fair value of the Company's stock and the exercise
price of the option. The Company accounts for equity instruments issued to
non-employees in accordance with the provisions of SFAS No. 123 and Emerging
Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling,
Goods or Services.

  Net Earnings (Loss) Per Share

     Basic and diluted net earnings (loss) per share have been computed in
accordance with SFAS No. 128, Earnings Per Share. Basic net earnings (loss) per
share is computed using the weighted-average number of outstanding shares of
common stock excluding weighted-average number of shares of restricted stock
subject to repurchase. Diluted net earnings (loss) per share is computed using
the weighted-average number of shares of common stock outstanding and, when
dilutive, shares of restricted common stock subject to repurchase, potential
shares of common stock from options and warrants using the treasury stock method
and from convertible securities using the "as-if converted basis."

                                        49
<PAGE>   50
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     The following table presents the calculation of basic and diluted net
earnings (loss) per common share (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                         ----------------------------
                                                          2000       1999      1998
                                                         -------    ------    -------
<S>                                                      <C>        <C>       <C>
Numerator:
  Net earnings (loss)..................................  $22,362    $ (232)   $(4,749)
                                                         =======    ======    =======
Denominator
  Weighted-average shares outstanding -- basic.........   49,964     8,474      2,390
                                                         -------    ------    -------
Effect of dilutive securities
  Shares issuable under stock options..................    4,819        --         --
  Restricted stock subject to repurchase...............    8,726        --         --
  Shares issuable pursuant to warrants.................       43        --         --
  Shares issuable upon conversion of preferred stock...    2,517        --         --
                                                         -------    ------    -------
  Weighted-average shares outstanding -- diluted.......   66,069     8,474      2,390
Net earnings (loss) per share -- basic.................  $  0.45    $(0.03)   $ (1.99)
                                                         =======    ======    =======
Net earnings (loss) per share -- diluted...............  $  0.34    $(0.03)   $ (1.99)
                                                         =======    ======    =======
</TABLE>

     Potential shares of common stock, which have been excluded from the
determination of net earnings per share for the year ended December 31, 2000,
consist of shares issuable under stock options with exercise prices greater than
the average fair market value of the Company's common stock. Potential shares of
common stock, which have been excluded from the determination of net loss per
share for the years ended December 31, 1999 and 1998, consisted of shares of
restricted common stock subject to repurchase, and shares issuable under stock
options, warrants and upon the conversion of convertible preferred stock. These
potential shares, which have been excluded because the effect of such shares
would have been anti-dilutive for each of the periods presented, were as follows
(in thousands):

<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                            -------------------------
                                                            2000      1999      1998
                                                            -----    ------    ------
<S>                                                         <C>      <C>       <C>
Shares issuable under stock options.......................  4,307     6,678     3,000
Shares of restricted stock subject to repurchase:
  Founders................................................     --     8,072    12,310
  Other employees.........................................     --     3,266     3,328
Shares issuable pursuant to warrants to purchase
  convertible preferred stock on an "as-if converted"
  basis...................................................     --       270       270
Shares of convertible preferred stock on an "as-if
  converted" basis........................................     --    29,714    23,360
                                                            -----    ------    ------
                                                            4,307    48,000    42,268
</TABLE>

     The weighted-average exercise price of shares issuable under stock options
for the years ended December 31, 2000, 1999 and 1998 was $56.51, $1.33 and
$0.04, respectively. The weighted-average purchase price of shares of common
stock subject to the Company's right of repurchase was $0.0005, for all periods
presented, for shares issued to the Company's founders and was $0.32 and $0.03
for the years ended December 31, 1999 and 1998, respectively, for shares issued
to other employees. The weighted-average exercise price of warrants to purchase
shares of convertible preferred stock was $0.50 for all periods presented. Each
share of convertible preferred stock is convertible into two shares of common
stock.

                                        50
<PAGE>   51
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

  Other Comprehensive Income

     The Company reports comprehensive income or loss in accordance with 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 or loss, as defined, includes all
changes in equity (net assets) during a period from non-owner sources.

     The following table presents the calculation of comprehensive income as
required by SFAS No. 130. The components of comprehensive income are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER 31,
                                                          ---------------------------
                                                           2000      1999      1998
                                                          -------    -----    -------
<S>                                                       <C>        <C>      <C>
Net income (loss).......................................  $22,362    $(232)   $(4,749)
Change in net unrealized gain (loss) on
  available-for-sale investments........................       97       --         --
Tax (expense) benefit...................................      (39)      --         --
                                                          -------    -----    -------
Net unrealized gain.....................................       58       --         --
                                                          -------    -----    -------
Total comprehensive income..............................  $22,420    $(232)   $(4,749)
                                                          =======    =====    =======
</TABLE>

  Income Taxes

     Income taxes are computed using an asset and liability approach, which
requires the recognition of taxes payable or refundable for the current year and
deferred tax assets and liabilities for the future tax consequences of events
that have been recognized in the Company's consolidated financial statements or
tax returns. The measurement of current and deferred tax assets and liabilities
are based on provisions of the enacted tax law; the effects of future changes in
tax laws or rates are not anticipated. The measurement of deferred tax assets is
reduced, if necessary, by the amount of any tax benefits that, based on
available evidence, are not expected to be realized.

  Recent Accounting Pronouncements

     In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which establishes accounting and reporting
standards for derivative instruments, including derivative instruments embedded
in other contracts, (collectively referred to as derivatives) and for hedging
activities. Through December 31, 2000, the Company has not had any investments
in derivative instruments and the Company has not engaged in hedging activities.
Accordingly, the Company has evaluated the effects of adopting SFAS No. 133 and
currently does not believe that it will have a material impact on its financial
position, results of operations or cash flows. In June 2000, the FASB issued
Statement No. 138, Accounting for Certain Derivative Instruments and Certain
Hedging Activities. SFAS 138 addresses certain issues related to the
implementation of SFAS 133, but does not change the basic model of SFAS 133 or
further delay the implementation of SFAS 133.

 3. ACQUISITION

     On August 8, 2000, the Company completed the acquisition of Paragon, a
privately-held New Zealand company. Paragon is an engineering design services
company that specializes in the design of telecommunications services products.
In connection with this acquisition and in exchange for all outstanding ordinary
shares of Paragon, the former shareholders of Paragon received $5.0 million in
cash in August 2000. On the first anniversary of the closing date, they are
entitled to receive an additional $2.5 million and a further $2.5 million if
certain contract conditions are met, for a maximum second installment of $5.0
million. As a result of the acquisition, Paragon became a wholly-owned
subsidiary of the Company. The consolidated statements of

                                        51
<PAGE>   52
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

operations for the year ended December 31, 2000 include the results of
operations of Paragon for the period from August 8, 2000 to December 31, 2000.

     The acquisition was accounted for under the purchase method of accounting
in accordance with APB Opinion No. 16. Under the purchase method of accounting,
the purchase price is allocated to the assets acquired and liabilities assumed
based on their estimated fair values. Management's best estimates of the fair
values of the assets and liabilities of Paragon have been combined with the
recorded values of the assets and liabilities of the Company.

     The purchase price consists of the first installment of $5.0 million and
the minimum $2.5 million payment of the second installment. The minimum amount
of the second installment is valued at approximately $2.3 million based on the
present value at acquisition date, computed at an average annual return of 9.5%.
This amount is payable on August 8, 2001 and has been included in current
obligations under note payable and capital leases on our balance sheet at
December 31, 2000.

     The total purchase price is allocated as follows (in thousands):

<TABLE>
<S>                                                           <C>
Property and equipment......................................  $   93
Accounts receivable, net....................................     480
Net tangible assets acquired, excluding property and
  equipment and accounts receivable.........................     242
Assembled workforce.........................................   1,160
Goodwill....................................................   5,308
                                                              ------
          Total.............................................  $7,283
                                                              ======
</TABLE>

     The goodwill and assembled workforce are being amortized on a straight-line
basis over a four year period. As of December 31, 2000, accumulated amortization
related to the goodwill and assembled workforce acquired in the Paragon
acquisition totaled $635,000. If the maximum amount of the second installment
payment is made on the first anniversary of the consummation of the transaction
and is added to the purchase price, there would be an increase to intangible
assets of $2.5 million. Amortization of this additional purchase consideration
would commence at that time on a straight-line basis over the remainder of the
initial four-year period.

     The following summarized financial information, prepared on an unaudited
pro forma basis, reflects the consolidated results of operations for the years
ended December 31, 2000 and 1999, assuming Paragon had been acquired at the
beginning of the periods presented (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                          YEAR ENDED DECEMBER 31,
                                                          -----------------------
                                                             2000         1999
                                                          ----------    ---------
<S>                                                       <C>           <C>
Net revenues............................................   $150,812      $28,429
Net income (loss).......................................   $ 21,321      $(1,471)
Basic net earnings (loss) per share of common stock.....   $   0.43      $ (0.17)
Diluted net earnings (loss) per share of common stock...   $   0.32      $ (0.17)
</TABLE>

     The pro forma results are not necessarily indicative of what would have
occurred if the acquisition had been in effect for the periods presented. In
addition they are not intended to be a projection of future results or a
representation of the effects of the combined operations.

                                        52
<PAGE>   53
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

 4. ACCOUNTS RECEIVABLE

     Accounts receivable consisted of the following as of December 31 (in
thousands):

<TABLE>
<CAPTION>
                                                              2000     1999
                                                              -----    -----
<S>                                                           <C>      <C>
Accounts receivable.........................................  4,327    6,715
Allowance for doubtful accounts and sales returns...........  3,076      276
                                                              -----    -----
  Accounts receivable, net..................................  1,251    6,439
                                                              =====    =====
</TABLE>

     Bad debt expense was $2,600,000, $76,000, $0 in 2000, 1999 and 1998,
respectively.

 5. INVESTMENTS

     The following is a summary of available-for-sale securities (in thousands):

<TABLE>
<CAPTION>
                                                                  DECEMBER 31, 2000
                                                   ------------------------------------------------
                                                                  GROSS         GROSS
                                                   AMORTIZED    UNREALIZED    UNREALIZED     FAIR
                                                     COST         GAINS         LOSSES       VALUE
                                                   ---------    ----------    ----------    -------
<S>                                                <C>          <C>           <C>           <C>
Certificates of deposit..........................   $ 5,639        $ --          $ --       $ 5,639
Commercial paper.................................    15,130          --           (10)       15,120
Government notes and bonds.......................    49,123          77            --        49,200
Corporate notes and bonds........................    23,507          30            --        23,537
                                                    -------        ----          ----       -------
                                                    $93,399        $107          $(10)      $93,496
                                                    =======        ====          ====       =======
Reported as:
  Short-term investments.........................                                           $65,918
  Long-term investments..........................                                            23,939
  Restricted cash................................                                             3,639
                                                                                            -------
          Total..................................                                           $93,496
                                                                                            =======
</TABLE>

     As of December 31, 1999 the company had no short-term or long-term
investments.

     As of December 31, 2000, all of the Company's available-for-sale securities
classified as long-term had maturities between one year and two years.

 6. PROPERTY AND EQUIPMENT

     Property and equipment consisted of the following as of December 31 (in
thousands):

<TABLE>
<CAPTION>
                                                              2000      1999
                                                             ------    ------
<S>                                                          <C>       <C>
Computer equipment and purchased software..................  $3,037    $1,011
Test and lab equipment.....................................   1,398       233
Furniture and office equipment.............................     857       222
Leasehold improvements.....................................     113        39
                                                             ------    ------
                                                              5,405     1,505
Less accumulated depreciation and amortization.............   1,315       420
                                                             ------    ------
                                                             $4,090    $1,085
                                                             ======    ======
</TABLE>

     Depreciation and amortization expense of property and equipment totaled
$999,000, $312,000 and $108,000 for the years ended December 31, 2000, 1999 and
1998, respectively.

                                        53
<PAGE>   54
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

 7. INCOME TAXES

     The Company has provided a valuation allowance due to the uncertainty of
generating future profits that would allow for the realization of such deferred
tax assets. The change in the total valuation allowance for the years ended
December 31, 2000 and 1999 was a decrease of $4,000 and a decrease of
$1,076,000, respectively.

     The Internal Revenue Code and applicable state tax laws, impose substantial
restrictions on the ability of the Company to utilize net operating losses and
tax credit carryforwards in the event of an "ownership change," as defined in
Section 382 of the Internal Revenue Code. The issuance of Series A convertible
preferred stock on January 13, 1998, resulted in such a change. As a result, the
annualized loss and credit carryforwards as of January 13, 1998 of $100,000 and
$5,600, respectively, are subject to an annual limitation of approximately
$300,000. The net operating losses incurred from January 14, 1998 through
December 31, 1998 are not subject to an annual limitation.

     Income taxes for the years ended December 31, 2000, 1999 and 1998, were
comprised of the following (in thousands):

<TABLE>
<CAPTION>
                                                               2000      1999    1998
                                                              -------    ----    ----
<S>                                                           <C>        <C>     <C>
Current:
  Federal...................................................  $     8    $456    $--
  State.....................................................        4       7      1
  Foreign...................................................       47      --     --
                                                              -------    ----    ---
          Total current tax expense.........................       59     463      1
Deferred:
  Federal...................................................   (3,616)     --     --
  State.....................................................       --      --     --
                                                              -------    ----    ---
          Total deferred tax expense........................   (3,616)     --     --
Charge in lieu of income taxes attributable to stock options
  exercised:
  Federal...................................................   16,720      --     --
  State.....................................................    2,801      --     --
                                                              -------    ----    ---
          Total charge in lieu of income taxes..............   19,521      --     --
                                                              -------    ----    ---
          Total income tax expense..........................  $15,964    $463    $ 1
                                                              =======    ====    ===
</TABLE>

     The reconciliation between the amount computed by applying the U.S. federal
statutory tax rate of 35% in 2000 and 34% in 1999 and 1998 to income before
income taxes and actual income taxes as of December 31, 2000, 1999 and 1998
follows (in thousands):

<TABLE>
<CAPTION>
                                                         2000       1999       1998
                                                        -------    -------    -------
<S>                                                     <C>        <C>        <C>
Federal tax at statutory rate.........................  $13,414    $    79    $(1,614)
State taxes, net of federal income tax benefit........    1,823          8          1
Research and development and other credits............     (209)      (157)        --
Permanent differences relating to stock exercise......    1,843      1,273         --
Valuation allowances (utilized) not benefited.........   (1,265)       379        484
Net operating losses (utilized) not benefited.........       --     (1,128)     1,128
Other differences.....................................      358          9          2
                                                        -------    -------    -------
          Total income tax expense....................  $15,964    $   463    $     1
                                                        =======    =======    =======
</TABLE>

                                        54
<PAGE>   55
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     The tax effects of temporary differences that give rise to significant
portions of deferred tax assets as of December 31, 2000, 1999 and 1998 are as
follows (in thousands):

<TABLE>
<CAPTION>
                                                         2000       1999       1998
                                                        -------    -------    -------
<S>                                                     <C>        <C>        <C>
Deferred tax assets:
  Reserve for bad debt................................  $ 1,096    $    76    $    24
  Sales return reserve and other accruals.............      187        204         --
  Inventory reserve...................................    1,781         --         --
  Accrued vacation....................................      329         --         --
  Warranty reserve....................................      144         --         --
  Plant and equipment.................................       --         36         23
  Startup costs.......................................      458        640        814
  Deferred revenues...................................      697        222         --
  Goodwill, foreign branch............................      162         --         --
  Net operating loss carryforwards....................       --         17      1,410
                                                        -------    -------    -------
          Total gross deferred tax assets.............    4,854      1,195      2,271
Deferred tax liabilities:
  Plant and equipment.................................      (47)        --         --
                                                        -------    -------    -------
                                                          4,807      1,195      2,271
  Valuation allowance.................................   (1,191)    (1,195)    (2,271)
                                                        -------    -------    -------
          Net deferred tax assets.....................  $ 3,616    $    --    $    --
                                                        =======    =======    =======
</TABLE>

 8. COMMITMENTS AND CONTINGENCIES

  Purchase Commitments and Contingencies

     In 2000, the Company recorded a charge to cost of net revenues totaling
$7.3 million representing certain noncancelable purchase commitments for product
component parts in excess of forecast requirements. These purchase commitments
included commitments to the Company's third party manufacturer for component
parts to be purchased on behalf of the Company by its third party manufacturer,
as well as the Company's purchase commitments for component parts to its
vendors. This liability has been included in other current liabilities and
accrued expenses on the balance sheet as of December 31, 2000.

  Lease Commitments

     In July 1998, the Company entered into a leasing agreement with a financing
company which allows the Company to draw up to $900,000 for the lease of
hardware and $600,000 for the lease of software. The leases entered into under
this leasing agreement are accounted for as capital leases. This leasing
agreement expired April 29, 2000. The remaining lease obligations outstanding
under this agreement are repayable in 36 equal monthly installments of principal
plus interest commencing on the individual lease inception dates and are secured
by the leased assets.

     In connection with the equipment leasing agreement, the Company issued to
the financing company warrants to purchase 90,000 shares of Series A convertible
preferred stock at a price of $0.50 per share. The fair value of the warrants
was determined to be $27,000, calculated using the Black-Scholes option pricing
model, using the following assumptions: no dividends; contractual term of five
years; risk-free interest rate of 5.5%; and expected volatility of 65%. The fair
value of the warrants has been recorded as additional paid-in capital and is
being amortized as interest expense over the term of the lease agreement. The
Company has issued 176,896 shares of common stock upon net exercise of these
warrants.

                                        55
<PAGE>   56
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     The Company is also obligated under certain noncancelable operating leases
for office space, which requires the Company to pay related property taxes and
normal maintenance. The leases expire in various years through 2010. Rent
expense for the years ended December 31, 2000, 1999 and 1998 was $2,537,000,
$244,000 and $128,000, respectively.

     Future minimum lease payments under noncancelable, operating and capital
leases are as follows as of December 31, 2000 (in thousands):

<TABLE>
<CAPTION>
                                                            CAPITAL    OPERATING
                 YEAR ENDING DECEMBER 31,                   LEASES      LEASES
                 ------------------------                   -------    ---------
<S>                                                         <C>        <C>
  2001....................................................   $205       $ 4,010
  2002....................................................     42         3,889
  2003....................................................     --         4,023
  2004....................................................     --         4,162
  2005....................................................     --         4,277
  Thereafter..............................................     --        21,014
                                                             ----       -------
          Total minimum lease payments....................   $247       $41,375
                                                             ====       =======
Less: Amount representing imputed interest................     10
                                                             ----
Present value of minimum lease payments...................    237
Less: Current portion.....................................   $196
                                                             ----
Capital lease obligation, less current portion............   $ 41
                                                             ====
</TABLE>

     The Company subleases a facility, and certain furniture and fixtures
located at the facility, the Company previously occupied under a sublease
arrangement expiring in November 2001. Total payments to be received under this
noncancelable operating sublease in 2001 are $467,000.

     In May 2000, the Company entered into an operating lease agreement for new
corporate facilities. The lease term commenced July 1, 2000 and extends through
June 30, 2010. Lease payments will be made on an escalating basis for total
minimum lease payments of $42.7 million over the lease term. Rent expense is
recognized on a straight-line basis over the lease term. In May 2000, the
Company was required to make an advance lease payment for the first twelve
months of the lease. This payment, totaling $3.6 million, has been classified as
prepaid expenses at December 31, 2000.

     Upon execution of the lease agreement in May 2000 and extending through the
duration of the lease term, the Company is required to maintain a standby letter
of credit in the amount of $3.6 million. This letter of credit requires the
Company to hold funds in the form of a certificate of deposit with a financial
institution. The Company has classified these funds as restricted cash on the
balance sheet at December 31, 2000.

 9. 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. The Company has determined that it does not have separately
reportable operating segments. The Company operates in one principal business
segment across domestic and international markets.

                                        56
<PAGE>   57
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     Information regarding geographic areas for the year ended December 31, 2000
is as follows (in thousands):

<TABLE>
<S>                                                         <C>
REVENUES:
  United States...........................................  $131,370
  International...........................................    17,995
                                                            --------
          Total...........................................  $149,365
                                                            ========
LONG-LIVED ASSETS:
  United States...........................................  $  3,817
  New Zealand.............................................     6,032
  International -- others.................................        73
                                                            --------
          Total...........................................  $  9,922
                                                            ========
</TABLE>

     Revenues are attributed to countries based on the location of the
customers. All revenues for the years ended December 31, 1999 and 1998 were to
customers located in the United States and all of the Company's assets were
located in the United States as of December 31, 1999 and 1998.

10. STOCKHOLDERS' EQUITY

  Common Stock

     In 1998, the Company issued 16,951,000 shares of restricted common stock to
the three founding members of the Company at $0.0005 per share. The shares are
subject to a right of repurchase by the Company, which lapses monthly over four
year periods ending in October 2001 and January 2002, or on the occurrence of a
change of control event. Upon termination of employment, the Company may
repurchase all unvested shares at the original purchase price. The Company
maintains a right of first refusal with respect to restricted common stock. As
of December 31, 2000, 1999 and 1998, there were 3,834,000, 8,072,000 and
12,310,000 shares of restricted common stock subject to repurchase from the
three founding members of the Company.

     In February 2000, the Company completed its initial public offering. The
Company issued 6,900,000 shares of common stock at a price to the public of
$14.50 per share. The net proceeds of the initial public offering were
approximately $92.1 million. Upon closing of the initial public offering, all
convertible preferred stock (Series A and Series B) automatically converted to
29,713,860 shares of common stock. Upon the completion of the initial public
offering the Company was authorized to issue 200,000,000 shares of common stock,
$0.001 par value.

     In August 2000, the Company effected a 2-for-1 stock split in the form of a
stock dividend. All common shares, common options and per share amounts in the
accompanying financial statements have been adjusted to reflect the stock split.

     In September 2000, the Company completed a follow on offering of its common
stock. The Company issued 3,500,000 shares of common stock at a price to the
public of $50.00 per share. The net proceeds of the follow on offering were
approximately $165.5 million.

  1998 and 2000 Stock Plans

     In January 1998, the 1998 Stock Plan was adopted by the Board and
subsequently received stockholder approval. Upon completion of the Company's
initial public offering, the 1998 Stock Plan was terminated, no further option
grants were made under the 1998 Stock Plan, and all shares reserved but not yet
issued under the 1998 Stock Plan were made available for grant under the 2000
Stock Plan. The 1998 Stock Plan permitted

                                        57
<PAGE>   58
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

the Company to grant employees, outside directors, and consultants qualified
stock options, nonstatutory stock options, or stock purchase rights to purchase
shares of the Company's common stock. Options generally vest 25% with respect to
the number granted upon the first anniversary date of the option grant and the
remainder vest in equal monthly installments over the 36 months thereafter.
Options are exercisable immediately. Shares issued upon exercise of non-vested
stock options are subject to the Company's right to repurchase at the original
exercise price. The Company's repurchase right lapses in accordance with the
vesting schedule for the stock options. At December 31, 2000, 1999 and 1998,
2,602,000, 3,266,000 and 3,328,000, shares, respectively, resulting from the
early exercise of options were subject to repurchase at weighted-average
exercise prices of $0.38, $0.32 and $0.03, respectively.

     Under the 1998 Stock Plan, the Company issued 31,068 shares of common stock
in 1999 and 45,380 shares in 1998 in exchange for consulting services. The
aggregate estimated fair value of these shares and the resulting expense was
$25,000 for the 1999 issuances and $2,000 for the 1998 issuances. In addition,
in 1999 the Company granted 150,000 options to non-employee members of its
Advisory Board. These options were fully vested at the date of grant.
Amortization of deferred stock compensation in 1999 includes $217,500 of
compensation expense related to these option grants.

     In July 1999, the Company approved increases in the number of shares of
Common Stock reserved for issuance under the Company's 1998 Stock Plan from
10,648,000 to 14,148,000 shares.

     The 2000 Stock Plan was adopted by the Board of Directors in November 1999
and became effective upon the effectiveness of our initial public offering in
February 2000. The 2000 Stock Plan provides for the grant of incentive stock
options, nonstatutory stock options, and stock purchase rights to employees,
directors and consultants. The plan also provides for nondiscretionary grants of
nonstatutory options to outside directors. Options granted under the 2000 Stock
Plan are exercisable upon vesting. Options granted under the 2000 Stock Plan
generally vest 25% with respect to the number granted upon the first anniversary
date of the option grant and the remainder vest in equal monthly installments
over the 36 months thereafter. A total of 10,575,752 shares of common stock have
been reserved for issuance under the 2000 Stock Plan, including 575,752 shares
available for grant under the 1998 Stock Plan that were transferred to the 2000
Stock Plan. An annual increase in the share reserve will be added on the first
day of each year, beginning in 2001.

  2000 Nonstatutory Stock Plan

     The 2000 Nonstatutory Stock Plan was adopted by the Board of Directors in
August 2000. The 2000 Nonstatutory Stock Plan provides for the grant of
nonstatutory stock options and stock purchase rights to employees and
consultants. Options granted under the 2000 Nonstatutory Stock Plan generally
vest 25% with respect to the number granted upon the first anniversary date of
the option grant and the remainder vest in equal monthly installments over the
36 months thereafter. A total of 4,000,000 shares of common stock have been
reserved for issuance under the 2000 Nonstatutory Stock Plan.

                                        58
<PAGE>   59
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     A summary of the status of the Company's Stock Plans is as follows (in
thousands, except for per share data):

<TABLE>
<CAPTION>
                                                                              OUTSTANDING OPTIONS
                                                                             ----------------------
                                                                                          WEIGHTED-
                                                                             WEIGHTED-     AVERAGE
                                                    SHARES                    AVERAGE       GRANT
                                                   AVAILABLE    NUMBER OF    EXERCISE     DATE FAIR
                                                   FOR GRANT     SHARES        PRICE        VALUE
                                                   ---------    ---------    ---------    ---------
<S>                                                <C>          <C>          <C>          <C>
Authorized as of January 2, 1998 (inception).....    10,648          --
Granted with exercise price:
  Less than fair value...........................    (1,040)      1,040       $ 0.07       $ 0.25
  Equal to fair value............................    (5,613)      5,613         0.03         0.03
Exercised........................................        --      (3,373)        0.03
Canceled.........................................       280        (280)        0.03
                                                    -------      ------
Balances as of December 31, 1998.................     4,275       3,000         0.04
Authorized.......................................     3,500          --
Granted with exercise price:
  Less than fair value...........................    (6,168)      6,168         1.60       $ 3.65
Exercised........................................        --      (2,490)        0.46
                                                    -------      ------
Balances as of December 31, 1999.................     1,607       6,678         1.33
Authorized.......................................    14,000          --
Granted with exercise price:
  Less than fair value...........................    (1,031)      1,031         7.20       $23.95
  Equal to fair value............................   (10,526)     10,526        33.47        33.47
Exercised........................................        --      (2,372)        0.51
Canceled.........................................       524        (845)       36.13
                                                    -------      ------       ------
Balances as of December 31, 2000.................     4,574      15,018       $22.44
                                                    =======      ======       ======
</TABLE>

                                        59
<PAGE>   60
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     The following table summarizes information about stock options outstanding
and exerciseable as of December 31, 2000:

<TABLE>
<CAPTION>
              OPTIONS OUTSTANDING                   OPTIONS EXERCISEABLE
-----------------------------------------------   ------------------------
                    NUMBER OF       WEIGHTED-      NUMBER OF
                  SHARES SUBJECT     AVERAGE         SHARES      WEIGHTED-
                    TO OPTIONS      REMAINING      SUBJECT TO     AVERAGE
   RANGE OF        OUTSTANDING     CONTRACTUAL      OPTIONS      EXERCISE
EXERCISE PRICES   (IN THOUSANDS)   LIFE (YEARS)   EXERCISEABLE     PRICE
---------------   --------------   ------------   ------------   ---------
<S>               <C>              <C>            <C>            <C>
$         0.03           633           7.2              96         $0.03
          0.10            73           7.9              20          0.10
          0.25           236           8.2              45          0.25
  0.48 -  0.58           670           8.2             339          0.48
  0.78 -  0.98           174           8.5               9          0.98
  1.25 -  1.83           571           8.5              92          1.39
  1.95 -  2.50           391           8.7              92          2.35
  3.23 -  4.45         1,071           8.8             272          3.54
  5.31 -  7.20         5,502           9.2              87          5.77
         17.00           273           9.8              --            --
 27.50 - 40.81           150           9.3              --            --
 41.69 - 60.81         4,287           9.5              --            --
 66.63 - 75.50           987           9.5              --            --
                      ------                         -----         -----
                      15,018                         2,104         $1.90
                      ======                         =====         =====
</TABLE>

     The Company uses the intrinsic-value method in accounting for its
stock-based compensation arrangements for employees whereby compensation cost is
recognized to the extent the fair value of the underlying common stock exceeds
the exercise price of the stock options at the date of grant. Deferred stock
compensation of $3,967,000 in 2000, $13,070,000 in 1999 and $195,000 in 1998 has
been recorded for the excess of the fair value of the common stock underlying
the options at the grant date over the exercise price of the options.

     These amounts are being amortized on an accelerated basis over the vesting
period, generally four years, consistent with the method described in FASB
Interpretation No. 28. Amortization of deferred compensation was $7,017,000 in
2000, $3,584,000 in 1999 and $29,000 in 1998. The fair value of options granted
prior to the Company's initial public offering on February 1, 2000 are estimated
on the date of grant using the minimum value method with the following
weighted-average assumptions: no dividend yield; risk-free interest rates of
5.82%, 5.38% and 5.12% in 2000, 1999 and 1998, respectively, and an expected
life of four years. The fair value of options granted subsequent to the
Company's initial public offering are estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions: no dividend yield, risk-free interest rate of 5.82%, expected
volatility of 1.20 and an expected life of four years.

                                        60
<PAGE>   61
                            TURNSTONE SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                        DECEMBER 31, 2000, 1999 AND 1998

     Had compensation cost for the Company's stock-based compensation plan been
determined consistent with the fair value approach set forth in SFAS No. 123,
the Company's net income (loss) would have been as follows (in thousands, except
per share amounts):

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                        -----------------------------
                                                          2000       1999      1998
                                                        --------    ------    -------
<S>                                                     <C>         <C>       <C>
Net income (loss) -- as reported......................  $ 22,362    $ (232)   $(4,749)
Net income (loss) -- pro forma........................  $(46,377)   $ (702)   $(4,750)
Basic net earnings (loss) per share -- as reported....  $   0.45    $(0.03)   $ (1.99)
                                                        ========    ======    =======
Basic net earnings (loss) per share -- pro forma......  $  (0.93)   $(0.08)   $ (1.99)
                                                        ========    ======    =======
Diluted net earnings (loss) per share -- as
  reported............................................  $   0.34    $(0.03)   $ (1.99)
                                                        ========    ======    =======
Diluted net earnings (loss) per share -- pro forma....  $  (0.93)   $(0.08)   $ (1.99)
                                                        ========    ======    =======
</TABLE>

  2000 Employee Stock Purchase Plan

     The 2000 Employee Stock Purchase Plan was adopted by the Board of Directors
in November 1999 and became effective upon the effectiveness of our initial
public offering in February 2000. A total of 1,000,000 shares of common stock
have been reserved for issuance, with an annual increase for subsequent years. A
total of 74,000 shares have been issued pursuant to the 2000 Employee Stock
Purchase Plan as of December 31, 2000 at a weighted-average purchase price per
share of $12.33. The 2000 Employee Stock Purchase Plan provides eligible
employees the opportunity to purchase common stock, subject to certain
restrictions, through payroll deductions. The purchase price per share will be
85% of the fair market value of the common stock on the first day of the
applicable offering period or the last day of the applicable purchase period,
whichever is lower.

     To comply with the pro forma reporting requirements of SFAS No. 123
compensation cost is also estimated for the fair value of employee stock
purchase plan issuances, which is included in the pro forma totals above.
Therefore, the Company has estimated the compensation cost for its employee
stock purchase plan issuances in October 2000. The fair value of purchase rights
granted under the Purchase Plan is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions for the year ended December 31, 2000: no expected dividends;
expected volatility of 1.20; risk-free interest rate of 6.03%; and expected life
of nine months. The weighted-average per share fair value of the purchase rights
granted under the Purchase Plan during fiscal 2000 was $7.72.

                                        61
<PAGE>   62

                               SUPPLEMENTARY DATA

                        QUARTERLY RESULTS OF OPERATIONS
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                          QUARTER ENDED
                                                      ------------------------------------------------------
                                                      MARCH 31,    JUNE 30,    SEPTEMBER 30,    DECEMBER 31,
                                                        1999         1999          1999             1999
                                                      ---------    --------    -------------    ------------
                                                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                   <C>          <C>         <C>              <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Net revenues........................................   $   952     $ 4,719        $9,033          $12,492
Cost of revenues....................................       576       2,510         3,834            5,439
                                                       -------     -------        ------          -------
Gross profit........................................       376       2,209         5,199            7,053
Operating expenses:
  Research and development..........................       830       1,023         1,756            2,122
  Sales and marketing...............................       508         821         1,100            1,483
  General and administrative........................       191         308           444              616
  Amortization of deferred stock compensation.......        97       1,186           877            1,424
                                                       -------     -------        ------          -------
         Total operating expenses...................     1,626       3,338         4,177            5,645
Operating income (loss).............................    (1,250)     (1,129)        1,022            1,408
  Interest income (expense) and other, net..........        42          41            29               68
  Income tax expense................................        --          --            63              400
                                                       -------     -------        ------          -------
         Net income (loss)..........................   $(1,208)    $(1,088)       $  988          $ 1,076
Basic net earnings (loss) per share.................   $ (0.20)    $ (0.14)       $ 0.11          $  0.10
                                                       =======     =======        ======          =======
Diluted net earnings (loss) per share...............   $ (0.20)    $ (0.14)       $ 0.02          $  0.02
                                                       =======     =======        ======          =======
</TABLE>

<TABLE>
<CAPTION>
                                                                          QUARTER ENDED
                                                      ------------------------------------------------------
                                                      MARCH 31,    JUNE 30,    SEPTEMBER 30,    DECEMBER 31,
                                                        2000         2000          2000             2000
                                                      ---------    --------    -------------    ------------
                                                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                   <C>          <C>         <C>              <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Net revenues........................................   $23,107     $41,053        $56,227         $ 28,978
Cost of revenues(1).................................     8,756      17,076         23,356           23,268
                                                       -------     -------        -------         --------
Gross profit........................................    14,351      23,977         32,871            5,710
Operating expenses:
  Research and development..........................     2,728       3,622          5,884            6,495
  Sales and marketing...............................     2,078       3,635          3,495            4,060
  General and administrative(2).....................       783       1,113          1,643            3,355
  Amortization of intangibles.......................        --          --            231              404
  Amortization of deferred stock compensation.......     1,818       1,996          1,734            1,469
                                                       -------     -------        -------         --------
         Total operating expenses...................     7,407      10,366         12,987           15,783
Operating income (loss).............................     6,944      13,611         19,884          (10,073)
  Interest income (expense) and other, net..........       918       1,475          1,446            4,121
  Income tax expense (benefit)......................     3,277       6,034          8,515           (1,862)
                                                       -------     -------        -------         --------
         Net income (loss)..........................   $ 4,585     $ 9,052        $12,815         $ (4,090)
Basic net earnings (loss) per share.................   $  0.12     $  0.18        $  0.24         $  (0.07)
                                                       =======     =======        =======         ========
Diluted net earnings (loss) per share...............   $  0.07     $  0.14        $  0.19         $  (0.07)
                                                       =======     =======        =======         ========
</TABLE>

---------------
(1) Cost of revenues for the quarter ended December 31, 2000 include a $11.4
    million charge to write down the value of inventory on-hand at December 31,
    2000 and to accrue a liability for commitments made for future delivery of
    raw materials.

(2) General and administrative expense for the quarter ended December 31, 2000
    includes a $2.1 million charge for bad debt reserves as of December 31,
    2000.

                                        62
<PAGE>   63

                                    PART III

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

     Not applicable.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The Registrant incorporates by reference into this Item 10 portions of the
Registrant's Definitive Proxy Statement with respect to its 2001 Annual Meeting
of Stockholders, to be filed with the Securities and Exchange Commission not
later than 120 days after the end of the fiscal year ending December 31, 2000,
and the information set forth in the section entitled "Executive Officers of the
Registrant" in Part I, Item 4A of this Form 10-K.

ITEM 11. EXECUTIVE COMPENSATION

     The Registrant incorporates by reference into this Item 11 portions of the
Registrant's Definitive Proxy Statement with respect to its 2001 Annual Meeting
of Stockholders, to be filed with the Securities and Exchange Commission not
later than 120 days after the end of the fiscal year ending December 31, 2000.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The Registrant incorporates by reference into this Item 12 portions of the
Registrant's Definitive Proxy Statement with respect to its 2001 Annual Meeting
of Stockholders to be filed with the Securities and Exchange Commission not
later than 120 days after the end of the fiscal year ending December 31, 2000.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The Registrant incorporates by reference into this Item 13 portions of the
Registrant's Definitive Proxy Statement with respect to its 2001 Annual Meeting
of Stockholders, to be filed with the Securities and Exchange Commission not
later than 120 days after the end of the fiscal year ending December 31, 2000.

                                    PART IV

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

     (a) 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

             See Item 8 of this Form 10-K.

         2. SCHEDULES

             The following financial statement schedule of Turnstone Systems,
             Inc. for the years ended December 31, 2000, 1999 and 1998 is filed
             as part of this Report and should be read in conjunction with the
             consolidated financial statements.

             Schedule II -- Valuation and Qualifying Accounts

             All other schedules are omitted because they are not applicable or
             the required information is shown in the consolidated financial
             statements or notes thereto.

                                        63
<PAGE>   64

         3. EXHIBITS

             The exhibits listed on the accompanying index to exhibits
             immediately following the financial statement schedule are filed as
             part of, or incorporated by reference into, this Form 10-K.

<TABLE>
<CAPTION>
    EXHIBIT
     NUMBER                           DESCRIPTION
    --------                          -----------
    <S>       <C>
     3.1*     Amended and Restated Certificate of Incorporation of
              Turnstone Systems
     3.2*     Amended and Restated Bylaws of Turnstone Systems
     4.1*     Form of Common Stock certificate
     4.2*     Registration Rights Agreement, dated January 12, 1998, by
              and among Turnstone Systems and certain stockholders of
              Turnstone Systems named herein, as amended as of January 12,
              1999 and November 21, 1999
     4.3**    Form of Founder's Restricted Stock Purchase Agreement
              entered into as of January 2, 1998, between Turnstone
              Systems and each of P. Kingston Duffie, M. Denise Savoie and
              Richard N. Tinsley
    10.1*     Form of Indemnification Agreement entered into by Turnstone
              Systems with each of its directors and executive officers
    10.2*     1998 Stock Plan and forms of agreement thereunder
    10.3*     2000 Stock Plan and forms of agreement thereunder
    10.4*     2000 Nonstatutory Stock Plan and forms of agreement
              thereunder
    10.5**    2000 Employee Stock Purchase Plan and forms of agreement
              thereunder
    10.6**    Manufacturing Agreement dated as of October 16, 1998,
              between Turnstone Systems and A-Plus Manufacturing
              Corporation
    10.7**    OEM Purchase Agreement, dated effective as of September 1,
              1999, between Turnstone Systems and Lucent Technologies
              Inc., as amended as of September 28, 1999 and December 9,
              1999
    10.8*     Lease dated April 28, 2000, between Turnstone Systems and
              South Bay/San Tomas Associates
    10.9**    Application Services Agreement, dated effective as of
              December 23, 1999, between Turnstone Systems and AristaSoft
              Corporation
    10.10***  Agreement relating to sale and purchase of all the shares in
              Paragon Solutions Limited, dated July 19, 2000, among
              Turnstone Systems, each vendor listed in Schedule I thereto
              and Graham Parkins, as the vendor's representative
    21.1      Subsidiaries
    23.1      Consent of KPMG LLP
</TABLE>

---------------
  * Incorporated by reference herein to the Registration Statement on Form S-1
    and all amendments thereto filed with the Securities and Exchange Commission
    (No. 333-45130).

 ** Confidential treatment requested and received as to certain portions. These
    exhibits are incorporated by reference herein to the Registration Statement
    on Form S-1 and all amendments thereto filed with the Securities and
    Exchange Commission (No. 333-45130).

*** Incorporated by reference herein to Exhibit 2.1 of our Current Report on
    Form 8-K filed with the Securities and Exchange Commission (No. 333-45130).

                                        64
<PAGE>   65

     (b) REPORTS ON FORM 8-K

         We filed a current report on Form 8-K with the Securities and Exchange
         Commission on August 11, 2000 to report, under Item 2, that we had
         entered into a share purchase agreement to acquire all of the
         outstanding ordinary shares of Paragon Solutions Limited for up to a
         maximum of US$10 million in cash. We filed an amendment to this current
         report on Form 8-K with the Securities and Exchange Commission on
         September 1, 2000 with the required financial information.

                                        65
<PAGE>   66

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
                  YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                 BALANCE AT    ADDITIONS                      BALANCE
                                                 BEGINNING     CHARGED TO                    AT END OF
                  DESCRIPTION                    OF PERIOD     OPERATIONS    (DEDUCTIONS)     PERIOD
                  -----------                    ----------    ----------    ------------    ---------
<S>                                              <C>           <C>           <C>             <C>
Allowance for doubtful accounts:
  2000.........................................     $ 76         $2,600         $  --         $2,676
  1999.........................................     $ --         $   76         $  --         $   76
  1998.........................................     $ --         $   --         $  --         $   --
Sales return reserve:
  2000.........................................     $200         $  512         $(312)        $  400
  1999.........................................     $ --         $  200         $  --         $  200
  1998.........................................     $ --         $   --         $  --         $   --
</TABLE>

                                        66
<PAGE>   67

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed
on its behalf by the undersigned, who is duly authorized, in the City of Santa
Clara, State of California on this 13th day of March, 2001.

                                          TURNSTONE SYSTEMS, INC.

                                          By:    /s/ RICHARD N. TINSLEY
                                            ------------------------------------
                                                     Richard N. Tinsley
                                               President and Chief Executive
                                                           Officer
                                               (Principal Executive Officer)

                                          By:    /s/ TERRENCE J. SCHMID
                                            ------------------------------------
                                                     Terrence J. Schmid
                                                  Chief Financial Officer
                                            (Principal Financial and Accounting
                                                           Officer)

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Richard N. Tinsley and Terrence J.
Schmid, and each of them, his true and lawful attorneys-in-fact, each with the
power of substitution, for him in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with Exhibits thereto and
other documents in connection therewith with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or substitute or substitutes, may do or cause to be done by
virtue hereof.

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

<TABLE>
<CAPTION>
                     SIGNATURE                                     TITLE                     DATE
                     ---------                                     -----                     ----
<C>                                                  <C>                                <S>
              /s/ RICHARD N. TINSLEY                    President, Chief Executive      March 13, 2001
---------------------------------------------------   Officer and Director (Principal
                Richard N. Tinsley                          Executive Officer)

              /s/ P. KINGSTON DUFFIE                   Chief Technology Officer and     March 13, 2001
---------------------------------------------------              Director
                P. Kingston Duffie

           /s/ ROBERT J. FINOCCHIO, JR.                          Director               March 13, 2001
---------------------------------------------------
             Robert J. Finocchio, Jr.

                /s/ JOHN K. PETERS                               Director               March 13, 2001
---------------------------------------------------
                  John K. Peters

              /s/ ANDREW W. VERHALEN                             Director               March 13, 2001
---------------------------------------------------
                Andrew W. Verhalen

               /s/ GEOFFREY Y. YANG                              Director               March 13, 2001
---------------------------------------------------
                 Geoffrey Y. Yang
</TABLE>

                                        67
<PAGE>   68

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
 NUMBER                             DESCRIPTION
-------                             -----------
<S>         <C>
 3.1*       Amended and Restated Certificate of Incorporation of
            Turnstone Systems
 3.2*       Amended and Restated Bylaws of Turnstone Systems
 4.1*       Form of Common Stock certificate
 4.2*       Registration Rights Agreement, dated January 12, 1998, by
            and among Turnstone Systems and certain stockholders of
            Turnstone Systems named herein, as amended as of January 12,
            1999 and November 21, 1999
 4.3**      Form of Founder's Restricted Stock Purchase Agreement
            entered into as of January 2, 1998, between Turnstone
            Systems and each of P. Kingston Duffie, M. Denise Savoie and
            Richard N. Tinsley
10.1*       Form of Indemnification Agreement entered into by Turnstone
            Systems with each of its directors and executive officers
10.2*       1998 Stock Plan and forms of agreement thereunder
10.3*       2000 Stock Plan and forms of agreement thereunder
10.4*       2000 Nonstatutory Stock Plan and forms of agreement
            thereunder
10.5**      2000 Employee Stock Purchase Plan and forms of agreement
            thereunder
10.6**      Manufacturing Agreement dated as of October 16, 1998,
            between Turnstone Systems and A-Plus Manufacturing
            Corporation
10.7**      OEM Purchase Agreement, dated effective as of September 1,
            1999, between Turnstone Systems and Lucent Technologies
            Inc., as amended as of September 28, 1999 and December 9,
            1999
10.8*       Lease dated April 28, 2000, between Turnstone Systems and
            South Bay/San Tomas Associates
10.9**      Application Services Agreement, dated effective as of
            December 23, 1999, between Turnstone Systems and AristaSoft
            Corporation
10.10***    Agreement relating to sale and purchase of all the shares in
            Paragon Solutions Limited, dated July 19, 2000, among
            Turnstone Systems, each vendor listed in Schedule I thereto
            and Graham Parkins, as the vendor's representative
21.1        Subsidiaries
23.1        Consent of KPMG LLP
</TABLE>

---------------
  * Incorporated by reference herein to the Registration Statement on Form S-1
    and all amendments thereto filed with the Securities and Exchange Commission
    (No. 333-45130).

 ** Confidential treatment requested and received as to certain portions. These
    exhibits are incorporated by reference herein to the Registration Statement
    on Form S-1 and all amendments thereto filed with the Securities and
    Exchange Commission (No. 333-45130).

*** Incorporated by reference herein to Exhibit 2.1 of our Current Report on
    Form 8-K filed with the Securities and Exchange Commission (No. 333-45130).

                                        68