** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **ý** | **QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934**        |
|------------|-----------------------------------------------------------------------------------------------|
|       |                                                                                          |
|       | **For the quarterly period ended June 30, 2003**                                              |
|       |                                                                                          |   |
|       | **OR**                                                                                        |
|       |                                                                                          |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|       |                                                                                          |   |
|       |                                                                                          | **For the transition period from                    to                .** |
|       |                                                                                          |   |
|       |                                                                                          | **Commission file number:  000-26887** |

** **

**SiliconImage, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    |   | **77-0396307**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **1060 East Arques Avenue  Sunnyvale, California 94085**        |
| (Address of principal executive offices and zip  code)          |
|                                                            |   |                                 |
| **(408) 616-4000**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) Yes ý No o and (2) has beensubject to such filing requirements for the past 90 days Yes ý No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). Yes ý No o

 

Thenumber of shares of the registrant’s Common Stock, $0.001 par value per share,outstanding as of July 31, 2003 was 70,589,476 shares.

 

 

----

 

**Silicon Image, Inc.**

**Quarterly Report on Form 10-Q**

**Three and Six Months Ended**

**June 30, 2003**

 

**Table of Contents**

 
| **Part I**     | **Financial  Information (Unaudited)**                                                                      |
|----------------|-------------------------------------------------------------------------------------------------------------|
|           |                                                                                                        |
| Item 1         | Financial Statements                                                                                        |
|           |                                                                                                        |
|           | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2003 and 2002 |
|           |                                                                                                        |
|           | Condensed  Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002                            |
|           |                                                                                                        |
|           | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 2003 and 2002            |
|           |                                                                                                        |
|           | Notes to  Unaudited Condensed Consolidated Financial Statements                                             |
|           |                                                                                                        |
| Item.2         | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                 |
|           |                                                                                                        |
| Item 3         | Quantitative and Qualitative  Disclosures About Market Risk                                                 |
|           |                                                                                                        |
| Item 4         | Controls and Procedures                                                                                     |
|           |                                                                                                        |
| **Part II**    | **Other  Information**                                                                                      |
|           |                                                                                                        |
| Item 1         | Legal Proceedings                                                                                           |
|           |                                                                                                        |
| Item 2         | Change in Securities and Use of  Proceeds                                                                   |
|           |                                                                                                        |
| Item 3         | Defaults  Upon Senior Securities                                                                            |
|           |                                                                                                        |
| Item  4        | Submission  of Matters to a Vote of Security Holders                                                        |
|           |                                                                                                        |
| Item 5         | Other  Information                                                                                          |
|           |                                                                                                        |
| Item 6         | Exhibits and Reports  on Form 8-K                                                                           |
|           |                                                                                                        |
| **Signatures** |
|           |
| Exhibit Index  |
|           |                                                                                                        |
| Exhibit        | 31.1                                                                                                        |
|           |                                                                                                        |
| Exhibit        | 31.2                                                                                                        |
|           |                                                                                                        |
| Exhibit        | 32.1                                                                                                        |
|           |                                                                                                        |
| Exhibit        | 32.2                                                                                                        |

 

2

----

 

**Part I****. Financial Information**

 

**Item 1.**** Financial Statements**

 

**Silicon Image, Inc.**

**Condensed Consolidated Statements of Operations**

**(in thousands, except per share amounts)**

**(unaudited)**

 
|                                             |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |   |
|--------------------------------------------------|--------|--------------------------------|--------|------------------------------|--------|
|                                             |   | **2003**                       |   | **2002**                     |   | **2003** |   | **2002** |   |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Revenue:                                         |   |                           |   |                         |   |   |   |   |   |
| Product                                          |   | $                              | 19,745 |                         | $      | 18,222 |   | $ | 39,467 |   | $ | 34,827 |   |
| Development, licensing and royalties             |   | 4,587                          |   | 1,050                        |   | 9,541 |   | 1,532 |   |
| Total revenue                                    |   | 24,332                         |   | 19,272                       |   | 49,008 |   | 36,359 |   |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Cost and operating expenses:                     |   |                           |   |                         |   |   |   |   |   |
| Cost of revenue (1)                              |   | 10,651                         |   | 9,088                        |   | 21,841 |   | 17,574 |   |
| Research and development (2)                     |   | 9,368                          |   | 8,205                        |   | 18,205 |   | 15,583 |   |
| Selling, general and administrative (3)          |   | 4,355                          |   | 4,576                        |   | 8,663 |   | 9,510 |   |
| Stock compensation expense (benefit)             |   | 2,253                          |   | (3,066                       | )      | 1,891 |   | 7,385 |   |
| Amortization of intangible assets                |   | 373                            |   | 857                          |   | 373 |   | 1,766 |   |
| Patent defense and acquisition integration costs |   | 583                            |   | 683                          |   | 1,796 |   | 1,389 |   |
| Restructuring                                    |   | —                         |   | 3,500                        |   | 986 |   | 5,693 |   |
| In-process research and development              |   | 5,482                          |   | —                       |   | 5,482 |   | — |   |
| Impairment of goodwill and intangible assets     |   | —                         |   | 5,200                        |   | — |   | 5,200 |   |
| Total cost and operating expenses                |   | 33,065                         |   | 29,043                       |   | 59,237 |   | 64,100 |   |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Loss from operations                             |   | (8,733                         | )      | (9,771                       | )      | (10,229 | ) | (27,741 | ) |
| Gain on escrow settlement, net                   |   | —                         |   | —                       |   | 4,618 |   | — |   |
| Interest income and other, net                   |   | 67                             |   | 163                          |   | 176 |   | 433 |   |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Net loss                                         |   | $                              | (8,666 | )                            | $      | (9,608 | ) | $ | (5,435 | ) | $ | (27,308 | ) |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Net loss per share:                              |   |                           |   |                         |   |   |   |   |   |
| Basic and diluted                                |   | $                              | (0.13  | )                            | $      | (0.15 | ) | $ | (0.08 | ) | $ | (0.43 | ) |
|                                             |   |                           |   |                         |   |   |   |   |   |
| Weighted average shares                          |   | 69,012                         |   | 64,580                       |   | 68,085 |   | 64,011 |   |

 

----

(1)Excludes stock compensation expense (benefit) of $78,000 and $(544,000) for thethree months ended June 30, 2003 and June 30, 2002, respectively, and $(57,000)and $379,000 for the six months ended June 30, 2003 and 2002, respectively.

 

(2)Excludes stock compensation expense (benefit) of $1.8 million and $(833,000)for the three months ended June 30, 2003 and June 30, 2002, respectively, and$2.0 million and $5.1 million for the six months ended June 30, 2003 and 2002,respectively.

 

(3)Excludes stock compensation expense (benefit) of $334,000 and $(1.7) millionfor the three months ended June 30, 2003 and June 30, 2002, respectively, and$(20,000) and $2.0 million for the six months ended June 30, 2003 and 2002,respectively.

 

*See accompanying Notes to theUnaudited Condensed Consolidated Financial Statements*

 

3

----

 

**Silicon Image, Inc.**

**CondensedConsolidated Balance Sheets**

**(in thousands, except share amounts)**

(unaudited)

 
|                                                                                                                                                                         |   | **June 30,  2003** |   | **Dec. 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
|                                                                                                                                                                         |   |               |   |               |   |
| **Assets**                                                                                                                                                                   |   |               |   |               |   |
| Cash and cash equivalents                                                                                                                                                    |   | $                  | 25,187 |               | $      | 26,263 |   |
| Short-term investments                                                                                                                                                       |   | 5,834              |   | 9,570              |   |
| Accounts receivable, net of allowance for doubtful  accounts of $519 at June 30 and at December 31                                                                           |   | 15,731             |   | 11,589             |   |
| Inventories                                                                                                                                                                  |   | 7,391              |   | 7,301              |   |
| Prepaid expenses and other current assets                                                                                                                                    |   | 1,405              |   | 2,510              |   |
| Total current assets                                                                                                                                                         |   | 55,548             |   | 57,233             |   |
|                                                                                                                                                                         |   |               |   |               |   |
| Property and equipment, net                                                                                                                                                  |   | 7,458              |   | 6,653              |   |
| Goodwill                                                                                                                                                                     |   | 13,021             |   | 13,021             |   |
| Intangible assets, net                                                                                                                                                       |   | 3,904              |   | —             |   |
| Other assets                                                                                                                                                                 |   | 577                |   | 709                |   |
| Total assets                                                                                                                                                                 |   | $                  | 80,508 |               | $      | 77,616 |   |
|                                                                                                                                                                         |   |               |   |               |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                               |   |               |   |               |   |
| Current Liabilities:                                                                                                                                                         |   |               |   |               |   |
| Accounts payable                                                                                                                                                             |   | $                  | 9,714  |               | $      | 10,314 |   |
| Accrued liabilites                                                                                                                                                           |   | 9,081              |   | 11,183             |   |
| Capital lease and other obligations                                                                                                                                          |   | 2,821              |   | 3,816              |   |
| Deferred margin on sales to distributors                                                                                                                                     |   | 3,993              |   | 4,133              |   |
| Total current liabilities                                                                                                                                                    |   | 25,609             |   | 29,446             |   |
|                                                                                                                                                                         |   |               |   |               |   |
| Shareholders’ Equity:                                                                                                                                                   |   |               |   |               |   |
| Convertible preferred stock, par value $0.001;  5,000,000 shares authorized; no shares issued or outstanding                                                                 |   | —             |   | —             |   |
| Common stock, par value $0.001; shares authorized:  150,000,000 - June 30 and December 31; shares issued and outstanding:  70,134,894 - June 30 and 66,639,522 - December 31 |   | 70                 |   | 67                 |   |
| Additional paid-in capital                                                                                                                                                   |   | 229,345            |   | 214,459            |   |
| Notes receivable from stockholders                                                                                                                                           |   | —             |   | (109               | )      |
| Unearned stock compensation                                                                                                                                                  |   | (9,237             | )      | (6,403             | )      |
| Accumulated deficit                                                                                                                                                          |   | (165,279           | )      | (159,844           | )      |
| Total stockholders’ equity                                                                                                                                              |   | 54,899             |   | 48,170             |   |
| Total liabilites and stockholders’ equity                                                                                                                               |   | $                  | 80,508 |               | $      | 77,616 |   |

 

*See accompanying Notes to Unaudited CondensedConsolidated Financial Statements*

 

4

----

 

**Silicon Image, Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(in thousands)**

**(unaudited)**

 
|                                                                     |   | **Six Months Ended June 30** |   |
|--------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                     |   | **2003**                     |   | **2002** | ** ** |
|                                                                     |   |                         |   |   |   |
| ***Cash flows from  operating activities:***                             |   |                         |   |   |   |
| Net loss                                                                 |   | $                            | (5,435 | ) | $ | (27,308 | ) |
| Adjustments to reconcile net loss to cash used in  operating activities: |   |                         |   |   |   |
| Stock compensation expense                                               |   | 1,891                        |   | 7,385 |   |
| Amortization of intangible assets                                        |   | 373                          |   | 1,766 |   |
| Non-cash restructuring                                                   |   | 646                          |   | 3,965 |   |
| Impairment of goodwill and intangible assets                             |   | —                       |   | 5,200 |   |
| In-process research and development expense                              |   | 5,482                        |   | — |   |
| Non-cash gain on escrow settlement, before cash  costs                   |   | (4,692                       | )      | — |   |
| Depreciation and amortization                                            |   | 2,210                        |   | 1,999 |   |
| Changes in assets and liabilities, net of amounts  acquired:             |   |                         |   |   |   |
| Accounts receivable                                                      |   | (4,142                       | )      | (1,736 | ) |
| Inventories                                                              |   | (90                          | )      | (903 | ) |
| Prepaid expenses and other assets                                        |   | 1,259                        |   | 709 |   |
| Accounts payable                                                         |   | (632                         | )      | 1,226 |   |
| Accrued liabilities                                                      |   | (2,374                       | )      | 1,073 |   |
| Deferred margin on sales to distributors                                 |   | (140                         | )      | 1,302 |   |
| Cash used in operating activities                                        |   | (5,644                       | )      | (5,322 | ) |
|                                                                     |   |                         |   |   |   |
| ***Cash flows from  investing activities:***                             |   |                         |   |   |   |
| Proceeds from sales and maturities of short-term  investments            |   | 7,295                        |   | 3,477 |   |
| Purchases of short-term investments                                      |   | (3,559                       | )      | (955 | ) |
| Acquisition costs, net of cash acquired                                  |   | 3                            |   | — |   |
| Purchases of property and equipment                                      |   | (2,560                       | )      | (2,193 | ) |
| Cash provided by investing activities                                    |   | 1,179                        |   | 329 |   |
|                                                                     |   |                         |   |   |   |
| ***Cash flows from  financing activities:***                             |   |                         |   |   |   |
| Proceeds from issuances of common stock, net                             |   | 4,658                        |   | 5,285 |   |
| Repayment of stockholders’ notes receivable                         |   | 109                          |   | 61 |   |
| Repayments of capital lease and other obligations                        |   | (1,378                       | )      | (1,131 | ) |
| Cash provided by financing activities                                    |   | 3,389                        |   | 4,215 |   |
|                                                                     |   |                         |   |   |   |
| **Net decrease in cash and cash  equivalents**                           |   | (1,076                       | )      | (778 | ) |
| Cash and cash equivalents — beginning of period                     |   | 26,263                       |   | 18,946 |   |
| Cash and cash equivalents — end of period                           |   | $                            | 25,187 |   | $ | 18,168 |   |
|                                                                     |   |                         |   |   |   |
| **Non-cash investing and financing  activities:**                        |   |                         |   |   |   |
| Financing of property and equipment                                      |   | $                            | 383    |   | $ | — |   |
| Stock  and options issued in connection with the Transwarp acquisition   |   | $                            | 14,371 |   | $ | — |   |

 

*See accompanying Notes to Unaudited Condensed ConsolidatedFinancial Statements*

 

5

----

 

**Silicon Image, Inc.**

**Notes to Unaudited****Condensed Consolidated Financial Statements**

###### **June 30, 2003**

 

1.                                       Basis of Presentation

 

In theopinion of management, the accompanying unaudited condensed consolidatedfinancial statements of Silicon Image, Inc. included herein have been preparedon a basis consistent with our December 31, 2002 audited financial statementsand include all material adjustments, consisting of normal recurringadjustments, necessary to fairly state the consolidated financial position ofSilicon Image and its subsidiaries (collectively, the “Company”) at June 30,2003 and the consolidated results of the Company’s operations and cash flowsfor the three and six months ended June 30, 2003 and 2002.  Allintercompany accounts and transactions have been eliminated.  Theseinterim financial statements should be read in conjunction with our auditedconsolidated financial statements and notes thereto included in our Form 10-Kfor the fiscal year ended December 31, 2002.  Results of operations forthe three and six  months ended June 30,2003 are not necessarily indicative of future operating results.

 

2.                                       Recent Accounting Pronouncements

 

In May2003, the Financial Accounting Standard Board, or FASB, issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity.” SFAS No. 150 establishes standards for how companiesclassify and measure certain financial instruments with characteristics of bothliabilities and equity. SFAS No. 150 requires companies to classify a financialinstrument that is within its scope as a liability (or an asset in somecircumstances), and is effective beginning the third quarter of fiscal 2003. Webelieve that the adoption of this standard will have no material effect on ourconsolidated financial statements.

 

In January2003, the FASB issued FASB Interpretation No. 46, or FIN 46, “Consolidation ofVariable Interest Entities - an interpretation of ARB No. 51.” FIN 46 requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the equity investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. FIN 46 is effectiveimmediately for all new variable interest entities created or acquired afterJanuary 31, 2003. For variable interest entities created or acquired prior toFebruary 1, 2003, the provisions of FIN 46 must be applied for the firstinterim or annual period beginning after June 15, 2003. We believe that theadoption of this standard will have no material effect on our consolidatedfinancial statements.

 

InNovember 2002, the Emerging Issues Task Force reached a consensus on Issue00-21 (“EITF 00-21”), “Multiple-Deliverable Revenue Arrangements.”  EITF 00-21 addresses how to account forarrangements that may involve the delivery or performance of multiple products,services and/or rights to use assets. The consensus mandates how to identifywhether goods or services or both which are to be delivered separately in abundled sales arrangement should be accounted for separately because they are“separate units of accounting.” The guidance can affect the timing of revenuerecognition for such arrangements, even though it does not change rulesgoverning the timing or patterns of revenue recognition of individual items accountedfor separately. The final consensus will be applicable to agreements enteredinto in fiscal periods beginning after June 15, 2003, with early adoptionpermitted. Additionally, companies will be permitted to apply the consensusguidance to all existing arrangements as the cumulative effect of a change inaccounting principle in accordance with Accounting Principles Board Opinion No.20, “Accounting Changes.” We are assessing the potential effect of thisguidance, but at this point we do not believe the adoption of EITF 00-21 willhave a material effect on our consolidated financial statements.

 

Had we recorded compensation expense for our stock options based on thegrant-date fair value as prescribed by SFAS No. 123 and SFAS No. 148, our netloss would have been as follows (in thousands):

 
|                                                                                                    |   | **Three Months Ended** |    | **Six Months Ended** |   |
|---------------------------------------------------------------------------------------------------------|--------|------------------------|---------|----------------------|--------|
|                                                                                                    |   | **June 30, 2003**      |    | **June 30, 2002**    |   | **June 30, 2003** |   | **June 30, 2002** |   |
|                                                                                                    |   |                   |    |                 |   |   |   |   |   |
| Net loss — as reported                                                                             |   | $                      | (8,666  | )                    | $      | (9,608 | ) | $ | (5,435 | ) | $ | (27,308 | ) |
| Stock-based employee compensation expense  determined using fair value method                           |   | (5,586                 | )       | (6,266               | )      | (11,606 | ) | (12,689 | ) |
| Stock-based employee compensation cost (benefit)  included in the determination of net loss as reported |   | 1,360                  |    | (4,506               | )      | 949 |   | 5,343 |   |
|                                                                                                    |   |                   |    |                 |   |   |   |   |   |
| Pro forma net loss                                                                                      |   | $                      | (12,892 | )                    | $      | (20,380 | ) | $ | (16,092 | ) | $ | (34,654 | ) |
|                                                                                                    |   |                   |    |                 |   |   |   |   |   |
| Basic and diluted net loss per share — pro forma                                                   |   | $                      | (0.19   | )                    | $      | (0.32 | ) | $ | (0.24 | ) | $ | (0.54 | ) |
| Basic and diluted net loss per share— as reported                                                  |   | $                      | (0.13   | )                    | $      | (0.15 | ) | $ | (0.08 | ) | $ | (0.43 | ) |

 

6

----

 

The grant-date fair value was estimated usingthe Black-Scholes pricing model with the following assumptions:

 
|                        |   | **Three  Months Ended June 30** |   | **Six Months Ended June 30** |   |
|-----------------------------|--------|---------------------------------|--------|------------------------------|--------|
|                        |   | **2003**                        |   | **2002**                     |   | **2003** |   | **2002** |   |
|                        |   |                            |   |                         |   |   |   |   |   |
| Expected life               |   | 5                               |   | 5                            |   | 5 |   | 5 |   |
| Interest rate               |   | 3.0                             | %      | 4.0                          | %      | 3.0 | % | 4.0 | % |
| Volatility                  |   | 90                              | %      | 90                           | %      | 90 | % | 90 | % |
| Dividend yield              |   | —                          |   | —                       |   | — |   | — |   |
| Weighted average fair value |   | $                               | 3.69   |                         | $      | 7.19 |   | $ | 4.15 |   | $ | 4.74 |   |
|                             |        |                                 |        |                              |        |  |  |  |  |  |  |  |  |

 

The weighted average,grant-date fair value of stock purchase rights granted under our Employee StockPurchase Plan and the assumptions used are as follows:

 
|                                   |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |       |
|----------------------------------------|--------|--------------------------------|--------|------------------------------|------------|
|                                   |   | **2003**                       |   | **2002**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                   |   |                           |   |                         |       |   |   |   |   |
| Expected life (years)                  |   | 1.5                            |   | 1.5                          |       | 1.5 |   | 1.5 |   |
| Interest rate                          |   | 1.3                            | %      | 1.7                          | %          | 1.3 | % | 1.7 | % |
| Dividend yield                         |   | —                         |   | —                       |       | — |   | — |   |
| Volatility                             |   | 90                             | %      | 90                           | %          | 90 | % | 90 | % |
| Weighted average grant date fair value |   | $                              | 2.93   |                         | $          | 2.47 |   | $ | 2.76 |   | $ | 2.46 |   |
|                                        |        |                                |        |                              |            |  |  |  |  |  |  |  |  |

 

3.                                       Net Loss Per Share

 

Basic net loss per share is computed using the weighted-averagenumber of common shares outstanding during the period, excluding shares subjectto repurchase, and diluted net loss per share is computed uisng theweighted-average number of common shares and dilute equivalents outstandingduring the period, if any, determined using the treasury stock method. Thefollowing table sets forth the computation of basic and diluted net loss pershare (in thousands, except per share amounts):

 
|                                               |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |   |
|----------------------------------------------------|--------|--------------------------------|--------|------------------------------|--------|
|                                               |   | **2003**                       |   | **2002**                     |   | **2003** |   | **2002** |   |
|                                               |   |                           |   |                         |   |   |   |   |   |
| Net loss                                           |   | $                              | (8,666 | )                            | $      | (9,608 | ) | $ | (5,435 | ) | $ | (27,308 | ) |
|                                               |   |                           |   |                         |   |   |   |   |   |
| Weighted average shares                            |   | 69,491                         |   | 65,118                       |   | 68,380 |   | 64,681 |   |
|                                               |   |                           |   |                         |   |   |   |   |   |
| Less: unvested common shares subject to repurchase |   | (479                           | )      | (538                         | )      | (295 | ) | (670 | ) |
|                                               |   |                           |   |                         |   |   |   |   |   |
|                                               |   | 69,012                         |   | 64,580                       |   | 68,085 |   | 64,011 |   |
| Basic and diluted net loss per share               |   | $                              | (0.13  | )                            | $      | (0.15 | ) | $ | (0.08 | ) | $ | (0.43 | ) |

 

As a result of our net losses, all common shareequivalents would have been anti-dilutive and have therefore been excluded fromthe diluted net loss per share calculation. The weighted average securitiesthat were anti-dilutive and excluded from our calculation of diluted net lossper share were approximately 21,843,000 and 20,268,000 for the three monthperiods ended June 30, 2003 and 2002, respectively, and approximately22,002,000 and 20,777,000 for the six month periods ended June 30, 2003 and2002, respectively.

 

Had we been profitable for the three and sixmonth periods ended June 30, 2003, the number of weighted average securitiesoutstanding that would have been added to weighted average shares for purposesof calculating diluted earnings per share would have been  (in thousands):

 
|                                        |   | **Three Months Ended  June 30** |   | **Six Months Ended  June 30** |   |
|---------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                        |   | **2003**                        |   | **2002**                      |   | **2003** |   | **2002** |   |
| Unvested common stock subject to repurchase |   | 468                             |   | 538                           |   | 281 |   | 670 |   |
|                                        |   |                            |   |                          |   |   |   |   |   |
| Stock options                               |   | 6,612                           |   | 19,730                        |   | 6,915 |   | 20,107 |   |
|                                             |        |                                 |        |                               |        |  |  |  |  |  |  |  |  |

 

 

7

----

 

4.                                       Balance SheetComponents

 
|                                 |   | **June 30,  2003** |   | **Dec. 31,  2002** |   |
|--------------------------------------|--------|--------------------|--------|--------------------|--------|
| Inventories:                         |   |               |   |               |   |
| Raw materials                        |   | $                  | 1,553  |               | $      | 1,376 |   |
| Work in process                      |   | 3,037              |   | 2,487              |   |
| Finished goods                       |   | 2,801              |   | 3,438              |   |
|                                 |   | $                  | 7,391  |               | $      | 7,301 |   |
|                                 |   |               |   |               |   |
| Accrued liabilities:                 |   |               |   |               |   |
| Accrued payroll and related expenses |   | $                  | 2,440  |               | $      | 2,502 |   |
| Restructuring accrual                |   | 2,354              |   | 2,736              |   |
| Accrued legal fees                   |   | 757                |   | 1,865              |   |
| Warranty accrual                     |   | 603                |   | 223                |   |
| Other accrued liabilities            |   | 2,927              |   | 3,857              |   |
|                                 |   | $                  | 9,081  |               | $      | 11,183 |   |

 

Warranty Accrual

 

At the time ofrevenue recognition, we provide an accrual for estimated costs to be incurredpursuant to our warranty obligations. Our estimate is based primarily onhistorical experience.  Warranty accrual activity for the six months endedJune 30, 2003 was as follows (in thousands):

 
| Balance at January 1, 2003                         |   | $      | 223    |   |
|----------------------------------------------------|--------|--------|--------|--------|
| Provision for warranties issued during the  period |   | 480    |   |
| Accruals related to pre-existing warranties        |   | — |   |
| Cash and other settlements made during the  period |   | (100   | )      |
| Balance at June 30, 2003                           |   | $      | 603    |   |

 

5.                                       Stock-BasedCompensation

 

We account for stock-basedcompensation arrangements in accordance with the provisions of AccountingPrinciples Board Opinion No. 25 (APB 25), “Accounting for Stock Issued toEmployees,” and related interpretations, and comply with the disclosureprovisions of Statement of Financial Accounting Standard No. 148 (SFAS No.148), “Accounting for Stock-Based Compensation—Transition and Disclosure (anamendment of FASB Statement No. 123).” Expense associated with stock-basedcompensation is amortized over the vesting period of the individual award usingan accelerated method, as described in Financial Accounting Standards BoardInterpretation No. 28.

 

We are required to determinethe fair value of stock option grants to non-employees and to record the amountas an expense over the period during which services are provided to us.Management calculates the fair value of these stock option grants using theBlack-Scholes model, which requires us to estimate the life of the stockoption, the volatility of our stock, an appropriate risk-free interest rate,and our dividend yield. The calculation of fair value is highly sensitive tothe expected life of the stock option and the volatility of our stock, both ofwhich we estimate based primarily on historical experience.

 

8

----

 

The following tablesummarizes the components of our stock compensation expense (benefit) for thethree and six months ended June 30, 2003 and 2002 (in thousands):

 
|                                            |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |   |
|-------------------------------------------------|--------|--------------------------------|--------|------------------------------|--------|
|                                            |   | **2003**                       |   | **2002**                     |   | **2003** |   | **2002** |   |
| Options granted to employees                    |   | $                              | 58     |                         | $      | 244 |   | $ | 280 |   | $ | 681 |   |
| Options granted to non-employees                |   | 425                            |   | 625                          |   | 784 |   | 1,226 |   |
| Option repricings                               |   | 527                            |   | (5,171                       | )      | (831 | ) | 2,761 |   |
| Options assumed in connection with acquisitions |   | 1,243                          |   | 1,236                        |   | 1,658 |   | 2,717 |   |
| Stock compensation expense (benefit)            |   | $                              | 2,253  |                         | $      | (3,066 | ) | $ | 1,891 |   | $ | 7,385 |   |

 

6.                                       Restructuring andImpairment Activities

 

During the third quarter of 2001, we began aprogram to focus our business on products and technology, including thoseobtained through acquisitions, in which we have, or believe we can achieve, amarket leadership position. As part of this program, we decided to cancelnumerous products under development, to remove certain projects from ourdevelopment plan, to phase out or de-emphasize certain existing products and tointegrate the operations of two acquired companies—CMD Technology (CMD) andSilicon Communication Lab (SCL).

 

In connection with this program, we reduced ourworkforce in the fourth quarter of 2001 by approximately 60 people, or 20%.This workforce reduction was the initial step in eliminating duplicatepositions that resulted from our acquisitions, and also represented theelimination of other positions based on our new product and technology focus.Positions were eliminated from all functional areas–operations, R&D andSG&A. Because of this workforce reduction, we recorded a restructuringexpense of $1.5 million in the fourth quarter of 2001, consisting of cashseverance-related costs of $599,000, non-cash severance-related costs of$303,000 representing the intrinsic value of modified stock options, anexpected loss on leased facilities of $500,000 and fixed asset write-downs of$50,000. In addition, we reversed $286,000 of unearned compensation, acomponent of stockholders’ equity, for unvested stock options that werecancelled in connection with employee terminations.

 

In the first quarter of 2002, we implemented asecond workforce reduction in connection with the program discussed above,eliminating an additional 35 positions, or 13% of our workforce. Positions wereeliminated from all functional areas. This reduction resulted from thecontinued integration of acquired companies, as well as continued execution ofour product and technology strategy, whereby we decided to phase out the legacystorage subsystem board products we acquired from CMD and to develop new boardproducts only if we believed it would facilitate or accelerate the use of ourstorage semiconductor products. In connection with this workforce reduction, werecorded a restructuring expense of $2.2 million in the first quarter of 2002,consisting of cash severance-related costs of $198,000, non-cashseverance-related costs of $318,000 representing the intrinsic value ofmodified stock options, an expected loss on leased facilities of $1.2 millionand fixed asset write-downs of $500,000 for assets to be disposed of. Inaddition, we reversed $76,000 of unearned compensation, a component ofstockholders’ equity, for unvested stock options that were cancelled in connectionwith employee terminations.

 

In April 2002, we decided to transition to alicensing model for our storage subsystem board products, whereby instead ofdeveloping, manufacturing and selling board products to facilitate oraccelerate the use of our storage semiconductor products, we would develop andlicense board designs in exchange for license fees, royalties and the use ofour semiconductor products. In connection with this decision, we implemented athird workforce reduction, eliminating 14 positions, or 5% of our workforce,and recorded a restructuring expense of $3.5 million, consisting of cashseverance-related costs of $450,000, non-cash severance-related costs of $1.6million representing the intrinsic value of modified stock options and fixed assetwrite-downs of $1.5 million for assets to be disposed of. We also reversed$302,000 of unearned compensation, a component of stockholders’ equity, forunvested stock options that were cancelled in connection with employeeterminations.

 

In connection with ourdecision to stop selling board products and to transition to a licensing model,we assessed recoverability of our intangible assets subject to amortization inaccordance with SFAS No. 144. During the quarter ended June 30, 2002, animpairment expense of $749,000 was recognized for acquired technology and$60,000 was recognized for patent and other intangible assets, based upon ourprojection of significantly reduced future cash flows. Additionally, we reducedour estimate of the useful lives of the remaining intangible assets subject toamortization such that these assets were fully amortized by the end of 2002. Wealso tested the carrying value of goodwill for impairment in accordance withSFAS No. 142 and used the services of a third party to assist with theanalysis. As a result of our impairment test, a goodwill impairment expense of$4.4 million was recognized during the second quarter of 2002. To determine theamount of the impairment, we estimated the fair value of our storage systemsbusiness based primarily on expected future cash flows. We then reduced thisamount by the fair value of identifiable tangible and intangible assets otherthan goodwill (also based primarily on expected future cash flows), andcompared the unallocated fair value of the business to the carrying value ofgoodwill. To the extent goodwill exceeded the unallocated fair value of thebusiness, an impairment expense was recognized.

 

In December 2002, we revised our estimate of theloss we expect to incur on subleased facilities and recorded a restructuringexpense of $1.5 million. Real estate market conditions deteriorated in thefourth quarter of 2002, causing us to reassess the length of time it will taketo find tenants and the fair value lease rate of our available space. As ofDecember 31, 2002, our expected loss on subleased facilities is based onestimated sublease income of $1.6 million over the remaining lease terms. Tothe extent we are unable to generate $1.6 million of sublease income, ourfuture results of operations and financial condition will be negativelyaffected.

 

 

9

----

 

                InMarch 2003, we reorganized the company into lines of business for PC, CE andStorage products to enable us to better manage our long-term growthpotential.  In connection with this reorganization, we reduced ourworkforce by 27 people, or approximately 10%.  These reductions wereprimarily in engineering and operations functions.  Because of thisworkforce reduction, we recorded restructuring expense of $1.0 million in thefirst quarter of 2003, consisting of cash severance-related costs of $340,000and non-cash severance-related costs of $646,000, representing the intrinsicvalue of modified stock options.

 

Severance related costs were determined based onthe amount of pay people received that was not for services performed and bymeasuring the intrinsic value of stock options that were modified to thebenefit of terminated employees. For those employees terminated in the threemonth period ending March 31, 2003, the remaining service period from thecommunication date did not exceed 60 days. The expected loss on leasedfacilities resulted from our plan to consolidate our remaining workforce to theextent practicable and sublease any excess space. To determine the expectedloss, we compared our lease and operating costs for the space to our estimateof  the net amount we would be able torecover by subleasing the space. This estimate was based on a number ofassumptions, including the length of time it will take to secure a tenant, thesublease rate per square foot, the cost of necessary improvements ormodifications and real estate broker commissions. The fixed asset write-downsin 2001 and 2002 were determined based on the estimated fair value of assets,primarily computer hardware and software that would no longer be utilized afterthe employees’ termination dates.

 

Severance and benefits payments are substantially complete. Leasepayments will be made in the form of cash through the end of the related leaseterms of July 2003 and November 2005. The following table presentsrestructuring activity for 2001 though June 30, 2003 (in thousands):

 
|                            |   | **Severance  and Benefits** |   | **Leased  Facilities** |   | **Fixed Assets** |   | **Total** |   |
|---------------------------------|--------|-----------------------------|--------|------------------------|--------|------------------|--------|-----------|--------|
| 2001 provision                  |   | $                           | 902    |                   | $      | 500              |   | $         | 50     |   | $ | 1,452 |   |
| Cash payments                   |   | (191                        | )      | —                 |   | —           |   | (191      | )      |
| Non-cash activity               |   | (303                        | )      | (115                   | )      | —           |   | (418      | )      |
| Balance as of December 31, 2001 |   | 408                         |   | 385                    |   | 50               |   | 843       |   |
| 2002   provision           |   | 2,547                       |   | 2,633                  |   | 2,013            |   | 7,193     |   |
| Cash payments                   |   | (865                        | )      | (420                   | )      | —           |   | (1,285    | )      |
| Non-cash activity               |   | (1,952                      | )      | —                 |   | (2,063           | )      | (4,015    | )      |
| Balance as of December 31, 2002 |   | 138                         |   | 2,598                  |   | —           |   | 2,736     |   |
| 2003 provision                  |   | 986                         |   | —                 |   | —           |   | 986       |   |
| Cash payments                   |   | (399                        | )      | (323                   | )      | —           |   | (722      | )      |
| Non-cash activity               |   | (646                        | )      | —                 |   | —           |   | (646      | )      |
| Balance as of June 30, 2003     |   | $                           | 79     |                   | $      | 2,275            |   | $         | — |   | $ | 2,354 |   |

 

7.                                       Debt Facility

 

In October 2002, we entered into a new debtfacility that includes a revolving line of credit of up to $7.5 million, a termloan of $3.6 million, and equipment advances of $1.0 million. Borrowings underthe revolving line are limited to the lesser of $7.5 million or our borrowingbase of 80% of eligible accounts receivable. The revolving line has a maturitydate of September 26, 2003. There were no borrowings outstanding under thisline at June 30, 2003. The $3.6 million term loan refinanced $3.1 million ofdebt acquired in connection with our acquisition of CMD and $500,000 of otherbank debt, and requires monthly payments through its maturity of October 1,2004.  During the three months ended March 31, 2003, we borrowed $383,000under the equipment advances portion of the facility.  This term loanbears interest at 5% and requires monthly payments through its maturity inFebruary 2005.  Equipment advances were available to us only through March31, 2003; therefore, the unused portion of this facility of $617,000 expired asof March 31, 2003.  All borrowings under the revolving line and the $3.6million term loan are at prime (4.25% at June 30, 2003) plus 0.25%, and thefacility is secured by substantially all of our assets, excluding intellectualproperty. This facility contains certain quarterly and annual financialcovenants with which we must comply. We were not in compliance with one of thequarterly covenants at December 31, 2002; however, we were granted a waiverfrom the lending institution and were not in default of the loan agreement. Asof June 30, 2003, we were in compliance with all of our financial covenants.However, since we were not in compliance at December 31, 2002, and cannot beassured we will be in compliance in the future, we have classified all amountsoutstanding under the credit agreement as current liabilities as of June 30,2003.

 

8.                                 Legal Proceedings

 

On April 24, 2001, we filed suit in the U.S. District Court for theEastern District of Virginia against Genesis Microchip Corp. and GenesisMicrochip, Inc. (collectively, Genesis) for infringement of our U.S. patentnumber 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (theFederal Suit). On April 24, 2001, we also filed a complaint against Genesiswith the International Trade Commission of the United States government (ITC)for unlawful trade practices related to the importation of articles infringingour patent (the ITC investigation). The actions sought injunctions to halt theimportation, sale, manufacture and use of Genesis DVI receiver chips thatinfringe our patent, and monetary damages. We voluntarily moved to dismiss theITC investigation, with notice that we would proceed directly in the FederalSuit. Our motion to dismiss was granted on February 7, 2002. We filed anamended complaint in the Federal Suit as of February 28, 2002. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. Also in April 2002, we filed a motion to dismiss certain of Genesis’counterclaims. In addition, we filed a motion to bifurcate trial of thecounterclaims to the extent the court does not dismiss them. In May 2002, theCourt granted our motion to dismiss certain of the counterclaims, with leave toamend. Genesis re-filed counterclaims against us for fraud and patent misuse.We filed another motion to dismiss these counterclaims. In December 2002, theparties entered into a memorandum of understanding (MOU) to settle thecase.  In January, the parties presenteddifferent interpretations of the MOU to the Court.  On July 15, 2003, the Court granted our motion to interpret the 

10

----

 

MOU in the manner we requested, and ruled that Genesis had engaged inefforts to avoid its obligations under the MOU.  On August 6, 2003, the Court entered a final judgment based onits July 15, 2003 ruling.  Under thefinal judgment order, Genesis was ordered to make a substantial cash payment,and to make royalty payments. To date, we have not recognized any income orrevenue associated with the matter, including amounts previously received forwhich payment was not honored. Due to the continuing and contentious nature ofthis litigation, we will not record any income or revenue related to thismatter until litigation is complete. Management intends to prosecute ourposition vigorously until this matter is resolved. Through June 30, 2003, wehave spent approximately $10.0 million on this matter and expect to continue toincur significant costs through at least the third quarter of 2003, and longerif further litigation based upon or related to the breach of the MOU, or fraud,is commenced, or if Genesis appeals. Management intends to file a motion for reimbursement of some of ourexpenses, including some of our legal fees, but there is no assurance that theCourt will grant such motion.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters have been named as defendants in a securities class action lawsuitcaptioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001)pending in Federal District Court for the Southern District of New York. Thelawsuit alleges that all defendants were part of a scheme to manipulate theprice of Silicon Image’s stock in the aftermarket following Silicon Image’sinitial public offering in October 1999. Response to the complaint anddiscovery in this action on behalf of Silicon Image and individual defendantshas been stayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, the Courtdenied the underwriters’ motion to dismiss and ordered that the case mayproceed against issuers including against Silicon Image. At this time, wecannot accurately predict the outcome of this litigation; however, a proposedsettlement has been negotiated that has yet to be reviewed and approved by theCourt.  In the event that the settlementis approved, we do not expect it to have a material effect on our results ofoperations or financial position.  Inthe event that the settlement is not approved, we intend to defend this mattervigorously.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters have been named as defendants in a securities class action lawsuitcaptioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D.Fla. 2003) pending in Federal District Court for the Southern District ofFlorida. Plaintiff filed an action on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.Silicon Image has not been served with a copy of the complaint. The plaintiffin this matter has filed an amended complaint in which Silicon Image, and thenamed officers, were dropped as defendants. We believe that the proposed settlement described above, if approved,would encompass the claims in this case. We believe that these claims werewithout merit and, if revived, and not subject to the settlement, we woulddefend this matter vigorously.

 

In addition, we are involved in a number of judicial and administrativeproceedings incidental to our business. We intend to prosecute or defend, asappropriate, such matters vigorously, and although adverse decisions orsettlements may occur in one or more of such cases, the final resolution ofthese matters, individually or in the aggregate, is not expected to have amaterial adverse effect on our results of operations or financial position.

 

9.                                       Customer andGeographic Information

 

Revenue by geographic area was as follows (in thousands):

 
|          |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |       |
|---------------|--------|--------------------------------|--------|------------------------------|------------|
|          |   | **2003**                       |   | **2002**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
|          |   |                           |   |                         |       |   |   |   |   |
| Taiwan        |   | $                              | 8,622  |                         | $          | 6,554 |   | $ | 18,437 |   | $ | 12,639 |   |
| Japan         |   | 3,029                          |   | 2,196                        |       | 5,623 |   | 4,363 |   |
| United States |   | 6,567                          |   | 5,654                        |       | 13,341 |   | 10,181 |   |
| Hong Kong     |   | 1,459                          |   | 2,043                        |       | 2,978 |   | 3,614 |   |
| Korea         |   | 1,004                          |   | 1,532                        |       | 2,125 |   | 2,600 |   |
| Other         |   | 3,651                          |   | 1,293                        |       | 6,504 |   | 2,962 |   |
|          |   | $                              | 24,332 |                         | $          | 19,272 |   | $ | 49,008 |   | $ | 36,359 |   |

 

11

----

 

Revenue by product line was as follows (in thousands):

 
|                                 |   | **Three Months Ended June 30** |   | **Six Months Ended June 30** |       |
|--------------------------------------|--------|--------------------------------|--------|------------------------------|------------|
|                                 |   | **2003**                       |   | **2002**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                 |   |                           |   |                         |       |   |   |   |   |
| PC                                   |   | $                              | 7,136  |                         | $          | 11,759 |   | $ | 15,929 |   | $ | 23,504 |   |
| Consumer Electronics                 |   | 5,255                          |   | 2,097                        |       | 8,505 |   | 3,506 |   |
| Storage IC                           |   | 6,774                          |   | 2,977                        |       | 13,410 |   | 4,581 |   |
| Storage Systems                      |   | 580                            |   | 1,389                        |       | 1,623 |   | 3,236 |   |
| Development, licensing and royalties |   | 4,587                          |   | 1,050                        |       | 9,541 |   | 1,532 |   |
|                                 |   | $                              | 24,332 |                         | $          | 19,272 |   | $ | 49,008 |   | $ | 36,359 |   |

 

For each period presented, substantially alllong-lived assets were located within the United States.

 

For the three months ended June 30, 2003, two customers each generated15% and 12% of our revenue. For the six months ended June 30, 2003, twocustomers each generated 13.7% and 11.0% of our revenue and, as of June 30,2003, 4 customers each represented 12.8%, 9.9%, 8.4% and 8.2% of gross accountsreceivable.

 

For the three months ended June 30, 2002, two customers each generated14% and 11% of our revenue. For the six months ended June 30, 2002, twocustomers each generated 13% of our revenue and, as of June 30, 2002, threecustomers each represented 18%, 13% and 10% of gross accounts receivable.

 

10.                                 Guarantees

 

Certain of our  licensing agreements indemnify our customers forexpenses or liabilities resulting from claimed infringements of patent,trademark or copyright by third parties related to the intellectual propertycontent of our products. Certain of these indemnification provisions areperpetual from execution of the agreement and, in some instances, the maximumamount of potential future indemnification is not limited. To date, we have notpaid any such claims or been required to defend any lawsuits with respect to aclaim. However, there can be no assurance that such claims will not be filed inthe future.

 

11.                                 Acquisition

 

Transwarp Networks, Inc:

 

In April 2003, we acquired TransWarp Networks, Inc. (“TWN”), adevelopment stage enterprise. Through this transaction, we acquired certainintellectual property and engineering expertise that will enable us to broadenour storage product offerings and to develop more advanced storage products.TWN was acquired by means of a merger, pursuant to which all outstanding sharesof TWN’s capital stock were exchanged for shares of Silicon Image’s commonstock. In addition, all outstanding options to purchase TWN common stock wereconverted into options to purchase Silicon Image’s common stock. In accordancewith EITF Issue No. 98-3, “Determining Whether a Nonmonetary TransactionInvolves Receipt of Productive Assets or of a Business”, this transaction wasaccounted for as an asset purchase.

 

The total purchase price was approximately $14.7 million, consisting ofthe issuance of approximately 2.5 million shares of Silicon Image common stock,valued at $11.4 million, 0.8 million shares of Silicon Image common stockissuable upon exercise of options, valued at $3.0 million, and transactioncosts of $0.3 million. The purchase price was allocated as follows (inthousands):

 
| Assembled workforce                 |   | $      | 520    |   |
|-------------------------------------|--------|--------|--------|--------|
|                                |   |   |   |
| Core technology                     |   | 1,295  |   |
|                                |   |   |   |
| Developed technology                |   | 548    |   |
|                                |   |   |   |
| In-process research and development |   | 5,482  |   |
|                                |   |   |   |
| Non-compete agreement               |   | 1,914  |   |
|                                |   |   |   |
| Net tangible assets acquired        |   | 93     |   |
|                                |   |   |   |
| Unearned compensation               |   | 4,819  |   |
|                                |   |   |   |
| Total                               |   | $      | 14,671 |   |

 

The assembled workforce will be amortized over 18 months. Developedtechnology and the non-compete agreement will be amortized over a period ofthree years (the length of the non-compete agreement), and core technology willbe amortized over a period of four years. Unearned compensation will beamortized over the remaining employee vesting period, which ranges from 27months to 57 months.

 

12

----

 

The value allocalted to in-process research and development (“IPR&D”)was calculated using established valuation techniques accepted in the hightechnology industry. These techniques give consideration to relevant marketsizes and growth factors, expected industry trends, the anticipated nature andtiming of new product introductions by us and by our competitors, individualproduct sales cycles, and the estimated lives of each of the product’sunderlying technology. The value of IPR&D reflects the relative value andcontribution of the acquired research and development. In determining the valueassigned to IPR&D, we considered the R&D’s stage of completion, thecomplexity of the work completed to date, the difficulty of completing theremaining development, costs already incurred, and the projected cost tocomplete the project. A discount rate of 30% was used to determine the netpresent value of estimated cash flows for this project.

 

The values assigned to core technology and developed technology werebased upon discounted cash flows related to the existing product’s projectedincome stream. Elements of the projected income stream includes revenue, costof sales, SG&A expenses and R&D expenses. The discount rates used inthe present value calculations range from 20% to 25% and were generally derivedfrom a weighted average cost of capital, adjusted upward to reflect theadditional risks inherent in the development life cycle.  Such risks include the useful life of thetechnology, profitability levels of the technology, and the uncertainty of thetechnology advances that are known at the date of the acquisition.

 

Assembled workforce was valued based on the estimated costs to replacethe existing staff, including recruiting, hiring and training costs foremployees in all categories, and to fully deploy a work force of similar sizeand skill to the same level of productivity as the existing work force.

 

The valueof the non-compete agreement was based on the Income Approach, which measuresthe difference between cash flows generated assuming the existence of thenon-compete agreement (assuming no competition exists for the individualscovered by the non-compete) and the cash flows assuming competition. Theresulting net cash flows were discounted using a discount rate of 25%.

 

12.                           IntangibleAssets, net

 

Components of intangible assets are as follows (in thousands):

 
|                                           |   | **June 30, 2003**           |   | **December 31, 2002**         |   |
|------------------------------------------------|--------|-----------------------------|--------|-------------------------------|--------|
|                                           |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
|                                           |   |                        |   |                          |   |   |   |   |   |
| Intangible assets subject to amortization:     |   |                        |   |                          |   |   |   |   |   |
| Acquired technology                            |   | $                           | 1,843  |                          | $      | (126 | ) | $ | 10,726 |   | $ | (10,726 | ) |
| Non-compete agreement                          |   | 1,914                       |   | (160                          | )      | — |   | — |   |
| Assembled workforce                            |   | 520                         |   | (87                           | )      | — |   | — |   |
| Patents and other                              |   | —                      |   | —                        |   | 2,599 |   | (2,599 | ) |
|                                           |   | $                           | 4,277  |                          | $      | (373 | ) | $ | 13,325 |   | $ | (13,325 | ) |
|                                           |   |                        |   |                          |   |   |   |   |   |
| Intangible assets not subject to amortization: |   |                        |   |                          |   |   |   |   |   |
| Goodwill                                       |   | $                           | 13,021 |                          | $      | — |   | $ | 13,021 |   | $ | — |   |

 

Estimated amortization expense for our intangible assets is as followsfor fiscal years ending December 31 (in thousands):

 
| 2003 * |   | $     | 1,118  |   |
|--------|--------|-------|--------|--------|
| 2004   |   | 1,404 |   |
| 2005   |   | 1,144 |   |
| 2006   |   | 529   |   |
| 2007   |   | 82    |   |
|   |   | $     | 4,277  |   |

 

* Includes $373,000 ofamortization for the first six months of 2003

 

13

----

 

**Item 2****.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*This report contains forward-looking statements withinthe meaning of Section 21E of the Securities and Exchange Act of 1934 andSection 27A of the Securities Act of 1933. These forward-looking statements involvea number of risks and uncertainties, including those identified in the sectionof this Form 10-Q entitled “Factors Affecting Future Results,” that may causeactual results to differ materially from those discussed in, or implied by,such forward-looking statements. Forward-looking statements within this Form10-Q are identified by words such as “believes,” “anticipates,” “expects,”“intends,” “may,” “will” and other similar expressions. However, these wordsare not the only means of identifying such statements. In addition, anystatements that refer to expectations, projections or other characterizationsof future events or circumstances are forward-looking statements. We undertakeno obligation to publicly release the results of any revisions to theseforward-looking statements that may be made to reflect events or circumstancesoccurring subsequent to the filing of this Form 10-Q with the SEC. Our actualresults could differ materially from those anticipated in, or implied by,forward-looking statements as a result of various factors, including the risksoutlined elsewhere in this report. Readers are urged to carefully review andconsider the various disclosures made by Silicon Image, Inc. in this report andin our other reports filed with the SEC that attempt to advise interestedparties of the risks and factors that may affect our business.*

 

**Overview**

 

SiliconImage designs, develops and markets semiconductor products for applicationsthat require high-bandwidth, cost-effective solutions for high-speed digitaldata communications. The markets into which we sell our products are personalcomputer (PC), consumer electronics (CE) and storage.

 

Productssold into the PC market generated 33% of our revenue in the first six months of2003, 58% of our revenue in 2002, and 65% of our revenue in the first sixmonths of 2002.

 

Our PCproducts are based on PanelLink technology, which is our proprietaryimplementation of the digital visual interface (DVI) specification that definesa high-speed serial data communication link between computers and digitaldisplays. Despite accelerated DVI adoption, sluggish growth in the host portionof the PC market and a movement among graphic card manufacturers to eliminatethe need for discrete transmitters by integrating transmitter functionalityinto their graphic chips, has resulted in decreased overall demand for discretetransmitters. The display portion of the PC market remains predominantly analogor dual-interface, which is capable of receiving either an analog or digital signal.We do not offer an analog or dual-interface solution, but do partner with othercompanies to sell multiple-chip solutions into the dual-interface market. Thesemultiple-chip solutions are typically limited to higher end, larger displaysoperating at resolutions of SXGA and above. In addition, we have licensedcertain of our technologies to companies for use in making products for thedual-interface market. We believe that the display portion of the PC marketwill eventually transition to a pure digital solution, which should result inan expansion of the market suited to our product offering.

 

Productssold into the CE market generated 17% of our revenue in the first six months of2003, 11% of our revenue in 2002, and 10% of our revenue in the first sixmonths of 2002. Our CE products offer a secure digital video and audiotransmission for consumer devices, such as digital TVs and DVD players. Demandfor these products will be driven primarily by the adoption rate of newtechnologies, such as DVI with HDCP, and industry standards, such as HDMI.

 

Semiconductorproducts sold into the storage market generated 27% of our revenue in the firstsix months of 2003, 15% of our revenue in 2002, and 13% of our revenue in thefirst six months of 2002. Demand for our storage products is dependent upon therate at which interface technology transitions from parallel to serial, and theextent to which serial ATA and fibre channel functionality are integrated intochip sets and controllers offered by other companies, which would make ourdiscrete devices unnecessary.

 

Sales ofstorage subsystems products generated 3% of our revenue in the first six monthsof 2003, 8% of our revenue in 2002, and 9% of our revenue in the first sixmonths of 2002. We are phasing out our subsystems products and do not plan ondeveloping, manufacturing and selling new subsystems products in the future.Therefore, we expect sales of such products to represent less than 2% of ourrevenue in 2003. In conjunction with our decision to phase out our storagesystems products, we decided to design products for and/or license ourtechnology to third parties in this market.

 

We alsoderive revenue from licensing our intellectual property. Our licensing activityis complementary to our product sales and we believe this activity can helpaccelerate adoption curves associated with our technology. We expect licensingand royalties to account for approximately 15% to 20% of our revenue over thenext few years.

 

From ourinception in 1995 through the first half of 1997, we were engaged primarily indeveloping our first generation PanelLink digital transmitter and receiverproducts, developing our high-speed digital interconnect technology,establishing our digital interface technology as an open standard, and buildingstrategic customer and foundry relationships. During that period, we derivedsubstantially all of our revenue from contracts providing for the jointdevelopment of technologies for high-speed digital communication andintelligent panel controllers for flat panel displays, as well as fromlicensing our high-speed digital interconnect technology.

 

In thethird quarter of 1997, we began volume shipments of our first generationPanelLink digital transmitter and receiver products. Since that time, we havederived most of our revenue from the sale of PanelLink products and we haveintroduced several new generations of transmitter and receiver productsproviding higher speed and increased functionality. In 1999, we began shippingour first generation digital display controller product. Our digital displaycontroller products integrate our receiver with digital image processing anddisplay controller technology, which enables development of intelligentdisplays for the mass-market.

 

In October1999, we raised approximately $48 million in our initial public offering. Wehave incurred losses in each year and most quarterly periods since ourinception and, as of June 30, 2003, we had an accumulated deficit of $165million.

 

14

----

 

In 2000,we began focusing our resources on entering two new markets, storage and CE,which we believed would grow significantly and in which we believed we couldapply our technology and expertise in high-speed serial interfaces. During 2000,we acquired Zillion, a developer of high-speed transmission technology for datastorage applications, and DVDO, a provider of digital video processing systemsfor the CE market.

 

In 2001,we focused on accelerating our entry into the CE and storage markets,leveraging our IP into licensing revenue and restructuring the company toimprove profitability. During 2001, we acquired CMD, a provider of storagesubsystems and semiconductors designed for storage area networks, and SCL, aprovider of mixed-signal and high-speed circuit designs.

 

During2002, we achieved double-digit revenue growth in each fiscal quarter, resultingin record annual revenue of $81.5 million, which was a 57% increase from 2001revenue levels. We also began to see the benefits of our diversificationstrategy, which resulted in establishing a key presence in the CE and storagemarkets, both of which we expect to experience significant growth rates duringthe next several years. Additionally, we were able to successfully leverage ourintellectual property to generate $6.7 million of development and licensingrevenue.  We also focused on improving our profitability and reducing ourcash usage rate. Our cash and short-term investments declined by $5.4 millionin 2002, versus $19.0 million in 2001.

 

On April7, 2003, we issued approximately 2,501,000 shares of common stock in exchangefor all outstanding shares of TransWarp Networks’ (TransWarp) capital stock,and converted all outstanding TransWarp options into options to purchaseapproximately 760,000 shares of our common stock.  The purchase price forthis acquisition was approximately $14.7 million.  Approximately 392,000shares of our issued common stock will be held in escrow for a period ofeighteen months as collateral for indemnity obligations of the principalTransWarp stockholders.   We alsoassumed TransWarp’s 2002 Stock Option / Stock Issuance Plan, under which areserve of approximately 116,000 shares of our common stock remained availablefor future issuance. This transaction has been accounted for as an assetpurchase. We expensed $5.5 million of in-process research and development andrecorded tangible and intangible assets of $4.3 million in connection with thistransaction.

 

On July15, 2003, the Federal District Court in Richmond, Virginia, upheld ourinterpretation of a previously agreed upon Memorandum of Understanding (MOU).On August 6, 2003, the Court entered a final judgment based on its July 15,2003 ruling. Under the final judgement order, Genesis was ordered to make a substantialcash payment, and make royalty payments. To date we have not recognized anyincome or revenue associated with the matter, including amounts previouslyreceived for which payment was not honored. Under the settlement agreement,Genesis was granted a license for the right to use certain non-necessary patentclaims referred to in the Digital Visual Interface (DVI) Adopters Agreement. Inaddition, upon Genesis’ becoming a signatory to the HDMI Adopters Agreement,Genesis will be granted a license for the right to use these claims as part ofa High-Definition Multimedia Interface (HDMI) implementation. Genesis also wasgranted a license to expand use of certain DVI-related patent claims to theconsumer electronics marketplace. 

 

**Outlook**

 

We expect2003 revenue to increase from the level achieved in 2002. We also expect togenerate positive cash flow during the second half of 2003, independent of anysettlement proceeds received in connection with the previously mentionedGenesis settlement.

 

Our expectation of overall revenue growth in 2003 is based on threeassumptions. First, we have achieved numerous design wins in the CE market forDVI with HDCP and HDMI products, and expect these designs to go into productionduring 2003. Although it is difficult to predict exactly when and howaggressively revenue from these products will ramp during 2003, our expectationis that we will generate significant revenue from these designs and thatrevenue will grow quarter-over-quarter throughout the remainder of 2003. Second,we believe that the storage market will continue its transitions to 2 Gb fibrechannel switches and serial ATA technology, which should result in increasingrevenue from our fibre channel and SATALink products. We expect theavailability of serial ATA-enabled hard drives and other peripherals toimprove, which should enable acceleration of the transition to serial ATAtechnology. Third, we expect licensing and royalty revenue to reachapproximately $18.0 million during 2003, as we continue to implement ourstrategy of licensing our technology to companies that address market segmentsin which we have chosen not to directly participate and begin receivingroyalties from licenses entered into during 2001 and 2002. These factors willbe somewhat offset by decreased revenue within the PC market, which can beattributed primarily to the integration of transmitters in graphics chips.Additionally, revenue from storage systems products is expected to decreaseyear-over-year due to our transition out of that product line.

 

Among the factors that may cause our actual results to differ materiallyfrom those anticipated by our assumptions include the rate at which the PCmarket adopts DVI, acceptance of all digital solutions in the PC market, CEmarket acceptance of our DVI with HDCP and HDMI products, the rate at which thestorage market transitions to 2 Gb fibre channel switches and serial ATAtechnology, consumer demand in the PC and CE markets, the availability ofserial ATA-enabled hard drives and other peripherals, whether and how quicklyOEMs are able to integrate transmitters in their graphics chips and serial ATAfunctionality into their chip sets, our ability to leverage our intellectualproperty into licensing revenue and the ability of our semiconductor foundriesto manufacture our products in commercial volumes at an acceptable cost and ina timely manner. In addition, our revenue remains subject to competition andgeneral economic and market conditions, none of which can be accuratelypredicted.

 

Since theamount of stock compensation expense we record in any period is dependent onchanges in our stock price, we are not able to reasonably estimate the amountof stock compensation we will record in future periods. Therefore, ourdiscussion of gross margin percentage, R&D expense and SG&A expenseexpectations is on a non-GAAP basis.

 

Excluding non-cash charges for stock compensation expense, we expect ourgross margin percentage in the third quarter of 2003 to increase 2% - 3% fromthe second quarter of 2003, as a result of a shift in product mix to productswith higher gross margins and improved yields and product quality, offsetsomewhat by declines in average selling prices.

 

15

----

 

Excluding non-cash charges for stock compensation expense, we expect thedollar amount of our R&D expense in the third quarter of 2003 to increaseapproximately 3%-5% from the second quarter of 2003. R&D expense will beincurred for enhancements to existing products and for further development oftechnology related to consumer electronics and storage applications. Excludingnon-cash charges for stock compensation expense, we expect SG&A expense inthe third quarter of 2003 to increase approximately 2% from the second quarterof 2003, primarily as a result of increased commissions*.*

 

We expect to incur substantial non-cash stock compensation expense in2003 and future periods as a result of previous stock option repricings, stockoptions assumed in connection with acquisitions, the issuance of stock optionsto consultants, and modifications to stock options. We may also incur non-cashstock compensation expense in connection with future acquisitions. The amountof stock compensation expense in each period will fluctuate with changes in ourstock price and volatility.  Since the amount of stock compensationexpense or benefit in any given period is highly dependent on changes in ourstock price, it is not possible for us to reasonably estimate the amount ofexpense we will incur for a particular period.

 

During thesecond half of 2003, we expect to incur $0.7 million of expense for theamortization of intangible assets.

 

During 2003 and future periods, we may also incur non-cash expenses forthe impairment of intangible assets, which is something we cannot reasonablypredict or estimate at this time.

 

Additionally,if our litigation against Genesis is completed during the quarter, and wereceive a cash payment from Genesis due to us pursuant to the MOU, we willrecognize the settlement funds amount as non-operating income and the amount ofthe payment attributable to royalties will be recognized as licensingrevenues. The amount of legal fees we incur with respect to the litigationmatters described above will depend on the duration of our litigation matters,as well as the nature and extent of the litigation activities. We are not ableto accurately estimate the amount of legal fees we will incur in 2003 withrespect to the litigation matters described above; however, we do expect toincur substantial amounts through at least the third quarter of 2003, andlonger if further litigation based upon or related to the breach of the MOU, orfraud, is commenced, or if Genesis appeals.

 

**Commitments,Contingencies and Concentrations**

 

InSeptember 1998, we entered into an agreement with Intel to develop and promotethe adoption of a digital display interface specification. In connection withthis agreement, we granted Intel a warrant to purchase 285,714 shares of ourcommon stock at $1.75 per share. Under the same agreement, we granted Intel awarrant to purchase 285,714 shares of our common stock at $0.18 per share uponachievement of a specified milestone that was reached during the first quarterof 1999. Both of these warrants were exercised in May 2001. Additionally, if asecond specified milestone is achieved, which we do not believe is likely, wewould be required to grant Intel a third warrant to purchase 285,714 shares ofour common stock at $0.18 per share. The estimated fair value of such a warrantat June 30, 2003 would be $1.5 million.

 

Historically,a relatively small number of customers and distributors have generated asignificant portion of our revenue. For instance, our top five customers,including distributors, generated 45% of our revenue in the second quarter of2003, 40% of our revenue during the first quarter of 2003, and 41% of ourrevenue in 2002.  Additionally, the percentage of revenue generatedthrough distributors tends to be significant, since many OEM’s rely upon third partymanufacturers or distributors to provide purchasing and inventory managementfunctions. In the second quarter of 2003, 39% of our revenue was generatedthrough distributors, compared to 36% during the first quarter of 2003 and 42%in 2002.

 

Asignificant portion of our revenue is generated from products sold overseas.Sales to customers in Asia, including distributors, generated 68% of ourrevenue in the second quarter of 2003, compared to 71% of our revenue in thefirst quarter of 2003, and 64% of our revenue in 2002. The reason for ourgeographical concentration in Asia is that most of our products are part offlat panel displays, graphic cards and motherboards, the majority of which aremanufactured in Asia. The percentage of our revenue derived from any country isdependent upon where our end customers choose to manufacture their products.Accordingly, variability in our geographic revenue is not necessarilyindicative of any geographic trends, but rather is the combined effect of newdesign wins and changes in customer manufacturing locations. All revenue todate has been denominated in U.S. dollars.

 

Our lease and debt obligations as of June 30, 2003  are consistent with the informationpresented in our Form 10K for the fiscal year ended December 31, 2002.

 

**Recent Accounting Pronouncements**

 

In May2003, the Financial Accounting Standard Board, or FASB, issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity.” SFAS No. 150 establishes standards for how companiesclassify and measure certain financial instruments with characteristics of bothliabilities and equity. SFAS No. 150 requires companies to classify a financialinstrument that is within its scope as a liability (or an asset in some circumstances),and is effective beginning the third quarter of fiscal 2003. We believe thatthe adoption of this standard will have no material effect on our consolidatedfinancial statements.

 

In January2003, the FASB issued FASB Interpretation No. 46, or FIN 46, “Consolidation ofVariable Interest Entities—an interpretation of ARB No. 51.” FIN 46 requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the equity investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. FIN 46 is effectiveimmediately for all new variable interest entities created or acquired afterJanuary 31, 2003. For variable interest entities created or acquired prior toFebruary 1, 2003, the provisions of FIN 46 must be applied for the firstinterim or annual period beginning after June 15, 2003. We believe that theadoption of this standard will have no material effect on our consolidatedfinancial statements.

 

16

----

 

InNovember 2002, the Emerging Issues Task Force reached a consensus on Issue00-21(“EITF 00-21”), “Multiple-Deliverable Revenue Arrangements.”  EITF 00-21 addresses how to account forarrangements that may involve the delivery or performance of multiple products,services and/or rights to use assets. The consensus mandates how to identifywhether goods or services or both which are to be delivered separately in abundled sales arrangement should be accounted for separately because they are“separate units of accounting.” The guidance can affect the timing of revenuerecognition for such arrangements, even though it does not change rulesgoverning the timing or patterns of revenue recognition of individual itemsaccounted for separately. The final consensus will be applicable to agreementsentered into in fiscal periods beginning after June 15, 2003, with earlyadoption permitted. Additionally, companies will be permitted to apply theconsensus guidance to all existing arrangements as the cumulative effect of achange in accounting principle in accordance with Accounting Principles BoardOpinion No. 20, “Accounting Changes.” We are assessing the potential effect ofthis guidance, but at this point we do not believe the adoption of EITF 00-21will have a material effect on our consolidated financial statements.

 

**Results of Operations for the Three and Six MonthsEnded June 30, 2003, Compared to Results of Operations for the Three andSix Months Ended June 30, 2002**

 

*Revenue.   *Revenue was $24.3 million for thethree months ended June 30, 2003, compared to $19.3 million for the threemonths ended June 30, 2002, an increase of 26%. Revenue was$49.0 million for the six months ended June 30, 2003, compared to$36.4 million for the six months ended June 30, 2002, an increase of 35%. The$12.6 million increase in revenue during the six month periods isprimarily due to increased licensing activity, which contributed an additional$8.0 million of revenue. The remainder of the increase is primarilyattributable to our new product offerings in consumer electronics and storage,as well as overall growth in these markets. The effect of these increases waspartially offset by a decrease in demand for our PC products, which can beattributed primarily to a higher level of integration of our technology by ourcustomers, which eliminates the need for our discrete products, and decreasedrevenue from our storage subsystems products, which resulted from our decisionto phase out this product line.

 

*Cost of revenue.   *Cost of revenue consists primarily ofcosts incurred to manufacture, assemble, test and ship our products, as well asrelated overhead costs and provisions for excess and obsolete inventories. Costof revenue excludes non-cash stock compensation expense (benefit) of $78,000and $(544,000) for the three months ended June 30, 2003 and 2002, respectively,and $(57,000) and $379,000 for the six months ended June 30, 2003 and 2002,respectively. Including stock compensation expense, our cost of revenue andgross margin (revenue minus cost of revenue, as a percentage of revenue) wouldhave been $10.7 million, or 55.9%, and $8.5 million, or 55.7%, for the threemonth periods ended June 30, 2003 and 2002, respectively and $21.8 million, or55.6% of revenue and $18.0 million, or 50.6% of revenue, for the six monthsended June 30, 2003 and 2002, respectively. Excluding stock compensationexpense, gross margin increased to 55.4% for the six month period ended June30, 2003, from 51.7% for the same period in 2002. This increase is attributableprimarily to increased licensing revenue, which has no associated cost ofsales, and, to a lesser extent, reduced sales of storage subsystems productswhich are lower margin products than our PC products. These factors were offsetby decling ASP’s, yield and quality issues for certain new products, andincreased sales of storage IC products, which have lower margins than other PCproducts.

 

*Research and development.   *R&D consists primarily ofcompensation and related costs for employees, fees for independent contractorsand development tools and materials. R&D expense was $9.4 million, or38.5% of revenue, and $8.2 million, or 42.6% of revenue, for the three monthsended June 30, 2003 and 2002, respectively. R&D expense was$18.2 million, or 37.1% of revenue, and $15.6 million, or 42.9% ofrevenue, for the six months ended June 30, 2003 and 2002, respectively.

 

Theincrease in absolute dollars in both periods was primarily due to an increasein the number of R&D projects to support the multiple markets in which weoperate, as well as additional personnel, including personnel from TranswarpNetworks. R&D excludes non-cash stock compensation expense (benefit) of$1.8 million and $(833,000) for the three months ended June 30, 2003 and2002, respectively. Including stock compensation expense, R&D would havebeen $11.2 million and $7.4 million, or 45.9% and 38.3% of revenue,for the three months ended June 30, 2003 and 2002, respectively. R&Dexcludes $2.0 million and $5.1 million of non-cash stock compensationexpense for the six months ended June 30, 2003 and 2002, respectively.Including stock compensation expense, R&D would have been$20.2 million and $20.7 million, or 41.2% and 56.9% of revenue, forthe six months ended June 30, 2003 and 2002, respectively.

 

*Selling, general and administrative.*   SG&A consistsprimarily of employee compensation and benefits, sales commissions, andmarketing and promotional expenses. SG&A expense was $4.4 million, or17.9% of revenue, and $4.6 million, or 23.7% of revenue, for the three monthsended June 30, 2003 and 2002, respectively. SG&A expense was$8.7 million, or 17.7% of revenue, and $9.5 million, or 26.2% of revenue,for the six months ended June 30, 2003 and 2002, respectively. Thedecrease in absolute dollars in both periods was primarily due to a decrease inheadcount. SG&A excludes non-cash stock compensation expense (benefit) of$334,000 and $(1.7) million for the three months ended June 30, 2003 and2002, respectively. Including stock compensation expense, SG&A expensewould have been $4.7 million and $2.9 million, or 19.3% and 14.9% ofrevenue, for the three months ended June 30, 2003 and 2002, respectively.SG&A excludes non-cash stock compensation expense (benefit) of $(20,000)and $2.0 million for the six months ended June 30, 2003 and 2002,respectively. Including stock compensation expense, SG&A expense would havebeen $8.6 million and $11.5 million, or 17.6% and 31.7% of revenue,for the six months ended June 30, 2003 and 2002, respectively.

 

*Stock compensation expense (benefit).*   Stock compensationexpense (benefit) was $2.3 million, or 9.3% of revenue, and $(3.1) million, or(15.9)% of revenue, for the three months ended June 30, 2003 and 2002,respectively. Stock compensation expense was $1.9 million, or 3.9% ofrevenue, and $7.4 million, or 20.3% of revenue, for the six months endedJune 30, 2003 and 2002, respectively. The increase in expense during thethree month periods was due primarily to higher levels of expense associatedwith repriced options, as our stock price was higher as of June 30, 2003 thanit was as of June 30, 2002. The decrease in expense during the six monthperiods can be attributed primarily to our stock option repricing programs,which generated a significant amount of expense in the first quarterof 2002 due to a relatively high stock price as of March 31, 2002, whichwas also the first time the repriced options were in-the-money.

 

17

----

 

Thefollowing table summarizes the components of our stock compensation expense(benefit) for the three and six month periods ended June 30, 2003 and 2002(in  thousands):

 
|                                            |   | **Three Months Ended June 30** |       | **Six Months Ended June 30** |       |
|-------------------------------------------------|--------|--------------------------------|------------|------------------------------|------------|
|                                            |   | **2003**                       |       | **2002**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                            |   |                           | ** ** |                         | ** ** |   | ** ** |   | ** ** |
| Options granted to employees                    |   | $                              | 58         |                         | $          | 244 |   | $ | 280 |   | $ | 681 |   |
| Options granted to non-employees                |   | 425                            |       | 625                          |       | 784 |   | 1,226 |   |
| Option repricings                               |   | 527                            |       | (5,171                       | )          | (831 | ) | 2,761 |   |
| Options assumed in connection with acquisitions |   | 1,243                          |       | 1,236                        |       | 1,658 |   | 2,717 |   |
| Stock compensation expense (benefit)            |   | $                              | 2,253      |                         | $          | (3,066 | ) | $ | 1,891 |   | $ | 7,385 |   |

 

We  will incur substantialnon-cash stock compensation expense in future periods as a result of(1) the issuance of, or modifications to, restricted stock awards andstock option grants to employees and non-employees, (2) the repricingprograms we implemented in 2000 and 2001, and (3) amortization of ourexisting unearned compensation balance. Since the expense associated with ouroption repricings and grants to non-employees is dependent on our stock price,it will fluctuate from period to period and may increase significantly.

 

*Amortization of intangible assets.*   For the three monthsended June 30, 2003, we recorded $373,000 of expense for the amortizationof intangible assets recorded in connection with our acquisition of TranswarpNetworks’ assets. This compares to expense of $857,000 for the three monthsended June 30, 2002. For the six months ended June 30, 2003 and 2002,we recorded amortization expense of $373,000 and $1.8 million,respectively. The decrease for both periods is attributable to a lower amountof amortizable intangibles.

 

*Patent defense and acquisition integration costs.*   Patent defense andacquisition integration costs were $583,000 and  $1.8 million for the three and six months ended June 30,2003, compared to $683,000 and $1.4 million for the three and six months endedJune 30, 2002. Patent defense costs increased in 2003 due to increasedactivity in connection with the patent infringement lawsuit we filed againstGenesis Microchip in April 2001. Acquisition integration costs representcosts incurred to integrate CMD and SCL.

 

*Restructuring.* During the second quarter of 2002, weimplemented a third workforce reduction, eliminating 14 positions, inconnection with the program we began in the third quarter of 2001. Positionswere eliminated from all functional areas - operations, R&D and SG&A.This reduction resulted primarily from our decision to transition to a licensing model for our storage subsystemboard products, whereby instead of developing, manufacturing and selling boardproducts to facilitate or accelerate the use of our  storage semiconductor products, we will develop and license boarddesigns in exchange for license fees, royalties and the use of oursemiconductor products. In connection with this workforce  reduction, we recorded restructuring expensein the second quarter of 2002 of $3.5 million, consisting of cashseverance-related costs of $450,000, non-cash severance-related costs of$1.6 million, representing the intrinsic value of modified stock options,and fixed asset write-downs of $1.5 million. The second quarterrestructuring expense also included a net benefit of $97,000, resulting from achange in estimate of the amount of space that will be subleased and the leaserate to be obtained. In addition, we reversed $302,000 of unearnedcompensation, a component of stockholders’ equity, for unvested stock optionsthat were cancelled in connection with employee terminations. 

In March2003, we reorganized the company into lines of business for PC, CE and Storageproducts to enable us to better manage our long-term growth potential.  Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%.  These reductions were primarily in R&D andoperations functions.  Because of this workforce reduction, we recorded arestructuring expense of $1.0 million in the first quarter of 2003, consistingof cash severance-related costs of $340,000, and non-cash severance-relatedcosts of $646,000, representing the intrinsic value of modified stock options.

 

Severance-related costs were determined based on the amount of paypeople received that was not for services performed and by measuring theintrinsic value of stock options that were modified to the benefit ofterminated employees.  The expected loss on leased facilities resulted fromour plan to consolidate our remaining workforce to the extent practicable andsublease any excess space.  To determine the expected loss, we comparedour lease and operating costs for the space to our estimate of the net amountwe would be able to recover by subleasing the space.  This estimate wasbased on a number of assumptions, including the length of time it will take tosecure a tenant, the sublease rate per square foot, the cost of necessaryimprovements or modifications, and real estate broker commissions.  Thefixed asset write-downs in 2001 and 2002 were determined based on the estimatedfair value of assets, primarily computer hardware and software, that would nolonger be utilized after the employees’ termination date.

 

18

----

 

Severanceand benefits payments are substantially complete. Lease payments will be madein the form of cash through the end of the related lease terms of July 2003 andNovember 2005. The following table presents restructuring activity for 2001though June 30, 2003 (in thousands):

 
|                            |   | **Severance  and Benefits** |   | **Leased  Facilities** |   | **Fixed Assets** |   | **Total** |   |
|---------------------------------|--------|-----------------------------|--------|------------------------|--------|------------------|--------|-----------|--------|
| 2001provision                   |   | $                           | 902    |                   | $      | 500              |   | $         | 50     |   | $ | 1,452 |   |
| Cash payments                   |   | (191                        | )      | —                 |   | —           |   | (191      | )      |
| Non-cash activity               |   | (303                        | )      | (115                   | )      | —           |   | (418      | )      |
| Balance as of December 31, 2001 |   | 408                         |   | 385                    |   | 50               |   | 843       |   |
| 2002   provision           |   | 2,547                       |   | 2,633                  |   | 2,013            |   | 7,193     |   |
| Cash payments                   |   | (865                        | )      | (420                   | )      | —           |   | (1,285    | )      |
| Non-cash activity               |   | (1,952                      | )      | —                 |   | (2,063           | )      | (4,015    | )      |
| Balance as of December 31, 2002 |   | 138                         |   | 2,598                  |   | —           |   | 2,736     |   |
| 2003 provision                  |   | 986                         |   | —                 |   | —           |   | 986       |   |
| Cash payments                   |   | (399                        | )      | (323                   | )      | —           |   | (722      | )      |
| Non-cash activity               |   | (646                        | )      | —                 |   | —           |   | (646      | )      |
| Balance as of June 30, 2003     |   | $                           | 79     |                   | $      | 2,275            |   | $         | — |   | $ | 2,354 |   |

 

*Impairment of goodwill and intangible assets.*   In the secondquarter of 2002, we decided to transition to a licensing model for our storagesubsystem board products, whereby instead of developing, manufacturing andselling board products to facilitate or accelerate the use of our storagesemiconductor products, we will develop and license board designs in exchangefor license fees, royalties and the use of our semiconductorproducts. This decision resulted in a decrease to our estimate of futurecash flows from these products, which in turn resulted in a $5.2 million impairmentof goodwill and intangible assets acquired in connection with our acquisitionof CMD.

 

*In-process research and development (IPR&D).*   During the quarterended June 30, 2003, we completed the acquisition of the assets of TranswarpNetworks, Inc. (“TWN”) and recorded a one-time expense of $5.5 million forin-process research and development.  Asof the acquisition date, there was one identified development project that metthe necessary criteria - Polaris. The value of this project was determined byestimating the future cash flows from the time it was expected to becommercially feasible, discounting the net cash flows to present value, andapplying a percentage of completion to the calculated values. The net cashflows from the identified project were based on estimates of revenue, cost ofrevenue, research and development expenses, selling, general andadministrative expenses, and applicable income taxes. Revenue for Polaris isexpected to commence in 2004 and extend through 2007. We based our revenueprojections on estimates of market size and growth, expected trends intechnology and the expected timing of new product introductions by ourcompetitors and us. The discount rate used for this project was 30%, which webelieve is appropriate based on the risk associated with technology that is notyet commercially feasible. The percentage of completion for this project wasbased on research and development expenses incurred immediately prior to theacquisition as a percentage of the total estimated research and developmentexpenses to bring this project to technological feasibility. As of the date ofthe acquisition, we estimated that Polaris was 17% complete, with totalprojected costs of approximately $3,250,000.

 

Given the uncertainties of the commercialization process, we cannotassure you that deviations from our estimates will not occur. We believe thereis a reasonable chance of realizing the economic return expected from theacquired in-process technology. However, there is a risk associated with therealization of benefits related to commercialization of an in-process projectdue to rapidly changing customer needs, complexity of technology and growingcompetitive pressures. Therefore, we cannot assure you that any project willachieve commercial success. Failure to successfully commercialize an in-processproject would result in the loss of the expected economic return inherent inthe fair value allocation.

 

*Gain on escrow settlement, net. *During the quarter ended March 31, 2003, werecognized a net gain of $4.6 million associated with settlement of an escrowclaim against the selling shareholders of a company we acquired in 2001.

 

*Interest Income and other, net.*   Net interest incomeand other decreased to $67,000 for the three months ended June 30, 2003, from$163,000 for the three months ended June 30, 2002. Net interest income andother decreased to $176,000 for the six months ended June 30, 2003, from$433,000 for the six months ended June 30, 2002. The decrease, in bothperiods, is primarily due to lower interest rates and, to a lesser extent, adecrease in our cash and investment balances.

 

*Provision for income taxes.*   We did not record aprovision for income taxes in the three or six months ended June 30, 2003or June 30, 2002, as we did not generate book or taxable income during thoseperiods.

 

At  June 30, 2003, we had a net operatingloss carryforward for federal income tax purposes of approximately$70.0 million that expires in various years through 2022. These future taxbenefits have not been recognized as an asset on our balance sheet due touncertainties surrounding our ability to generate sufficient taxable income infuture periods to realize the  benefits.Under the Tax Reform Act  of 1986, theamounts of, and benefits from, net operating loss carryforwards may berestricted or limited in certain circumstances. We do not expect to be subjectto these restrictions or limitations.

 

19

----

 

**Liquidity and Capital Resources**

 

At June 30, 2003, we had $29.9 million of working capital and$31.0 million of cash, cash equivalents and short-term investments.

 

Operating activities used $5.6 million of cash for the six months endedJune 30, 2003, and $5.3 million of cash during the six months endedJune 30, 2002.  During the sixmonths ended June 30, 2003, net income, excluding depreciation, stockcompensation expense, amortization of intangible assets, non-cash restructuringcharges, non-cash gains on escrow settlement, and the non-cash charge relatingto in-process research and development, was $0.5 million. Increases in accountsreceivable, inventories, and decreases in accounts payable and accruedliabilities, used $7.2 million of cash, which was partially offset by $1.3million of cash provided by decreased prepaid expenses and other assets. Duringthe six months ended June 30, 2002, net loss, excluding depreciation, stockcompensation expense, amortization and impairment of intangible assets, andnon-cash restructuring charges, was $7.0 million, which accounts for most ofthe cash used in operating activities during this period. Increases in accountspayable, accrued liabilities and deferred margin provided $3.6 million ofcash, offset somewhat by a $1.7 million increase in accounts receivable.

 

We generated $1.2 million of cash from investing activities during thesix months ended June 30, 2003, and $329,000 during the six months endedJune 30, 2002. The primary source of cash in both periods was net proceedsfrom purchases and sales of short-term investments of  $3.7 million in 2003 and $2.5 million in 2002, partiallyoffset by capital expenditures of $2.6 million in 2003 and  $2.2 million in 2002.

 

Financing  activities provided$3.4 million of cash during the six months ended June 30, 2003, and$4.2 million of cash during the six months ended June 30, 2002. Cashprovided by financing activities in both periods was primarily from stockoption exercises and proceeds from sales of shares under our employee stockpurchase plan, partially offset by repayments of our capital lease and otherobligations.

 

Ourcontractual obligations at June 30, 2003, and the effect such obligationsare expected to have on our liquidity and cash flow in future periods, have notchanged materially since December 31, 2002 as described in ourForm 10-K.

 

Based  on our expected cashusage, we believe our existing cash and short-term investment balance issufficient to meet our capital and operating requirements for at least the next12 months. Operating and capital requirements depend on many factors,including the levels at which we generate revenue and maintain margins,inventory and accounts receivable, the cost of securing access to adequatemanufacturing capacity and our operating expenses. To the extent existingresources and cash from operations are insufficient to support our activities,we may need to raise additional funds through public or private equity or debtfinancing. These funds may not be available, or if available, we may not beable to obtain them on terms favorable to our stockholders or us.

 

**RISK FACTORS**

* *

*You should carefully considerthe following risk factors, together with all other information contained orincorporated by reference in this prospectus, before you decide to purchaseshares of our common stock. These factors could cause our future results todiffer materially from those expressed in or implied by forward-lookingstatements made by us. Additional risks and uncertainties not presently knownto us or that we currently deem immaterial may also harm our business. Thetrading price of our common stock could decline due to any of these risks, andyou may lose all or part of your investment.*

 

**We operate in rapidly evolving markets, which makes itdifficult to evaluate our future prospects.**

 

The revenue and income potential of our business and the markets weserve is unproven. We began volume shipments of our first display products inthe third quarter of 1997. The Digital Visual Interface (DVI) specification,which is based on technology developed by us and used in many of our products,was first published in April 1999. The DVI specification defines ahigh-speed data communication link between computers and digital displays, suchas flat panel displays, projectors and cathode ray tubes. We completed ourfirst generation of consumer electronics and storage IC products in mid-to-late2001. In addition, the preliminary serial ATA specification was first publishedin August 2001 and the High Definition Multimedia Interface (HDMI)specification was first released in December 2002. Accordingly, we facerisks and difficulties frequently encountered by early-stage companies in newand rapidly evolving markets. If we do not successfully address these risks anddifficulties, our results of operations could be negatively affected.

 

**We have a history of losses and may not become profitable.**

 

We have incurred net losses in each fiscal yearsince our inception, including net losses of $40.1 million and$76.1 million for the years ended December 31, 2002 and 2001,respectively, and a net loss of $5.4 million for the six months ended June 30,2003. We expect to continue to incur net losses for the foreseeable future.Accordingly, we may not achieve and sustain profitability.

 

**Our quarterly operating results may fluctuate significantly andare difficult to predict.**

 

Our quarterly operating results are likely tovary significantly in the future based on a number of factors over which wehave little or no control. These factors include, but are not limited to:

 

•                  the growth, evolution and rate of adoption of industrystandards for our key markets, including digital-ready PCs and displays,consumer electronics and storage devices;

 

 

 

20

----

 

•       competitivepressures, such as the ability of competitors to successfully introduceproducts that are more cost-effective or thatoffer greater functionality thanour products, including by integrating into their products functionalityoffered by our products, and the prices set by competitors for their products,and the potential for alliances, combinations, mergers and acquisitions amongour competitors;

 

•                  average selling prices of our products, which areinfluenced by competition and technological advancements, among other factors;

 

•                  government regulations regarding the timing and extentto which digital content must be made available to consumers;

 

•                  the availability of other semiconductors or other keycomponents that are required to produce a complete solution for the customer;usually, we supply one of many necessary components;

 

•                  the fact that our licensing revenue is heavilydependent on a few key deals being completed for any given period, the timingof which is not always predictable and is especially susceptible to delaybeyond the period in which completion is expected, and our concentrateddependence on a few licensees for substantial portions of our expectedlicensing revenue;

 

•                  the cost of components for our products and pricescharged by the third parties who manufacture, assemble and test our products;

 

•                  fluctuations in the price of our common stock, whichdrive a substantial portion of our non-cash stock compensation expense; and

 

•                  the nature and extent of litigation activities,particularly our patent infringement suit against Genesis.

 

Because we have little or no control over thesefactors, our operating results are difficult to predict. Any substantialadverse change in any of these factors could negatively affect our business andresults of operations.

 

**Our future quarterly operating results are highly dependentupon how well we manage our business.**

 

Our quarterly operating results may fluctuatebased on how well we manage our business. Some of the factors that may affecthow well we manage our business include the following:

 

•                  our ability to manage product introductions andtransitions;

 

•                  our ability to successfully manage our entry into newmarkets such as storage and consumer electronics;

 

•                  our ability to achieve acceptable manufacturing yieldsand develop automated test programs within a reasonable time frame for our newproducts;

 

•                  our ability to close licensing deals and makedeliverables and milestones on which recognition of revenue often depends;

 

•                  our ability to structure our organization to enableachievement of our operating objectives and to meet the needs of our customersand markets;

 

•                  the success of the distribution channels through whichwe choose to sell our products; and

 

•                  our ability to manage expense and inventory levels.

 

If we fail to effectively manage our business,this could adversely affect our results of operations.

 

**The licensing component of our business strategy may not besuccessful.**

 

Part of our business strategyis to license certain of our technology to companies that address markets inwhich we do not want to directly participate. We have limited experiencemarketing and selling our technology on a licensing basis. In conjunction withthe business strategy we adopted in late 2001, we signed our first licensecontract in December 2001, and have signed others since then; however,there can be no assurance that additional companies will be interested inlicensing our technology on commercially favorable terms or at all. We alsocannot ensure that companies who license our technology will introduce and sellproducts incorporating our technology, will accurately report royalties owed tous, will pay agreed upon royalties, will not infringe upon or misappropriateour intellectual property and will maintain the confidentiality of ourproprietary information. Licensing revenue is heavily dependent on a few keydeals being completed, the timing of which is not always predictable and isespecially susceptible to delay beyond the period in which completion isexpected. Also, generating revenue from licensing arrangements is a lengthy andcomplex process that may last beyond the period in which efforts begin, andonce an agreement is in place, the timing of revenue recognition may bedependent on customer acceptance of deliverables, achievement of milestones,customer commercialization of the licensed technology, and other factors. Inaddition, in any period, our expectation of licensing revenue is or may bedependent on one or a few licenses being completed. Licensing that occurs inthe course of actual or contemplated litigation is subject to risk that theadversarial nature of the transaction will induce non-compliance ornon-payment. Due to these factors, the amount of license revenue recognized inany period may differ significantly from our expectations.

 

21

----

 

**Our strategic restructuring program may not be successful.**

 

During the third quarter of2001, we began a program to focus our business on products and technology,including those obtained through acquisitions, in which we have, or believe wecan achieve, a leadership position. As part of this program, we decided tocancel numerous products under development, to remove certain projects from ourdevelopment plan, to phase out or de-emphasize certain existing products, tolicense our technology to companies that participate in markets we do notaddress and to integrate the operations of our two recently acquired companies,CMD Technology and Silicon Communication Lab. In particular, we intend toconcentrate on our discrete transmitter and receiver products for PCs anddisplays, and on developing products and promoting adoption of the HDMI andserial ATA standards for the consumer electronics and storage markets,respectively. Additionally, in the second quarter of 2002, we transitioned to alicensing model for our storage systems business and are therefore phasing outour board level products through the middle of 2003. We expect that we willcontinue to generate revenue from sales of products being phased out or de-emphasizedfor a limited period of time and that costs for selling and marketing theseproducts will be minimal due to the limited resources allocated for thispurpose. However, if demand for these products is not sufficient to use ourexisting inventory, we may incur charges for excess and obsolete inventory.Products to be phased out or de-emphasized represented approximately 25% of ourrevenue in 2001 and 10% of our revenue for the year ended December 31,2002. In connection with this program, we have implemented three workforcereductions eliminating 109 positions, or 36% of our third quarter 2001workforce, and have recorded restructuring expense of $8.6 million. Inaddition, we reduced our workforce by 27 people, or approximately 10%, in thefirst quarter of 2003 in connection with a realignment of our company intolines of business. In connection with this workforce reduction, we recorded$1.0 million of restructuring expense in the first quarter of 2003.

 

There is no guarantee that our strategic restructuringprogram or reorganization will be successful. The markets in which we arepromoting new technologies and standards are still developing and evolving, andthere can be no assurance regarding the rate or extent of adoption of these newtechnologies and standards.

 

**We face intense competition in our markets, which may lead toreduced revenue from sales of our products and increased losses.**

 

The PC, CE and storage markets in which weoperate are intensely competitive. These markets are characterized by rapidtechnological change, evolving standards, short product life cycles anddeclining selling prices. Our display products face competition from a numberof sources, including analog solutions, DVI-based solutions, dual (analog andDVI based) solutions and other digital interface solutions. We expectcompetition in the display market to increase. For example, Analog Devices,ATI, Broadcom, Chrontel, Genesis Microchip, Matrox, National Semiconductor,nVidia, Phillips, Pixelworks, SIS, Smart ASIC, ST Microelectronics, TexasInstruments and Thine are shipping products or have announced intentions tointroduce products that we expect will compete with our PanelLink products.Other companies have announced DVI-based solutions and we expect thatadditional companies are likely to enter the market. Current or potentialcustomers, including our own licensees, may also develop solutions that couldcompete with us, directly or indirectly, such as the integration of a DVItransmitter into a graphics processing unit or integration of a DVI receiverinto a monitor controller.

 

In the CE market, our digital interface productsare used to connect cable set-top boxes, satellite set-top boxes and DVDplayers to digital televisions. These products incorporate DVI and High-bandwidthDigital Content Protection (HDCP), or HDMI with or without HDCP support.Companies that have announced or are shipping DVI-HDCP solutions include TI,Thine, Broadcom and Genesis. In addition, our video processing products facecompetition from products sold by AV Science, Broadcom, Focus Enhancements,Genesis, Mediamatics, Micronas Semiconductor, Oplus, Philips, Pixelworks andTrident. We also compete, in some instances, against in-house processingsolutions designed by large original equipment manufacturers. We expectcompetition for HDMI products from the other HDMI founders and adopters,including Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba.

 

In the storage market, our Fibre Channelproducts face competition from companies selling similar discrete products,including Agilent, PMC Sierra and Vitesse, from other Fibre Channel SerDesproviders who license their core technology, such as LSI Logic, and fromcompanies that sell Host Bust Adaptors (HBA) controllers with integratedSerDes, such as QLogic and Agilent. In the future, our current or potentialcustomers may also develop their own proprietary solutions that may includeintegration of SerDes.

 

Our serial ATA products compete with similarproducts from Marvell and Promise. In addition, other companies such asAdaptec, APT, Intel, LSI Logic, ServerWorks and Vitesse, have developed orannounced intentions to develop serial ATA controllers. We also  compete against Intel and other motherboardchip-set makers that have integrated serial ATA functionality into theirchipsets.

 

Our parallel ATA products compete with similarproducts from Promise and Highpoint. Our RAID controller board products facecompetition from Mylex, Infortrend, and Chaparral.

 

Some of these competitors have already establishedsupplier or joint development relationships with current or potential customersand may be able to leverage their existing relationships to discourage thesecustomers from purchasing products from us or persuade them to replace ourstorage products with theirs. Many of our competitors have longer operatinghistories, greater presence in key markets, better name recognition, access tolarger customer bases and significantly greater financial, sales and marketing,manufacturing, distribution, technical and other resources than we do. Inaddition, some of our competitors could merge (for example, Genesis andPixelworks announced, and then terminated, such a merger), which may enhancetheir market presence. As a result, they may be able to adapt more quickly tonew or emerging technologies and customer requirements, or devote moreresources to the promotion and sale of their products. We cannot assure youthat we can compete successfully against current or potential competitors, orthat competition will not reduce our revenue and increase our losses.

 

 

 

22

----

 

**Growth of the market for our PC products depends on thewidespread adoption and use of the DVI specification.**

 

                Oursuccess is largely dependent upon the rapid and widespread adoption of the DVIspecification, which defines a high-speed data communication link betweencomputers and digital displays. We cannot predict the rate at whichmanufacturers of computers and digital displays will adopt the DVI specification.To date, relatively few systems implementing all of the electrical andmechanical aspects of the DVI specification have been shipped. The DVI adoptionrate in the PC market increased to 12% in 2002, from 7% in 2001. Adoption ofthe DVI specification may be affected by the availability of computercomponents able to communicate DVI-compliant signals, such as transmitters,receivers, connectors and cables necessary to implement the specification.Other specifications may also emerge that could adversely affect the acceptanceof the DVI specification. For example, a number of companies have promotedalternatives to the DVI specification using other interface technologies, suchas low voltage differential signaling, or LVDS. Further delays in the widespreadadoption of the DVI specification could reduce acceptance of our products,limit or reduce our revenue growth and increase our losses.

 

**Demand for our consumer electronics products is dependent onthe adoption and widespread use of the HDMI 1.0 specification.**

 

Our success in the consumer electronics marketis largely dependent upon the rapid and widespread adoption of the HDMI 1.0specification, which combines high-definition video and multi-channel audio inone digital interface and uses our patented underlying transition minimizeddifferential signaling (TMDSTM) technology, and optionally Intel’s HDCPtechnology, as the basis for the interface. Version 1.0 of the specificationwas published for adoption on December 9, 2002. We cannot predict the rateat which manufacturers will adopt the HDMI specification or if thespecification will be adopted at all. Adoption of the HDMI specification may beaffected by the availability of consumer products, such as DVD players andtelevisions, and of computer components that implement this new interface.Other competing specifications may also emerge that could adversely affect theacceptance of the HDMI specification. Delays in the widespread adoption of theHDMI specification could reduce acceptance of our products, limit or reduce ourrevenue growth and increase our losses.

 

**Our ability to increase sales of our products for displaysystems depends on host system manufacturers including DVI-complianttransmitters in their systems.**

 

Our success in the PC market depends onincreasing sales of our receiver products to display manufacturers. To increasesales of our receiver products, we need computer manufacturers to incorporateDVI-compliant transmitters in their systems, making these systemsdigital-ready. During 2002, we introduced a low-cost add-in card that can beused in conjunction with Intel’s 845G chip set to provide an all-digitalconnection to flat panels. Intel’s 845G chip set is intended to provide anall-digital path on the motherboard bus, and should make it easier to providedigital video out. Use of Intel’s 845G chip set, or any digital path chip set,is not universal and may not gain market acceptance. If computers are notdigital-ready, they will not operate with digital displays, which will limitand may reduce the demand for our digital host and receiver products.

 

**Our success depends on managing our relationship with Intel.**

 

Intel has a dominant role in many of the marketsin which we compete, such as PCs and storage, and is a growing presence in the CEmarket. We have a multi-faceted relationship with Intel that is complex andrequires significant management attention, including:

 

•                  Intel has been an investor of ours;

 

•                  Intel and we have been parties to a businesscooperation agreement;

 

•                  Intel and we are parties to a patent cross-license;

 

•                  Intel and we worked together to develop HDCP;

 

•                  An Intel subsidiary has the exclusive right to licenseHDCP, of which we are a licensee;

 

•                  Intel and we were two of the original founders of theDigital Display Working Group (DDWG);

 

•                  Intel is a promoter of the serial ATA working group,of which we are a contributor;

 

•                  Intel is a supplier to us and a customer for ourproducts;

 

•                  We believe that Intel has the power to drive adoptionof DVI and serial ATA by making them widely available in its chip sets andmotherboards, which could affect demand for our products;

 

•                  Intel may potentially integrate the functionality ofour products, including fibre channel, serial ATA or DVI, into its own chipsand chip sets, thereby displacing demand for some of our products;

 

•                  Intel may design new technologies that would requireus to re-design our products for compatibility, thus increasing our R&Dexpense and reducing our revenue;

 

•                  Intel’s technology, including its 845G chip set, maylower barriers to entry to other parties who may enter the market and competewith us; and

 

•                  Intel may enter into or continue relationships withour competitors that can put us at a relative disadvantage.

 

Our cooperation and competition with Intel canlead to positive benefits if managed effectively. If our relationship withIntel is not managed effectively, it could seriously harm our business,negatively affect our revenue, and increase our operating expenses.

 

23

----

 

**Our success depends on the growth of the digital displaymarket.**

 

Our PC business depends on the growth of thedigital display market. The potential size of the digital display market andits rate of development are uncertain and will depend on many factors,including:

 

•                  the number of digital-ready computers that are beingproduced and consumer demand for these computers;

 

•                  the rate at which display manufacturers replace analogor non-compliant DVI interfaces with fully DVI-compliant interfaces;

 

•                  the availability of cost-effective semiconductors thatimplement a fully DVI-compliant interface; and

 

•                  improvements to analog technology, which may decreaseconsumer demand for our digital display products.

 

In order for the digital display market to grow,digital displays must be widely available and affordable to consumers. In thepast, the supply of digital displays, such as flat panels, has been cyclicaland consumers have been very price sensitive. Also, some manufacturers haveimplemented DVI interfaces that are not fully DVI-compliant. These interfacesoften interfere with the operability of our products which function best with afully DVI-compliant interface. Our ability to sustain or increase our revenuemay be limited should there not be an adequate supply of, or demand for,affordable digital displays with fully DVI-compliant interfaces.

 

**Our success depends on the development and growth of marketsfor products based on new and emerging storage technologies.**

 

Our product development efforts in the storagemarket are focused on the development of products using new interfacetechnologies such as fibre channel and serial ATA. The markets for these newinterface technologies are at an early stage of development, and there can beno assurance that they will replace other storage interfaces that are nowwidely used, such as parallel ATA and SCSI. The potential size and rate ofdevelopment of these markets are uncertain and will depend on many factors,including:

 

•                  the rate at which manufacturers of storage subsystemsadopt new interface technologies, which may be more costly to implement thanexisting interface technologies until volumes are sufficient to bring costs tocompetitive levels;

 

•                  the availability of cost-effective semiconductors andcomponents for storage subsystems, such as serial ATA-enabled hard drives andserial ATA enabled optical drives (CD and DVD), that implement new interfacetechnologies for the storage market;

 

•                  whether Intel or other motherboard manufacturers integratethe functionality of our products, such as serial ATA, into their chips andchip sets; and

 

•                  improvement to existing storage interface technologiessuch as parallel ATA and SCSI, or the introduction of other new storageinterface technologies, either of which may decrease consumer demand for ourstorage products.

 

In particular, the rate of implementation of theserial ATA interface will depend on how quickly drive manufacturers,motherboard and PC providers and chipmakers are able to resolve technicalcommunication and functionality issues to enable a “plug and play” environmentin which a computer system is automatically able to recognize and configurestorage devices. Resolution of these issues could be time-consuming, and willdepend in good measure on the ability of chipmakers to incorporate the requiredhigh-speed serial data transfer capabilities into their semiconductors withoutsacrificing manufacturing yields.

 

Any delay in acceptance of new interfacetechnologies, or a reduction in the growth or size of the market for systemsbased on serial ATA or fibre channel technologies, would limit sales of ourstorage products and reduce our revenue. Any delay in the availability ofserial ATA compatible drives or acceleration of serial ATA or fibre channelSerDes integration efforts by motherboard or storage controller manufacturersmay also reduce our revenue.

 

We have promulgated a SATALite specification towhich we have invited key industry members to participate. This programincludes certain licenses to our technology that we hope will increase marketacceptance of our serial ATA products. There can be no assurance that thisprogram will succeed, or that SATALite participants will not use our technologyto compete against us.

 

To date, we have achieved a number of designwins for our serial ATA and fibre channel storage products. Even after we haveachieved a design win from an Original Equipment Manufacturer (OEM), we may notrealize any revenue, or significant revenue, from that OEM since a design winis not a binding commitment to purchase our products and the OEM may notachieve market acceptance for their product. Further delay in serialATA-enabled drive availability may lead OEMS to re-open their designs anddesigns we have won may be subject to being lost, which could reduce ourrevenue and increase our operating expenses in competing to re-win designs.

 

**A significant amount of our revenue is associated with theadoption of new or emerging technologies within the PC industry. The PCindustry has slowed and the adoption of these new technologies may not occur asplanned.**

 

A large portion of our revenue is directly orindirectly related to the PC industry and the adoption of new or emergingtechnologies within the PC industry. Accordingly, we are highly dependent onthe adoption of new or emerging technologies within the PC industry, whichexperienced a slowdown in growth during the second half of 2000 that hascontinued through the second quarter of 2003. We cannot predict the duration orseverity of the downturn in the PC and display market, or in the generaleconomy, or its effect on our revenue and operating results, including theadoption of these new or emerging technologies. If the market for PCs andPC-related displays continues to grow at a slow rate or contracts whether dueto reduced demand from end users, macroeconomic conditions or other factors,our business and results of operations could be negatively affected.

 

24

----

 

 

 

Although we are attempting to broaden ourproduct offerings to include more products for the consumer electronics andstorage markets, there can be no guarantee that we will succeed in this effort.To date, we have achieved reasonable success, but if we fail to consistentlyachieve design wins in the consumer electronics and storage markets, we willremain highly dependent on the PC industry.

 

**We do not have long-term commitments from our customers andwe allocate resources based on our estimates of customer demand.**

 

Substantially all of our sales are made on thebasis of purchase orders, rather than long-term agreements. In addition, ourcustomers may cancel or reschedule purchase orders. We purchase inventorycomponents and build our products according to our estimates of customerdemand. This process requires us to make multiple assumptions, including volumeand timing of customer demand for each product, manufacturing yields andproduct quality. If we overestimate customer demand or product quality or underestimate manufacturing yields, we may build products that we may not be able tosell at an acceptable price or at all. As a result, we would have excessinventory, which would increase our losses. Additionally, if we underestimatecustomer demand or if sufficient manufacturing capacity is unavailable, we willforego revenue opportunities or incur significant costs for rapid increases inproduction, lose market share and damage our customer relationships.

 

**Our lengthy sales cycle can result in a delay betweenincurring expenses and generating revenue, which could harm our operatingresults.**

 

Because our products are based on new technologyand standards, a lengthy sales process, typically requiring several months ormore, is often required before potential customers begin the technicalevaluation of our products. This technical evaluation can exceed nine months,and it can then be an additional nine months before a customer commences volumeshipments of systems incorporating our products, if at all. Given our lengthysales cycle, we may experience a delay between the time we incur expendituresand the time we generate revenue, if any. As a result, our operating resultscould be seriously harmed if a significant customer reduces or delays orders,or chooses not to release products incorporating our products.

 

**We depend on a few key customers and the loss of any of themcould significantly reduce our revenue.**

 

Historically, a relativelysmall number of customers and distributors have generated a significant portionof our revenue. For the first six months of 2003, shipments to World PeaceInternational, an Asian distributor, generated 14% of our revenue, andlicensing revenues and royalties from Sunplus accounted for 11% of our revenue.For the year ended December 31, 2002, shipments to World PeaceInternational generated 15% of our revenue, and shipments to Weikeng generated11% of our revenue. In addition, an end-customer may buy through multipledistributors, contract manufacturers, and / or directly, which could create aneven greater concentration. We cannot be certain that customers and keydistributors that have accounted for significant revenue in past periods,individually or as a group, will continue to sell our products and generaterevenue. As a result of this concentration of our customers, our results ofoperations could be negatively affected if any of the following occurs:

 

•                  one or more of our customers, including distributors,becomes insolvent or goes out of business;

 

•                  one or more of our key customers or distributorssignificantly reduces, delays or cancels orders; or

 

•                  one or more significant customers selects productsmanufactured by one of our competitors for inclusion in their future productgenerations.

 

Due to our entrance into new markets, ourcustomer base has broadened significantly and we therefore anticipate beingless dependent on a relatively small number of customers to generate revenue.However, as product mix fluctuates from quarter to quarter, we may become moredependent on a small number of customers or a single customer for a significantportion of our revenue in a particular quarter, the loss of which couldadversely affect our operating results.

 

**We sell our products through distributors, which limits ourdirect interaction with our customers, therefore reducing our ability toforecast sales and increasing the complexity of our business.**

 

Many original equipment manufacturers rely onthird-party manufacturers or distributors to provide inventory management andpurchasing functions. Distributors generated 37% of our revenue in the firstsix months of 2003, and 42% of our revenue for the year ended December 31,2002. The decrease is as expected as our licensing revenue, which is direct,was a higher percentage of our revenue in the first six months of 2003 than itwas in 2002. Selling through distributors reduces our ability to forecast salesand increases the complexity of our business, requiring us to:

 

•                  manage a more complex supply chain;

 

•      monitor andmanage the level of inventory of our products at each distributor;

 

•      estimatethe impact of credits, return rights, price protection and unsold inventory atdistributors; and

 

•      monitor thefinancial condition and credit-worthiness of our distributors, many of whichare located outside of the United States, and the majority of which are notpublicly traded.

 

Any failure to manage these challenges coulddisrupt or reduce sales of our products.

 

25

----

 

**Our success depends on the development and introduction ofnew products, which we may not be able to do in a timely manner because theprocess of developing high-speed semiconductor products is complex and costly.**

 

The development of new products is highlycomplex, and we have experienced delays, some of which exceeded one year, inthe development and introduction of new products on several occasions in thepast. In 2001 and 2002, we announced our first products for the storage marketand we expect to introduce new consumer electronics, storage and DVI productsin the future. As our products integrate new, more advanced functions, theybecome more complex and increasingly difficult to design, manufacture anddebug. Successful product development and introduction depends on a number offactors, including, but not limited to:

 

•                  accurate prediction of market requirements andevolving standards, including enhancements to existing standards such as DVI,HDCP and SATA, and development and adoption of new or emerging standards suchas HDMI;

 

•                  development of advanced technologies and capabilities,and new products that satisfy customer requirements;

 

•                  timely completion and introduction of new productdesigns;

 

•                  use of leading-edge foundry processes and achievementof high manufacturing yields and low cost testing; and

 

•                  market acceptance of new products.

 

Accomplishing all of this is extremelychallenging, time-consuming and expensive and there is no assurance that wewill succeed. Product development delays may result from unanticipatedengineering complexities, changing market or competitive product requirementsor specifications, difficulties in overcoming resource limitations, theinability to license third party technology or other factors. If we are notable to develop and introduce our products successfully and in a timely manner,our costs could increase or our revenue could decrease, both of which wouldadversely affect our operating results. In addition, it is possible that we mayexperience delays in generating revenue from these products or that we maynever generate revenue from these products. We must work with a semiconductorfoundry and with potential customers to complete new product development and tovalidate manufacturing methods and processes to support volume production andpotential re-work. Each of these steps may involve unanticipated difficulties,which could delay product introduction and reduce market acceptance of theproduct. In addition, these difficulties and the increasing complexity of ourproducts may result in the introduction of products that contain defects orthat do not perform as expected, which would harm our relationships withcustomers and our ability to achieve market acceptance of our new products.There can be no assurance that we will be able to achieve design wins for ourplanned new products, that we will be able to complete development of theseproducts when anticipated, or that these products can be manufactured incommercial volumes at acceptable yields, or that any design wins will produceany revenue. Failure to develop and introduce new products, successfully and ina timely manner, may adversely affect our results of operations.

 

**We have made acquisitions in the past and may makeacquisitions in the future, if advisable, and these acquisitions involvenumerous risks.**

 

Our growth depends upon market growth and ourability to enhance our existing products and introduce new products on a timelybasis. One of the ways we develop new products and enter new markets is throughacquisitions. In 2000, we completed the acquisitions of Zillion and DVDO, andin 2001, we completed the acquisitions of CMD and SCL. In April 2003, weacquired TransWarp Networks. We may acquire additional companies ortechnologies. Acquisitions involve numerous risks, including, but not limited to,the following:

 

•                  difficulty and increased costs in assimilatingemployees, including our possible inability to keep and retain key employees ofthe acquired business;

 

•                  disruption of our ongoing business;

 

•                  discovery of undisclosed liabilities of the acquiredcompanies and legal disputes with founders or shareholders of acquiredcompanies;

 

•                  inability to successfully incorporate acquiredtechnology and operations into our business and maintain uniform standards,controls, policies and procedures; and

 

•                  inability to commercialize acquired technology.

 

No assurance can be given that our acquisitionsof Zillion, DVDO, CMD, SCL or TransWarp, or our future acquisitions, if any,will be successful or provide the anticipated benefits, or that they will not adverselyaffect our business, operating results or financial condition. Failure tomanage growth effectively and to successfully integrate acquisitions made by uscould materially harm our business and operating results.

 

**The cyclical nature of the semiconductor industry may createfluctuations in our foundry, test and assembly capacity.**

 

In the past, the semiconductor industry has beencharacterized by significant downturns and wide fluctuations in supply anddemand. For example, demand in the semiconductor industry rose to record levelsin 1999, but is currently in a downward cycle. The industry has alsoexperienced significant fluctuations in anticipation of changes in generaleconomic conditions. This cyclicality has led to significant fluctuations in productdemand and in the foundry, test and assembly capacity of third party suppliers.Production capacity for semiconductors fabricated using 0.18 micron technologycould be subject to allocation, whereby not all of our production requirementswould be met. This may impact our ability to meet

 

26

----

 

demand and could also increase our production costs.Cyclicality has also accelerated decreases in average selling prices per unit.We may experience fluctuations in our future financial results because ofchanges in industry-wide conditions.

 

**We depend on third-party sub-contractors to manufacture,assemble and test nearly all of our products, which reduces our control overthe production process.**

 

We do not own or operate a semiconductorfabrication facility. We rely on Taiwan Semiconductor Manufacturing Company(TSMC), an outside foundry, to produce the vast majority all of oursemiconductor products. We also rely on Kawasaki, UMC and Atmel, for outsidefoundry services, and on Amkor and ASE to test certain of our semiconductorproducts. Our reliance on independent foundries, assembly and test facilitiesinvolves a number of significant risks, including, but not limited to:

 

•                  reduced control over delivery schedules, qualityassurance, manufacturing yields and production costs;

 

•                  lack of guaranteed production capacity or productsupply;

 

•                  lack of availability of, or delayed access to,next-generation or key process technologies; and

 

•                  our ability to transition to alternate sources ifservices are unavailable from primary suppliers.

 

In addition, our semiconductor products areassembled and tested by several independent subcontractors. We do not have along-term supply agreement with our subcontractors, and instead obtainproduction services on a purchase order basis. Our outside sub-contractors haveno obligation to supply products to us for any specific period of time, in anyspecific quantity or at any specific price, except as set forth in a particularpurchase order. Our requirements represent a small portion of the totalproduction capacity of our outside foundries, assembly and test facilities andour sub-contractors may reallocate capacity to other customers even duringperiods of high demand for our products. These foundries may allocate or moveproduction of our products to different foundries under their control, even indifferent locations, which may be time consuming, costly, and difficult, havean adverse affect on quality, yields, and costs, and require us and/or ourcustomers to re-qualify the products, which could open up design wins tocompetition and result in the loss of design wins and design-ins. If oursubcontractors are unable or unwilling to continue manufacturing our productsin the required volumes, at acceptable quality, yields and costs, and in atimely manner, our business will be substantially harmed. As a result, we wouldhave to identify and qualify substitute contractors, which would betime-consuming, costly and difficult. This qualification process may alsorequire significant effort by our customers, and may lead to re-qualificationof parts, opening up design wins to competition, and loss of design wins anddesign-ins. Any of these circumstances could substantially harm our business.In addition, if competition for foundry, assembly and test capacity increases,our product costs may increase and we may be required to pay significantamounts or make significant purchase commitments to secure access to productionservices.

 

**The nature of our production process is complex, whichreduces identification of problems until well into the production cycle or, insome cases, after the product has been shipped.**

 

The manufacture of semiconductors is a complexprocess, and it is often difficult for semiconductor foundries to achieveacceptable product yields. Product yields depend on both our product design andthe manufacturing process technology unique to the semiconductor foundry. Sincelow yields may result from either design or process difficulties, identifyingyield problems can only occur well into the production cycle, when an actualproduct exists that can be analyzed and tested.

 

Further, we only test our products after theyare assembled, as their high-speed nature makes earlier testing difficult andexpensive. As a result, defects often are not discovered until after assembly.This could result in a substantial number of defective products being assembledand tested or shipped, thus lowering our yields and increasing our costs. Theserisks could result in product shortages or increased costs of assembling,testing or even replacing our products.

 

Although we test our products before shipment,they are complex and may contain defects and errors. In the past we haveencountered defects and errors in our products. Because our products aresometimes integrated with products from other vendors, it can be difficult toidentify the source of any particular problem. Delivery of products withdefects or reliability, quality or compatibility problems, may damage ourreputation and our ability to retain existing customers and attract newcustomers. In addition, product defects and errors could result in additionaldevelopment costs, diversion of technical resources, delayed product shipments,increased product returns, warranty and product liability claims against usthat may not be fully covered by insurance. Any of these circumstances couldsubstantially harm our business.

 

**We face foreign business, political and economic risksbecause a majority of our products and our customers’ products are manufacturedand sold outside of the United States.**

 

A substantial portion of our business isconducted outside of the United States, and as a result, we are subject toforeign business, political and economic risks. Nearly all of our products aremanufactured in Taiwan or elsewhere in Asia, and for the six months ended June30, 2003 and year ended December 31, 2002 72% of our revenue was generatedfrom customers and distributors located outside of the United States, primarilyin Asia. We anticipate that sales outside of the United States will continue toaccount for a substantial portion of our revenue in future periods.Accordingly, we are subject to international risks, including, but not limitedto:

 

•                  difficulties in managing from afar;

 

•                  political and economic instability, includinginternational tension in Iraq, Korea and the China Strait and lack of normaldiplomatic relationships between the United States and Taiwan;

 

27

----

 

•                  less developed infrastructures in newlyindustrializing countries;

 

•                  susceptibility of foreign areas to terrorist attacks;

 

•                  susceptibility to interruptions of travel, includingthose due to international tensions (including the war in Iraq), the SARSepidemic (particularly affecting the Asian markets we serve), and the financialinstability and bankruptcy of major air carriers;

 

•                  bias against foreign, especially American, companies;

 

•                  difficulties in collecting accounts receivable;

 

•                  expense and difficulties in protecting ourintellectual property in foreign jurisdictions;

 

•                  difficulties in complying with multiple, conflictingand changing laws and regulations, including export requirements, tariffs,import duties, visa restrictions, environmental laws and other barriers;

 

•                  exposure to possible litigation or claims in foreignjurisdictions; and

 

•                  competition from foreign-based suppliers and theexistence of protectionist laws and business practices that favor thesesuppliers, such as withholding taxes on payments made to us.

 

These risks could adversely affect our businessand our results of operations. In addition, original equipment manufacturersthat design our semiconductors into their products sell them outside of theUnited States. This exposes us indirectly to foreign risks. Because sales ofour products are denominated exclusively in United States dollars, relativeincreases in the value of the United States dollar will increase the foreigncurrency price equivalent of our products, which could lead to a reduction insales and profits in that country.

 

**The success of our business depends upon our ability toadequately protect our intellectual property.**

 

We rely on a combination of patent, copyright,trademark, mask work and trade secret laws, as well as nondisclosure agreementsand other methods, to protect our proprietary technologies. We have been issuedpatents and have a number of pending patent applications. However, we cannotassure you that any patents will be issued as a result of any applications or,if issued, that any claims allowed will protect our technology. In addition, wedo not file patent applications on a worldwide basis, meaning we do not havepatent protection in some jurisdictions. It is possible that existing or futurepatents may be challenged, invalidated or circumvented and effective patent,copyright, trademark and trade secret protection may be unavailable or limitedin foreign countries. It may be possible for a third party to copy or otherwiseobtain and use our products or technology without authorization, developsimilar technology independently or design around our patents in the UnitedStates and in other jurisdictions. It is also possible that some of ourexisting or new licensing relationships will enable other parties to use ourintellectual property to compete against us. Legal actions to enforceintellectual property rights tend to be lengthy and expensive, and the outcomeoften is not predictable. As a result, despite our efforts and expenses, we maybe unable to prevent others from infringing upon or misappropriating ourintellectual property, which could harm our business.  In addition, practicality also limits our assertion ofintellectual property rights.  Patentlitigation is expensive and its results are often unpredictable.  Assertion of intellectual property rightsoften results in counterclaims for perceived violations of the defendant’sintellectual property rights and/or antitrust claims.  Certain parties after receipt of an assertion of infringementwill cut off all commercial relationships with the party making the assertion,thus making assertions against suppliers, customers, and key business partnersunwise.  Accordingly, if we forgo makingsuch claims, we may risk creating legal and equitable defenses for aninfringer.

 

**Our participation in the Digital Display Working Grouprequires us to license some of our intellectual property for free, which maymake it easier for others to compete with us in the DVI PC market.**

 

We are a promoter of the DDWG, which publishedand promotes the DVI specification. Our strategy includes establishing the DVIspecification as the industry standard, promoting and enhancing thisspecification and developing and marketing products based on this specificationand future enhancements. As a result:

 

•                  we must license for free specific elements of ourintellectual property to others for use in implementing the DVI specification;and

 

•                  we may license additional intellectual property forfree as the DDWG promotes enhancements to the DVI specification.

 

Accordingly, companies that implement the DVIspecification in their products can use specific elements of our intellectualproperty for free to compete with us.

 

**Our participation as a founder in the working groupdeveloping HDMI requires us to license some of our intellectual property, whichmay make it easier for others to compete with us in the market.**

 

In April 2002, together with Sony, Philips,Thomson, Toshiba, Matsushita and Hitachi, we announced the formation of aworking group to define the next-generation digital interface specification forconsumer electronics products. Version 1.0 of the specification was publishedfor adoption on December 9, 2002. The HDMI specification combineshigh-definition video and multi-channel audio in one digital interface and usesSilicon Image’s patented underlying TMDS technology along with Intel’s HDCP asthe basis for the interface. The founders of the working group have signed afounder’s agreement in which each commits to license certain intellectualproperty to each other, and to adopters of the specification.

 

28

----

 

 

 

Our strategy includes establishing the HDMIspecification as the industry standard, promoting and enhancing thisspecification and developing and marketing products based on this specificationand future enhancements. As a result:

 

•                  we must license specific elements of our intellectualproperty to others for use in implementing the HDMI specification; and

 

•                  we may license additional intellectual property as theHDMI founders group promotes enhancements to the HDMI specification.

 

Accordingly, companies that implement the HDMIspecification in their products can use specific elements of our intellectualproperty to compete with us. Although there will be license fees and royaltiesassociated with the adopters agreements, there can be no assurance that suchlicense fees and royalties will adequately compensate us for having to licenseour intellectual property. Fees and royalties received during the early yearsof adoption will be used to cover costs we incur to promote the HDMI standardand to develop and perform interoperability tests; in addition, after aninitial period, the HDMI founders may reallocate the license fees and royaltiesamongst themselves to reflect each founder’s relative contribution ofintellectual property to the HDMI specification.

 

**We have granted Intel rights with respect to our intellectualproperty, which could allow Intel to develop products that compete with ours orotherwise reduce the value of our intellectual property.**

 

We have entered into a patent cross-licenseagreement with Intel in which each of us granted the other a license to use thegrantor’s patents, except for identified types of products. We believe that thescope of our license to Intel excludes our current products and anticipatedfuture products. Intel could, however, exercise its rights under this agreementto use our patents to develop and market other products that compete with ours,without payment to us. Additionally, Intel’s rights to our patents could reducethe value of our patents to any third party who otherwise might be interestedin acquiring rights to use our patents in such products. Finally, Intel couldendorse competing products, including a competing digital interface, or developits own proprietary digital interface. Any of these actions could substantiallyharm our business and results of operations.

 

**We are and may continue to become the target of securitiesclass action suits which could result in substantial costs and divertmanagement attention and resources.**

 

Securities class action suits are often broughtagainst companies, particularly technology companies, following periods ofvolatility in the market price of their securities. Defending against thesesuits, even if meritless, can result in substantial costs to us and coulddivert the attention of our management. We and certain of our officers anddirectors, together with certain investment banks, have been named asdefendants in a securities class action suit filed against us on behalf ofpurchasers of our securities between October 5, 1999 and December 6,2000. It is alleged that the prospectus related to our initial public offeringwas misleading because it failed to disclose that the underwriters of ourinitial public offering had solicited and received excessive commissions fromcertain investors in exchange for agreements by investors to buy our shares inthe aftermarket for predetermined prices. Due to inherent uncertainties inlitigation, we cannot accurately predict the outcome of this litigation;however, a proposed settlement has been negotiated that has yet to be reviewedand approved by the Court.  In the eventthat the settlement is not approved, we believe that these claims are withoutmerit and we intend to defend vigorously against them. We and certain of ourofficers, together with certain investment banks and their current or formeremployees, were named as defendants in a securities class action suit filedagainst us on behalf of a putative class of shareholders who purchased stockfrom some or all of approximately 50 issuers whose public offerings wereunderwritten by Credit Suisse First Boston. The lawsuit alleges that SiliconImage and certain officers were part of a scheme by Credit Suisse First Bostonto artificially inflate the price of Silicon Image’s stock through thedissemination of allegedly false analysts’ reports. The plaintiff in thismatter has filed an amended complaint in which Silicon Image, and the namedofficers, were dropped as defendants. We believe that the settlement described above, if approved, wouldencompass the claims in this case. We believe that these claims were withoutmerit and, if revived, and not subject to the settlement, we intend to defendvigorously against them. However, these claims and any others that may bebrought, even if meritless, could require us to incur expenses and could divertour management’s attention and resources. In addition, any unfavorable outcomeof either of these litigations could adversely impact our business, financialcondition and results of operations.

 

**We are currently engaged in intellectual property litigationthat is time-consuming and expensive to prosecute. We may become engaged inadditional intellectual property litigation that could be time-consuming, maybebe expensive to prosecute or defend, and could adversely affect our ability tosell our product.**

 

In recent years, there hasbeen significant litigation in the United States and in other jurisdictionsinvolving patents and other intellectual property rights. This litigation isparticularly prevalent in the semiconductor industry, in which a number ofcompanies aggressively use their patent portfolios to bring infringementclaims. In addition, in recent years, there has been an increase in the filingof so-called “nuisance suits,” alleging infringement of intellectual propertyrights. These claims may be asserted as counterclaims in response to claimsmade by a company alleging infringement of intellectual property rights. Thesesuits pressure defendants into entering settlement arrangements to quicklydispose of such suits, regardless of merit. In addition, as is common in thesemiconductor industry, from time to time we have been notified that we may beinfringing certain patents or other intellectual property rights of others.Responding to such claims, regardless of their merit, can be time consuming,result in costly litigation, divert management’s attention and resources andcause us to incur significant expenses. As each claim is evaluated, we mayconsider the desirability of entering into settlement or licensing agreements.No assurance can be given that settlements will occur or that licenses can beobtained on acceptable terms or that litigation will not occur. In the eventthere is a temporary or permanent injunction entered prohibiting us frommarketing or selling certain of our products, or a successful claim ofinfringement against us requiring us to pay damages or royalties to a thirdparty, and we fail to develop or license a substitute technology, our business,results of operations or financial condition could be materially adverselyaffected.

 

In April 2001, we filed suit againstGenesis Microchip for infringement of one of our U.S. patents. At that time, wealso filed a

 

29

----

 

complaint against Genesis for unlawful trade practicesrelated to the importation of articles infringing our patent. In February 2002,our motion to dismiss the unlawful trade practices complaint was granted and wefiled an amended complaint against Genesis alleging infringement of two of ourU.S. patents. These patents relate to our DVI receiver products, which generatea significant portion of our revenue. The amended complaint seeks a declarationthat Genesis has infringed our patents, that Genesis’s behavior is notlicensed, an injunction to halt the importation, sale, manufacture and use ofGenesis DVI receiver chips that infringe our patents, and monetary damages. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. We filed a motion to dismiss certain of Genesis’scounterclaims. In addition, we filed a motion to bifurcate trial of thecounterclaims to the extent the court does not dismiss them. In May 2002,the Court granted our motion to dismiss certain of the counterclaims, withleave to amend. Genesis re-filed counterclaims against us for fraud and patentmisuse. We filed another motion to dismiss these counterclaims. InAugust 2002, the Court granted our motion and dismissed Genesis’s re-filedcounterclaims with prejudice. In December 2002, the parties entered into amemorandum of understanding (MOU) to settle the case.  In January, the parties presented different interpretations ofthe MOU to the Court.  On July 15, 2003,the Court granted our motion to interpret the MOU in the manner we requested,and ruled that Genesis had engaged in efforts to avoid its obligations underthe MOU.  On August 6, 2003, the Courtentered a judgment based on its July 15, 2003 ruling.

 

There can be no assurance that Genesis will notundertake further efforts to avoid its obligations under the MOU, and thatfurther proceedings (lawsuits, contempt citations, etc.) against Genesis, andcertain of its executives, its counsel, its former merger partner, Pixelworks,and others may not be required to obtain compliance or to obtain redress fornon-compliance.  There can be noassurance that Genesis will not appeal, and that further delays ornoncompliance may be required.  TheCourt’s ruling of July 15, 2003 also indicated that Genesis may have violatedcertain provisions of the MOU, including disclosure of confidential informationto Pixelworks. On August 5, 2003, Genesis and Pixelworks issued a joint pressrelease terminating their proposed merger. In that press release, Genesis andPixelworks jointly stated that "Pixelworks has confirmed that prior tosigning the merger agreement, it reveiwed the Memorandum of Understanding thatpurported to settle the lawsuit between Genesis Microchip and Silicon Image,Inc."  The effects of thesedisclosures  have not been fullyanalyzed, and may result in further proceedings. While this litigation,including any appeal or derivative proceedings, is pending, Genesis can use thetechnology covered by these patents to develop products that might compete withours. If we are unsuccessful in this litigation, we could be unable to preventGenesis or others from using the technology covered by this patent. Even if weprevail in this litigation, uncertainties regarding the outcome prior to thattime may reduce demand for our products. In addition, if the MOU is unappealedor upheld on appeal, future disputes may occur, including those regardingwhether and what intellectual property licenses were granted and the scope ofany such licenses and the royalty rates and payment terms for such licenses,whether the MOU was breached, whether consent was fraudulently obtained, andwhether a merger partner may succeed to the rights and/or the obligations underthe MOU. These disputes may result in additional costly and time-consuminglitigation or the license of additional elements of our intellectual propertyfor free.

 

Any potential intellectual property litigationagainst us could also force us to do one or more of the following:

 

•                  stop selling products or using technology that containthe allegedly infringing intellectual property;

 

•                  attempt to obtain a license to the relevantintellectual property, which license may not be available on reasonable termsor at all; and

 

•                  attempt to redesign products that contain theallegedly infringing intellectual property.

 

If we take any of these actions, we may beunable to manufacture and sell our products. We may be exposed to liability formonetary damages, the extent of which would be very difficult to accuratelypredict. In addition, we may be exposed to customer claims, for potentialindemnity obligations, and to customer dissatisfaction and a discontinuance ofpurchases of our products while the litigation is pending. Any of theseconsequences could substantially harm our business and results of operations.

 

**We have entered into, and may again be required to enterinto, patent or other intellectual property cross-licenses.**

 

Many companies havesignificant patent portfolios or key specific patents, or other intellectualproperty in areas in which we compete. Many of these companies appear to havepolicies of imposing cross-licenses on other participants in their markets,which may include areas in which we compete. As a result, we have beenrequired, either under pressure of litigation or by significant vendors orcustomers, to enter into cross licenses or non-assertion agreements relating topatents or other intellectual property. This permits the cross-licensee, orbeneficiary of a non-assertion agreement, to use certain or all of our patentsand/or certain other intellectual property for free to compete with us.

 

**We must attract and retain qualified personnel to besuccessful, and competition for qualified personnel is increasing in ourmarket.**

 

Our success depends to a significant extent uponthe continued contributions of our key management, technical and salespersonnel, many of who would be difficult to replace. The loss of one or moreof these employees could harm our business. Although we have entered into alimited number of employment contracts with certain executive officers, wegenerally do not have employment contracts with our key employees. We do nothave key person life insurance for any of our key personnel. Our success alsodepends on our ability to identify, attract and retain qualified technical,sales, marketing, finance and managerial personnel. Competition for qualifiedpersonnel is particularly intense in our industry and in our location. Thismakes it difficult to retain our key personnel and to recruit highly-qualifiedpersonnel. We have experienced, and may continue to experience, difficulty inhiring and retaining candidates with appropriate qualifications. To besuccessful, we need to hire candidates with appropriate qualifications andretain our key executives and employees.

 

The pressure on our stock price has had animpact on our ability to offer competitive equity-based incentives to currentand prospective employees, thereby affecting our ability to attract and retainhighly qualified technical personnel. If these adverse conditions continue, wemay not be able to hire or retain highly qualified employees in the future andthis could harm our business. In addition, new regulations proposed by TheNASDAQ National Market requiring shareholder approval for all stock optionplans, as well as new regulations proposed by the New York Stock Exchangeprohibiting NYSE member organizations from giving a proxy to vote on equitycompensation plans unless the beneficial owner of the shares has given votinginstructions, could make it more difficult for us to grant options to employeesin the future. There have been several proposals on whether and /or how toaccount for stock options. To the extent that new regulations make it moredifficult or expensive to grant options

 

30

----

 

to employees, we may incur increased cash compensationcosts or find it difficult to attract, retain and motivate employees, either ofwhich could harm our business.

 

We use contractors to provide services to thecompany, which often involves contractual complexity, tax and employment lawcompliance, and being subject to audits and other governmental actions. We havebeen audited for our contracting policies in the past, and may be in thefuture. Burdening our ability to freely use contractors to provide services tothe company may increase the expense of obtaining such services, and/or requireus to discontinue using contractors and attempt to find, interview, and hireemployees to provide similar services. Such potential employees may not be availablein a reasonable time, or at all, or may not be hired without undue cost.

 

**In the past, we implemented mandatory unpaid company-wideshutdowns as a cost reduction measure, but we may not continue to implementthese programs.**

 

In the last two fiscal years and in the firstand second quarters of 2003, we implemented mandatory company-wide shutdowns.Although these shutdown periods represent a cost savings to us, they may beperceived negatively by our customers, vendors and employees. We currentlyintend to implement a company-wide shutdown during both the third and fourthquarters of 2003. In addition, we may continue to implement company-wideshutdowns in future periods, which may negatively impact employee morale or theperception of our company by our customers and vendors. If we elect not toimplement these shutdowns, our operating expenses will increase.

 

**Our workforce reductions may seriously harm our business.**

 

In connection with therestructuring program we began in the third quarter of 2001 to focus ourbusiness on products and technology in which we have, or believe we canachieve, a leadership position, and the reorganization of the company in thefirst quarter of 2003 into lines of business, we have implemented fourworkforce reductions, eliminating a total of 136 positions. As a result of theelimination of these positions, our marketing, sales and customer supportcapabilities could be reduced, our ability to respond to unexpected challengesmay be impaired, and we may be unable to take advantage of new opportunities.These workforce reductions, or future workforce reductions, if any, may reduceemployee morale and create concern among existing employees about job security,which could lead to increased turnover. Workforce reductions may also raiseconcerns among customers, suppliers and other corporate partners regarding ourcontinued viability. Further, these workforce reductions may subject us to therisk of litigation, which could be costly to defend, divert the attention ofmanagement and subject us to possible liability for damages.

 

**Industry cycles may strain our management and resources.**

 

Cycles of growth and contraction in our industrymay strain our management and resources. To manage these industry cycleseffectively, we must:

 

•                  improve operational and financial systems;

 

•                  train and manage our employee base;

 

•                  successfully integrate operations and employees ofbusinesses we acquire or have acquired;

 

•                  attract, develop, motivate and retain qualifiedpersonnel with relevant experience; and

 

•                  adjust spending levels according to prevailing marketconditions.

 

If we cannot manage industry cycles effectively, ourbusiness could be seriously harmed.

 

**Our operations and the operations of our significantcustomers, third-party wafer foundries and third-party assembly and testsubcontractors are located in areas susceptible to natural disasters.**

 

Our operations are headquartered in the SanFrancisco Bay Area, which is susceptible to earthquakes, and the operations ofCMD, which we acquired, are based in the Los Angeles area, which is alsosusceptible to earthquakes. TSMC and UMC, the outside foundries that producethe majority of our semiconductor products, are located in Taiwan. AdvancedSemiconductor Engineering, or ASE, one of the subcontractors that assembles andtests our semiconductor products, is also located in Taiwan. For the sixmonths  ended June 30, 2003, customersand distributors located in Taiwan generated 38% of our revenue and customersand distributors located in Japan generated 11% of our revenue. For the sixmonths  ended June 30, 2002, customersand distributors located in Taiwan generated 35% of our revenue and customersand distributors located in Japan generated 12% of our revenue. Both Taiwan andJapan are susceptible to earthquakes, typhoons and other natural disasters.

 

Our business would be negatively affected if any ofthe following occurred:

 

•                  an earthquake or other disaster in the San FranciscoBay Area or the Los Angeles area damaged our facilities or disrupted the supplyof water or electricity to our headquarters or our Irvine facility;

 

•                  an earthquake, typhoon or other disaster in Taiwan orJapan resulted in shortages of water, electricity or transportation, limitingthe production capacity of our outside foundries or the ability of ASE toprovide assembly and test services;

 

•                  an earthquake, typhoon or other disaster in Taiwan orJapan damaged the facilities or equipment of our customers and distributors,resulting in reduced purchases of our products; or

 

31

----

 

•                  an earthquake, typhoon or other disaster in Taiwan orJapan disrupted the operations of suppliers to our Taiwanese or Japanesecustomers, outside foundries or ASE, which in turn disrupted the operations ofthese customers, foundries or ASE and resulted in reduced purchases of ourproducts or shortages in our product supply.

 

**Changes in environmental rules and regulations could increaseour costs and reduce our revenue.**

 

Several jurisdictions are considering whether toimplement rules that would require that certain products, includingsemiconductors, be made lead-free. We anticipate that some jurisdictions mayfinalize and enact such requirements. Some jurisdictions are also consideringwhether to require abatement or disposal obligations for products made prior tothe enactment of any such rules. Although several of our products are availableto customers in a lead-free condition, most of our products are not lead-free.Any requirement that would prevent or burden the development, manufacture orsales of lead-containing semiconductors would likely reduce our revenue forsuch products and would require us to incur costs to develop substitutelead-free replacement products, which may take time and may not always beeconomically or technically feasible, and may require disposal of non-compliantinventory. In addition, any requirement to dispose or abate previously-soldproducts would require us to incur the costs of  setting up and implementing such a program.

 

**Provisions of our charter documents and Delaware law couldprevent or delay a change in control, and may reduce the market price of ourcommon stock.**

 

Provisions of our certificate of incorporationand bylaws may discourage, delay or prevent a merger or acquisition that astockholder may consider favorable. These provisions include:

 

•                  authorizing the issuance of preferred stock withoutstockholder approval;

 

•                  providing for a classified board of directors withstaggered, three-year terms;

 

•                  prohibiting cumulative voting in the election ofdirectors;

 

•                  requiring super-majority voting to amend someprovisions of our certificate of incorporation and bylaws;

 

•                  limiting the persons who may call special meetings ofstockholders; and

 

•                  prohibiting stockholder actions by written consent.

 

Provisions of Delaware law also may discourage,delay or prevent someone from acquiring or merging with us.

 

**The price of our stock fluctuates substantially and maycontinue to do so.**

 

The stock market hasexperienced extreme price and volume fluctuations that have affected the marketvaluation of many technology companies, including Silicon Image. These factors,as well as general economic and political conditions, may materially andadversely affect the market price of our common stock in the future. The marketprice of our common stock has fluctuated significantly and may continue tofluctuate in response to a number of factors, including, but not limited to:

 

•                  actual or anticipated changes in our operatingresults;

 

•                  changes in expectations of our future financialperformance;

 

•                  changes in market valuations of comparable companiesin our markets;

 

•                  changes in market valuations or expectations of futurefinancial performance of our vendors or customers;

 

•                  changes in our key executives and technical personnel;and

 

•                  announcements by us or our competitors of significanttechnical innovations, design wins, contracts, standards or acquisitions.

 

Due to these factors, the price of our stock maydecline. In addition, the stock market experiences volatility that is oftenunrelated to the performance of particular companies. These market fluctuationsmay cause our stock price to decline regardless of our performance.

 

**Continued terrorist attacks or war could lead to furthereconomic instability and adversely affect our operations, results of operationsand stock price.**

 

The United States has taken, and continues totake, military action against terrorism and has engaged in war with Iraq andcurrently has an occupation force there and in Afghanistan. In addition, thecurrent nuclear arms crisis in North Korea could escalate into armedhostilities or war. Acts of terrorism or armed hostilities may disrupt orresult in instability in the general economy and financial markets and inconsumer demand for the OEM’s products that incorporate our products.Disruptions and instability in the general economy could reduce demand for ourproducts or disrupt the operations of our customers, suppliers, distributorsand contractors, many of whom are located in Asia, which would in turnadversely affect our operations and results of operations. Disruptions andinstability in financial markets could adversely affect our stock price. Armedhostilities or war in South Korea could disrupt the operations of the researchand development contractors we utilize there, which would adversely

 

32

----

 

affect our research and development capabilities andability to timely develop and introduce new products and product improvements.

 

**Item 3****. Quantitative and Qualitative Disclosures About Market Risk**

 

**Interest Rate Risk**

 

Our cash equivalents andshort-term investments consist primarily of fixed-income securities that aresubject to interest rate risk and will decline in value if interest ratesincrease. Due to the short duration of our cash equivalents and short-terminvestments, an immediate 10% change in interest rates would not be expected tohave a material effect on our near-term results of operations or financialcondition. Our long-term capital lease obligations bear interest at fixedrates; therefore, our results of operations would not be affected by immediatechanges in  interest rates.  Also,components of our stock compensation expense are tied to our stock price. Changes in our stock price can have a significant effect on the amount recordedas stock compensation expense.

 

**Foreign Currency Exchange Risk**

 

All of our sales aredenominated in U.S. dollars, and substantially all of our expenses are incurredin U.S. dollars, thus limiting our exposure to foreign currency exchange risk.We currently do not enter into forward exchange contracts to hedge exposuresdenominated in foreign currencies and do not use derivative financialinstruments for trading or speculative purposes. The effect of an immediate 10%change in foreign currency exchange rates should not have a material effect onour future operating results or cash flows; however, a long term change inforeign currency rates would likely result in increased wafer, packaging,assembly or testing costs.

 

**Item 4****. Controls and Procedures**

 

(a)                                                     We have carried out an evaluation, under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures (as defined in Exchange Act Rule 13a-15and 15(d)-15).  Based upon that evaluation, our Chief Executive Officerand Chief Financial Officer concluded that our disclosure controls andprocedures as of the end of the period covered by this report are effective intimely alerting them to material information relating to the Company (includingits consolidated subsidiaries) required to be included in our periodic SECfilings.

 

(b)                                                    There has beenno change in our internal controls over financial reporting that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**Part II****. Other Information**

 

**Item 1****. Legal Proceedings**

 

On April 24, 2001, we filed suit in the U.S. District Court for theEastern District of Virginia against Genesis Microchip Corp. and GenesisMicrochip, Inc. (collectively, Genesis) for infringement of our U.S. patentnumber 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (theFederal Suit). On April 24, 2001, we also filed a complaint against Genesiswith the International Trade Commission of the United States government (ITC)for unlawful trade practices related to the importation of articles infringingour patent (the ITC investigation). The actions sought injunctions to halt theimportation, sale, manufacture and use of Genesis DVI receiver chips thatinfringe our patent, and monetary damages. We voluntarily moved to dismiss theITC investigation, with notice that we would proceed directly in the FederalSuit. Our motion to dismiss was granted on February 7, 2002. We filed anamended complaint in the Federal Suit as of February 28, 2002. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. Also in April 2002, we filed a motion to dismiss certain of Genesis’counterclaims. In addition, we filed a motion to bifurcate trial of thecounterclaims to the extent the court does not dismiss them. In May 2002, theCourt granted our motion to dismiss certain of the counterclaims, with leave toamend. Genesis re-filed counterclaims against us for fraud and patent misuse.We filed another motion to dismiss these counterclaims. . In December 2002, theparties entered into a memorandum of understanding (MOU) to settle thecase.  In January, the parties presenteddifferent interpretations of the MOU to the Court.  On July 15, 2003, the Court granted our motion to interpret theMOU in the manner we requested, and ruled that Genesis had engaged in effortsto avoid its obligations under the MOU. On August 6, 2003, the Court entered afinal judgment based on its July 15, 2003 ruling. Under the final judgmentorder, Genesis was ordered to make a substantial cash payment, and to makeroyalty payments. To date, we have not recognized any income or revenueassociated with the matter, including amounts previously received for whichpayment was not honored. Due to the continuing and contentious nature of thislitigation, we will not record any income or revenue related to this matteruntil litigation is complete. Genesis may appeal.   Management intends to prosecute our position vigorously untilthis matter is resolved. Through June 30, 2003, we have spent approximately$10.0 million on this matter and expect to continue to incur significant coststhrough at least the third quarter of 2003, and longer if further litigationbased upon or related to the breach of the MOU, or fraud, is commenced, or ifGenesis appeals.  Management intends tofile a motion for reimbursement of some of our expenses, including some of ourlegal fees, but there is no assurance that the Court will grant such motion.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters, have been named as defendants in a securities class actionlawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY2001) pending in Federal District Court for the Southern District of New York.The lawsuit alleges that all defendants were part of a scheme to manipulate theprice of Silicon Image’s stock in the aftermarket following Silicon Image’sinitial public offering in October 1999. Response to the complaint and discoveryin this action on behalf of Silicon Image and individual defendants has beenstayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, the Courtdenied underwriters’ motion to dismiss and ordered that the case may proceedagainst issuers including against Silicon Image. At this time, we cannotaccurately predict the outcome of this litigation; however, a proposedsettlement has been negotiated that has yet to be reviewed and approved by theCourt.  In the event that the settlementis approved, we do not expect it to have a

 

33

----

 

material effect on our results or financial position.  In the event that the settlement is notapproved, we intend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters have been named as defendants in a securities class action lawsuitcaptioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D.Fla. 2003) pending in Federal District Court for the Southern District ofFlorida. Plaintiff filed an action on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.Silicon Image has not been served with a copy of the complaint. The plaintiffin this matter has filed an amended complaint in which Silicon Image, and thenamed officers, were dropped as defendants. We believe that the proposed settlement described above, if approved,would encompass the claims in this case. We believe that these claims arewithout merit and, if revived, and  notsubject to the settlement, we would defend this matter vigorously.

 

In addition, we are involved in a number of judicial and administrativeproceedings incidental to our business. We intend to prosecute or defend, asappropriate, such matters vigorously, and although adverse decisions orsettlements may occur in one or more of such cases, the final resolution ofthese matters, individually or in the aggregate, is not expected to have amaterial adverse effect on our results of operations or financial position.

 

The amount of legal fees we incur with respect to the litigation mattersdescribed above will depend on the duration of our litigation matters, as wellas the nature and extent of the litigation activities. We are not able toaccurately estimate the amount of legal fees we will incur in 2003 with respectto the litigation matters described above; however, we do expect to incursubstantial amounts through at least the third quarter of 2003, and longer iffurther litigation based upon or related to the breach of the MOU, or fraud, iscommenced, or if Genesis appeals.

 

**Item2****.  Changes in Securities and Use of Proceeds**

 

In connection with our acquisition of ZillionTechnologies, LLC, we are obligated under an exchange agreement to periodicallyissue to the two founders of Zillion shares of our common stock asconsideration for their membership interests in Zillion which we acquired andservices provided pursuant to their employment agreements with us.  TheZillion founders were granted registration rights with respect to the shares tobe issued under this exchange agreement.  These issuances of shares weremade in reliance on an exemption from registration under Section 4(2) of theSecurities Act.  On June 30, 2003, we issued 18,750 shares of our commonstock to the Zillion founders pursuant to the exchange agreement.  Theissuances of shares were made without general solicitation or advertising andwere only made to two individuals.

 

**Item 3.  Defaults Upon Senior Securities**

 

Not applicable.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

Weheld our 2003 Annual Meeting of Stockholders on May 20, 2003. The firstmatter voted upon at the meeting was the election of two Class I directorsto serve until the 2006 Annual Meeting of Stockholders. At the meeting, KeithMcAuliffe and Douglas Spreng were elected as Class I directors by thefollowing votes: 

 
| **Name******    |   | **Shares  For****** |   | **Shares  Against****** |   | **Shares  Abstaining****** |   | **Shares  Withheld****** |   | **Broker  Non-Votes****** |   |
|-----------------|--------|---------------------|--------|-------------------------|--------|----------------------------|--------|--------------------------|--------|---------------------------|--------|
| Keith McAuliffe |   | 53,354,614          |   | —                  |   | —                     |   | 544,880                  |   | —                    |   |
| Douglas Spreng  |   | 51,776,581          |   | —                  |   | —                     |   | 2,122,913                |   | —                    |   |

 

Ourboard of directors consists of six members and is divided into three classes,with each class consisting of two members and each class serving staggeredthree-year terms. The term of the Class II directors, who are currentlyDavid Hodges and Ronald Schmidt, will expire at the 2004 Annual Meeting ofStockholders, and the term of the Class III directors, who are currentlyDavid Courtney, David Lee and Andrew Rappaport, will expire a the 2005 AnnualMeeting of Stockholders.

 

Thesecond matter voted upon at the meeting was the amendments to our 1999 EquityIncentive Plan to increase the size of the automatic annual option grant todirectors for board service from 20,000 to 30,000 shares, and to extend theautomatic annual option grant to directors for committee service from only theaudit and compensation committees to any standing committee of the board. Atthe meeting, these amendments to the 1999 Equity Incentive Plan were approvedby the following vote: 

 
| **Shares For****** |   | **Shares  Against****** |   | **Shares  Abstaining****** |   | **Shares  Withheld****** |   | **Broker  Non-Votes****** |   |
|--------------------|--------|-------------------------|--------|----------------------------|--------|--------------------------|--------|---------------------------|--------|
| 36,591,033         |   | 17,244,252              |   | 64,209                     |   | —                   |   | —                    |   |

 

Thethird matter voted upon at the meeting was the ratification of the appointmentof PricewaterhouseCoopers LLP as independent accountants of Silicon Image forthe fiscal year ending December 31, 2003. At the meeting, the appointmentof PricewaterhouseCoopers LLP as independent accountants was ratified by the followingvote: 

 
| **Shares For** |   | **Shares  Against** |   | **Shares  Abstaining** |   | **Shares  Withheld** |   | **Broker  Non-Votes** |   |
|----------------|--------|---------------------|--------|------------------------|--------|----------------------|--------|-----------------------|--------|
| 53,513,389     |   | 354,574             |   | 31,531                 |   | —               |   | —                |   |

 

34

----

 

**Item 5.  Other Information**

 

Not applicable.

 

**Item 6.  Exhibits and Reports on Form 8-K**

 

(a)                                                     Exhibits

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                         |
|--------------------|--------|---------------------------------------------------------------------------------------------------------------------------|
| 31.1               |   | Certification pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
| 31.2               |   | Certification pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
| 32.1               |   | Certification pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |
| 32.2               |   | Certification pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

(b)                                                    Reports on Form 8-K

 

On April 21, 2003, we filed a current report on Form 8-K to report underItem 2 that we completed our acquisition of TransWarp Networks, Inc.

 

On April 23, 2003, we furnished a current report on Form 8-K to furnishunder Item 12 our earnings release, conference call script and transcript forthe first quarter of 2003.

 

On May 29, 2003, we filed a current report on Form 8-K to report underItem 5 that David Lee, our Chief Executive Officer and Chairman of the Board,entered into a Rule 10b5-1 sales plan with Deutsche Bank Alex. Brown.

 

35

----

 

**Signatures**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Dated:  August 14, 2003 | Silicon  Image, Inc.                                                    |
|-------------------------|-------------------------------------------------------------------------|
|                    |                                                                    |
|                    | */s/  Robert G. Gargus*                                            |   |
|                    | Robert  G. Gargus                                                       |
|                    | Vice  President Finance and Administration and Chief  Financial Officer |
|                    | (Principal  Financial and Accounting Officer)                           |

 

36

----

 

**EXHIBIT INDEX**

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                            |
|--------------------|--------|------------------------------------------------------------------------------------------------------------------------------|
| 31.1               |   | Certification by pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 31.2               |   | Certification by pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 32.1               |   | Certification by pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2               |   | Certification by pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

 

37

----