** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

##### **FORM 10-K**

#####  

**(Mark One)**

 
| **x**                                        |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**     |
|----------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|
|                                         |   |                                                                                                    |
| **For the fiscal year ended: JUNE 29, 2008** |
|                                         |   |                                                                                                    |
| **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: 000-22071**

 

**OVERLAND STORAGE, INC.**

(Exact name of registrant as specified in its charter)

 

| **California**                                                 | ** ** | **95-3535285**                    |
|----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (IRS Employer Identification No.) |
| ** **                                                     | ** ** | ** **                        |
| **4820 Overland Avenue, San Diego, California**                | ** ** | **92123**                         |
| (Address of principal executive offices)                       |       | (Zip Code)                        |

 
| **(858) 571-5555**                                                    |
|-----------------------------------------------------------------------|
| (Registrant’s telephone number, including area code)             |
|                                                                  |
| Securities registered pursuant to Section 12(b) of the Act: |

 

| **Title  of each class**   | ** ** | **Name of each exchange on which registered** |
|----------------------------|------------|-----------------------------------------------|
| Common Stock, no par value |       | The NASDAQ Stock Market LLC                   |

 
| Securities registered pursuant to Section 12(g) of  the Act: **None** |
|---------------------------------------------------------------------------------|

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. Yes  o   No  x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes  o   No  x

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes  x   No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein,and will not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.:

 
| Large accelerated filer o                                               | Accelerated  filer o         |
|-------------------------------------------------------------------------|------------------------------|
| Non-accelerated  filer o (Do not check if a smaller reporting  company) | Smaller  reporting company x |

 

Indicateby check mark whether the registrant is a shell company (as defined by Rule 12b-2of the Act). Yes  o   No x

 

Theaggregate market value of the voting stock held by non-affiliates of theregistrant as of December 30, 2007, the last business day of theregistrant’s second fiscal quarter, was approximately $14,308,145 (based on theclosing price reported on such date by The NASDAQ Global Market of theregistrant’s Common Stock). Shares of Common Stock held by officers anddirectors and holders of 10% or more of the outstanding Common Stock have beenexcluded from the calculation of this amount because such persons may be deemedto be affiliates. This determination of affiliate status is not necessarily aconclusive determination for other purposes.

 

Asof September 22, 2008, the number of outstanding shares of the registrant’sCommon Stock was 12,770,550.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the proxy statement to be filed in connection with registrant’s AnnualMeeting of Shareholders to be held on December 9, 2008 (the “ProxyStatement”) are incorporated herein by reference into Part III of thisreport.

 

 

 

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### **PART I**

###  

**ITEM 1.Business.**

 

*This report contains certain statements of a forward-looking naturethat involve risks, uncertainties and assumptions that are difficult topredict. Words and expressions reflecting optimism, satisfaction ordisappointment with current prospects, as well as words such as “believe,” “hopes,”“intends,” “estimates,” “expects,” “projects,” “plans,” “anticipates” andvariations thereof, identify forward-looking statements, but their absence doesnot mean that a statement is not forward-looking. Such forward-lookingstatements are not guarantees of performance and the company’s actual resultscould differ materially from those contained in such statements. Factors thatcould cause or contribute to such differences include the inherent andsignificant risks of integrating a new acquisition, possible delays in newproduct introductions and shipments; market acceptance of the company’s newproduct offerings; the ability to maintain strong relationships with brandedchannel partners; the timing and market acceptance of new product introductionsby competitors; worldwide information technology spending levels; unexpectedshortages of critical components; rescheduling or cancellation of customerorders; loss of a major customer; general competition and price pressures inthe marketplace; the company’s ability to control costs and expenses; andgeneral economic conditions. These forward-looking statements speak only as ofthe date of this report and the company undertakes no obligation to publiclyupdate any forward-looking statements to reflect new information, events orcircumstances after the date of this report.**You are cautioned thatsuch statements are only predictions and actual events or results may differmaterially. In evaluating such statements, you are urged to specifically considervarious factors identified in this report, including the matters set forthbelow under the caption “Risk Factors,” in Part I, Item 1A of this report,any of which could cause actual results to differ materially from thoseindicated by such forward-looking statements.*

 

**Overview**

 

We are an innovativeprovider of smart, affordable data protection appliances that help mid-rangebusinesses and distributed enterprises ensure their business-critical data is “constantlyprotected, readily available and always there.” Our award winning products include the following:

 

·                  the Snap Server® networked and desktop storage appliances;

 

·                  the ULTAMUS® RAID family of nearline data protectionappliances;

 

·                  the REO SERIES® of disk-based backup and recovery appliances;and

 

·                  the NEO SERIES® and ARCvault® family of tape backup and archive appliances.

 

Ourproducts span all three tiers of data storage (nearline data protectionappliances, disk-based backup and recovery and tape automation) and enable usto offer our customers end-to-end data protection solutions designed formid-range businesses and distributed enterprises.

 

For 27 years, we havedelivered data protection solutions designed for backup and recovery to ensurebusiness continuity. Historically, we have focused on delivering a portfolio oftape automation solutions including loader and library systems designed forsmall businesses and mid-range computing environments. In 2003, we expanded ourproduct offerings to include a family of intelligent disk-based backup andrecovery appliances to complement our tape solutions. In 2007, we introducedour line of nearline data protection appliances which we believe provide theadvanced features, performance and flexibility necessary to make informationtechnology (IT) departments as efficient and dynamic as the businesses theysupport. In 2008, we acquired the Snap Server NAS (Network Attached Storage)business from Adaptec, Inc., which we refer to as Snap Server, includingthe brand and all assets related to the Snap Server networked and desktopstorage appliances.

 

One of the main marketdifferentiators of many of our products has been that we design them around amodular, scalable architecture. This feature enables customers to purchasestorage as they need it, rather than having to purchase larger monolithicdevices with excess capacity. We enable our customers to purchase an initialmodule to meet their near-term needs, and later increase capacity and speed, inthe case of NEO and REO 9100 and 9100c, by adding modules that can beinterconnected to function as a single system. Our solution provides a lowerprice entry point, investment protection, and an increased level of faulttolerance, as each module is self-sufficient and will continue to function evenif another were to fail.

 

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We also differentiateourselves with our “go-to-market” approach. We are the only supplier in ourmarket space that does not have a direct sales force. The majority of our saleshave historically been generated through private label arrangements withoriginal equipment manufacturers (OEMs). The remainder of our sales are madethrough commercial distributors, direct market resellers (DMRs) and value-addedresellers (VARs) in our branded channel.

 

End-users of our productsinclude mid-range businesses, as well as distributed enterprise customersrepresented by divisions and operating units of large multi-nationalcorporations, governmental organizations, universities and other non-profitinstitutions. Our products are used in a broad range of industry sectorsincluding financial services, healthcare, retail, manufacturing,telecommunications, broadcasting, research and development and many others. Ourproducts are sold world-wide in the Americas, EMEA (Europe, Middle East,Africa) and Asia Pacific. During fiscal 2008, 51.2% of our revenue wasgenerated internationally, primarily in Europe.

 

Wewere incorporated in California in 1980 as Overland Data, Inc. and changedour name to Overland Storage, Inc. in 2002. Our headquarters are locatedat 4820 Overland Avenue, San Diego, California 92123, and our telephone numberis (858) 571-5555.

 

#### **OurDirection and Strategy**

####  

We currently offer our customers a complete portfolio ofsmart, affordable data protection appliances that help mid-range businesses anddistributed enterprises ensure their data is “constantly protected, readilyavailable and always there.”  Our productstrategy is to bring enterprise-class capabilities to mid-range customersthrough affordable and reliable solutions that reduce the backup window,improve data recovery speed, simplify short and long-term data retention andmake cost-effective disaster recovery more readily available. Our focus willcontinue to be on solutions that can be easily sold worldwide through OEMs andour indirect network of distributors, retailers and resellers.

 

Historically, magnetic tape has been used for all formsof data backup and recovery because magnetic tape was, and still is, the onlycost-effective, “removable,” high capacity storage media that can be takenoff-site to ensure that data is safeguarded in case of disaster. For a numberof years now, we have held a market-leading position in mid-range tapeautomation with our flagship NEO® products, andsales of tape automation appliances have represented more than 63.0% of ourrevenue for each of the last three fiscal years. In fiscal 2007, we launchedARCvault, a new tape automation platform. Although we expect that tapesolutions will continue to be the anchor of the data protection strategy atmost companies, tape backup is time consuming and often unreliable andinefficient. The process of recovering data from tape is also time consumingand inefficient. Ultimately, we expect that tape will be relegated to anarchival role for less-frequently accessed data.

 

Over the last few years, the advent of low-cost serial ATAdisk and iSCSI networking technology, together with greatly increasedregulatory compliance requirements and the continued growth of digital data,have driven businesses to use secondary storage disk-based backup appliances.One of the greatest benefits of disk-based backup is the speed of restoration.Approximately 80% of recovered data is two weeks old or younger, or has lastbeen accessed within that period. As a result, many IT managers are electing touse disk-based appliances as an intermediate staging area, with the backup dataeventually moving to tape. Additionally, new software technologies such asreplication and data deduplication are helping disk solutions overcome theportability and capacity advantages of tape. We have enjoyed success in thedisk-based backup space with our REO® VTL-basedappliance, and believe that additional deduplication and data movement softwarepositions REO as the most complete and capable family of disk-based appliancesin the world marketplace.

 

**Our Products and Services**

 

Our data storage productsinclude nearline data protection appliances, disk backup and recovery, dataprotection software, and tape backup and archive.

 

*Networked and Desktop Storage Appliances*

 

Following our acquisition ofSnap Server in June 2008, we now offer our customers the followingnetworked and desktop storage systems:

 

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·                  *Snap Server 110*– Snap Server 110 provides performance andease of use in a compact, whisper-quiet, desktop storage unit. Thedirect-attached storage unit is configured with a single SATA (Serial AdvancedTechnology Attachment) II drivefor either 250 or 500 gigabytes of storage capacity.

 

·                  *Snap Server 210*– Snap Server 210 provides performance andease of use in a compact, whisper-quiet, desktop storage unit. Thedirect-attached storage unit is configured with two SATA II drives for a totalof either 500 gigabytes or 1.0 terabyte of storage capacity and supports RAID(Redundant Array of Independent Disks) Level 1.

 

·                  *Snap Server 410*– Snap Server 410 provides outstandingperformance and ease of use in a 1U rack-mountable NAS system. It is configuredwith fixed capacities or 1.0, 2.0, or 4.0 terabytes and supports RAID Levels 1and 5.

 

·                  *Snap Server 520*– Snap Server 520 provides outstandingperformance and ease of use in a 1U rack-mountable NAS system that is scalableand flexible, to fit an array of storage needs and budgets. It is configuredwith four SATA II drives for an initial capacity of 1.0, 2.0, or 4.0 terabytesand is expandable with up to 25.2 terabytes of SAS (Serial Attached SCSI) or anadditional 84.0 terabytes of SATA storage. The Snap Server 520 supports RAIDLevels 1 and 5.

 

·                  *Snap Server 620*– Introduced in September 2008, SnapServer 620 provides best-in-class performance and ease of use in a 1Urack-mountable NAS system that is scalable and flexible, to satisfymission-critical storage needs. It is configured with high-performanceenterprise-class SATA drives for an initial capacity of between 1.0 to 4.0terabytes and is expandable with up to an additional 25.2 terabytes of SAS or84.0 terabytes of SATA storage. Snap Server 620 supports RAID levels 0, 1, 5, 6and 10.

 

·                  *Snap Server 650*– Snap Server 650 provides best-in-classperformance and ease of use in a 1U rack-mountable NAS system that is scalableand flexible, to satisfy mission-critical storage needs. It is configured withfour high-performance SAS drives for an initial capacity of 1.2 terabytes andis expandable with up to an additional 25.2 terabytes of SAS or an additional84.0 terabytes of SATA storage. The Snap Server 650 supports RAID Levels 1 and5.

 

·                  *Snap Expansion*– Snap Expansion provides cost-effective,flexible expansion for scalable Snap Server storage systems. The Snap Expansioncomes as an unpopulated chassis, which can be filled with up to 12 SAS or SATAdrives for a customized mix of price and performance. The Snap Expansion may beused to add storage to the Snap Server 520 or 650 systems.

 

*NearlineData Protection Appliances*

 

In February 2007, weintroduced our ULTAMUS RAID nearline data protection appliances which providemid-range business customers an affordable alternative to costly high-end NASand SAN (Storage Area Network) solutions. The ULTAMUS RAID product familyfeatures cableless design and hot swap components and supports RAID Levels 0,1, 5, 6, 10 and 50, active/active RAID controllers, and multiple4 gigabytes per second Fibre Channel (FC) host connections.

 

Our ULTAMUS productfamily currently consists of two products:

 

·                  *ULTAMUS RAID 1200* – ULTAMUS RAID 1200 provides the abilityto use 12 SAS disk drives and/or 12 SATA disk drives within the same 2Urack-mountable enclosure. This product has a native storage capacity of up to12.0 terabytes, and is expandable up to 60 drives and 60.0 terabytes.

 

·                  *ULTAMUS RAID 4800* – ULTAMUS RAID 4800 leads the industry instorage rack efficiency by offering up to 48 SATA II disk drives in its 4Urack-mountable enclosure. This product has a native storage capacity of up to48.0 terabytes using SATA disk drives, and scales up to 96.0 terabytes using anadditional 4U expansion chassis.

 

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*DiskBackup and Recovery Appliances*

 

Our REO SERIES of diskbackup and recovery appliances are powered by our embedded REO Protection OS® software. These appliances are readilyconfigurable as virtual tape libraries (VTL), standalone virtual tape drives,and/or disk volumes (LUNs). See “Data Protection Software” below for moreinformation about REO Protection OS and our other add-on software modules. REOappliances are compatible with all popular open systems or Windows-based backupsoftware, physical tape drives or tape libraries. They also connect easily toEthernet (iSCSI) or FC networks for seamless integration into existing backupenvironments.

 

OurREO product family currently consists of four models:

 

·                  *REO 1500* – Our REO 1500 product has four disk drives and anative storage capacity of up to 4.0 terabytes.

 

·                  *REO 4500**and 4500c* – OurREO 4500 and 4500c products have 12 disk drives and a native storage capacityof up to 12.0 terabytes; and our REO 4500 expansion array can be added to anexisting REO 4500 appliance to expand the total storage capacity of up to amaximum raw capacity of 36.0 terabytes (60.0 terabytes useable compressedvirtual tape capacity). The REO 4500c utilizes hardware compression to achieveboth high performance and higher density storage, typically resulting in 2:1storage capacity utilization.

 

·                  *REO 9100 and 9100c* – Our REO 9100 and 9100c products have 12or 24 disk drives and a native storage capacity of up to 24.0 terabytes; andour REO 9100 expansion array can be added to an existing REO 9100 appliance toexpand the total storage raw capacity of 72.0 terabytes (124.0 terabytesuseable compressed virtual tape capacity). The REO 9100c utilizes hardwarecompression to achieve both high performance and higher density storage,typically resulting in 2:1 storage capacity utilization.

 

·                  *REO 9500D*–**With up to281.0 terabytes useable at 25:1 deduplication ratio in a 5U chassis and up to200MB/sec performance.

 

*DataProtection Software*

 

Our embedded storageoperating system software (Protection OS) for REO and add-on software modulePACs (Programmable Automation Controllers) provide data protection intelligenceand advanced capabilities within and across our appliances.

 

·                  *Protection OS* – Our Protection OS software deliversvirtualization, data protection, management, and connectivity features to ourREO appliances, and enables users to implement our appliances in almost anystorage or backup environment. Protection OS is compatible with all popularoperating systems and backup software along with Ethernet (iSCSI) and FibreChannel networks. In November 2007, we launched version 5.0 of ourProtection OS.

 

·                  *REO Multi-Site PAC* – REO Multi-Site PAC® software makes it easy to add more advancedbackup and recovery capabilities to our REO appliances, including mirroring andconsolidation. This software is also available to protect remote data byfacilitating the transfer of data in virtual tape format from a remote REO to acentral REO for management and tape storage.

 

Our embedded storageoperating system software (GuardianOSTM) for Snap Server and add-on softwaremodules, such as Snap Enterprise Data ReplicatorTM (Snap EDR), provide data protection intelligence and advanced capabilities withinand between our NAS appliances.

 

·                  *GuardianOS*– GuardianOS, the award-winning Snap ServerOperating System, was specifically designed to deliver robust data managementthroughout distributed environments. GuardianOS combines cross-platform filesharing with block-level data access on a single device to provide a simple yetflexible solution. In addition to a unified storage architecture, GuardianOS5.0 offers simple scalability, centralized storage management, and acomprehensive suite of data protection tools to consolidate data and simplifymanagement.

 

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·                  *Snap Enterprise Data Replicator* – Snap Enterprise DataReplicator 7.2 is a powerful, high-performance data replication and protectionsolution with comprehensive data management, movement, and backup capabilities.Administrators can remotely move files between servers, replicate data fromtheir remote offices to a central server where it can be protected withestablished backup and restore procedures, or automatically distribute datafrom a central server to multiple remote offices. With Snap EDR, the administratorcan implement enterprise-wide data movement, backup, disaster recovery, andcompliance operations from a single location.

 

*TapeBackup and Archive Appliances*

 

Our automated tapelibraries are devices capable of managing multiple data cartridges. Theselibraries incorporate two or more tape drives to provide unattended backup oflarge quantities of data, which tape drives are supplied by other manufacturersbased on the leading mid-range tape technologies, including LTO (Linear TapeOpen) and SDLT (Super Digital Linear Tape). Our NEO SERIES libraries haveflexible configurations and feature redundant robotics, tape drives, powersupplies, controller cards and interfaces so that no single failure can disablethe entire library. Our NEOTM products and ARCvault libraries or autoloaders canbe combined with our REO appliances for a complete disk-to-disk-to-tapesolution.

 

Weoffer three versions of our NEO product family:

 

·                  *NEO 2000* – Our NEO 2000 product accommodates up to two tape drives and 30 cartridges and scales up toeight modules high to create a system of 16 tape drives and 240 cartridges.

 

·                  *NEO 4000* – Our NEO 4000 product accommodates up to four tape drives and 60 cartridges and scales up tofour modules high to create a system of 16 tape drives and 240 cartridges.Customers can configure NEO systems with a combination of NEO 2000 and 4000modules.

 

·                  *NEO 8000* – Our NEO 8000 product consists of a base model with 100-cartridge capacity which canbe scaled up to 12 tape drives and 500 cartridges through a field-enabledsoftware key. Additionally, two NEO 8000 libraries can be interconnected toprovide up to 1,000 cartridge capacity and 24 tape drives.

 

OurARCvault family of tape automation solutions is designed to deliver better valueto a price sensitive market. We offer three versions of our ARCvault family,each of which was launched in fiscal 2007:

 

·                  *ARCvault 12* – OurARCvault 12 autoloader consists of one tape drive and accommodates up to 12cartridges.

 

·                  *ARCvault 24* – Our ARCvault 24 tape library accommodates up to two tape drives and 24 cartridges.

 

·                  *ARCvault 48* – Our ARCvault 48 tape library accommodates up to four tape drives and 48 cartridges.

 

*Related Products and Services*

 

Wealso have a variety of products and services supporting our tape libraries andloaders. We currently offer the following additional products and services:

 

·                  Desktopand internal upgrade tape drives;

 

·                  Spares,post warranty return-to-factory and on-site service; and

 

·                  Media,including tape cartridges for SDLT and LTO formats.

 

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*VR**2**®** (Variable Rate Randomizer)*

 

VR2 is our patented data encoding technology. This technology, whichis embedded in an Applications Specific Integrated Circuit (ASIC) chip, iscapable of significantly increasing the native capacity and data transfer rateperformance of linear tape technologies without requiring any changes in tapepath design, recording heads and/or media. This performance is accomplished byachieving encoding efficiency of greater than 99%. We have licensed VR2 to Tandberg Data ASA for use in its Scalable Linear Recording(SLR) tape drives, to Imation Corporation as the owner of the Travan technologyformat, to Quantum Corporation for use in its Travan tape drive offerings, andto Sun Storage Tek for use in its T9940, T9840 and T10000 drives and futuretape drive products.

 

**Customers**

 

Our operating structure is designed for our mid-rangestrategy in that our products do not require us to have a “direct” (toend-users) sales or service force. We sell all of our products on an indirect basis, primarily throughthree channels: (i) OEMs; (ii) distributors, and (iii) VARs andDMRs. Regardless of the channel through which they are sold, all of ourproducts are designed and manufactured to meet OEM-level requirements andreliability standards.

 

·                  ***OEM Channel*** – Historically, we have had a significantOEM supply agreement with Hewlett Packard Company (HP), which incorporates ourARCvault and NEO products into its system offerings. In August 2005, weannounced that HP had selected an alternate supplier for its next-generationmid-range tape automation products. HP began purchasing the first product ofthis new line from the alternate supplier during the first quarter of calendaryear 2006. Although we believe that our sales to HP will continue to decline,HP has recently relaunched the tape automation products supplied by us withsupport for the new LTO-4 tape drives and this may slow the rate of replacementof our supplied products by the alternate supplier’s product.

 

Althoughwe continually strive to win new OEM business, the OEM sales cycle is oftenlengthy and uncertain. It typically consists of a general technologyevaluation, qualification of product specifications, verification of productperformance against these specifications, integration testing of the productwithin the customers’ systems, product announcement and volume shipment.

 

Asis customary in the industry, our OEM contracts have an initial three-yearterm, provide for periodic price reviews and the customers are not required topurchase minimum quantities. Our existing contract with HP (initially signed inAugust 2003 and extended for up to three years in July 2006) alsoprovides that title to inventory shipped from our warehouse into variousinventory hub locations remains with us until the products are pulled by HP tofulfill its customer’s orders. HP has been our largest customer, accounting forapproximately 35.2%, 45.8% and 49.7% of sales in fiscal 2008, 2007 and 2006,respectively. No other customer accounted for more than 10.0% of sales in anyyear during the three-year period ended June 30, 2008.

 

·                  ***Distribution Channel*** – Our primary distribution customers includeIngram Micro, Inc., Tech Data Corporation and Promark Technology in theUnited States and approximately 24 technical distributors in Europe. Typically,these distributors sell our products to smaller VARs and DMRs who in turn sellto end-users. The distribution agreements include provisions for rights ofreturn, stock rotation and price protection, and common terms in the commercialdistribution area. Because of these terms, revenue from shipments to thesecustomers is not recognized until the related products are in turn sold by thedistributor. We support these distributors through a dedicated field salesforce and provide further support through field sales personnel who work withthe smaller VARs and catalogers to generate end-user sales and create the pullthrough its distribution customers.

 

·                  ***VAR Channel*** – Our VAR channel includes systemsintegrators and larger VARs. Some of our VARs qualify to purchase productsdirect from us while others purchase through the distribution channel. Some ofthese customers specialize in the insurance, banking, financial, geophysical ormedical industries, and offer a variety of value-added services relating to ourproducts. Our products frequently are packaged by these customers as part of acomplete data processing system or combined with other storage devices, such asRAID systems, to deliver a complete storage subsystem. These customers alsorecommend our products as replacement solutions when backup systems areupgraded, and bundle our products with storage management software specific tothe end-user’s system. We support this channel through our field salesrepresentatives.

 

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Our products are soldboth domestically and internationally and we have sales personnel located invarious cities throughout the world. We divide our sales into threegeographical regions: (1) the Americas, consisting of North and SouthAmerica; (2) Europe, Middle East and Africa (EMEA); and (3) AsiaPacific (APAC). Primary support for customers in the Americas is provided fromour San Diego headquarters office. EMEA is supported by our wholly-ownedsubsidiaries located in: Wokingham, England; Paris, France; and Munich,Germany. The subsidiary in England provides sales, technical support and repairservices, while the subsidiaries in France and Germany provide sales andtechnical support. Our APAC customers are supported by our sales offices inChina, Singapore and Korea. As of August 26, 2008, as part of ourrestructuring, the China and Korea offices were closed. See “RecentDevelopments” in Management’s Discussion and Analysis****ofFinancial Condition and Results of Operation for more information about the restructuring.We assign to our international distributors the right to sell our products in acountry or group of countries. In addition, many domestic customers ship aportion of our products to their overseas customers.

 

Sales to customersoutside of the United States represent a significant portion of our sales.International sales are subject to various risks and uncertainties. See “Ourinternational operations are important to our business and involve unique risks”in Risk Factors below. Sales generated by our European channel generally showseasonal slowing during our first fiscal quarter (July through September),reflecting the summer holiday period in Europe.

 

The following table setsforth foreign revenue by geographic area (in thousands):

 
| ** **                                      | ** ** | **Fiscal Year** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Foreign revenue:                                |       |                 |       |   |   |   |   |
| Europe (other than United Kingdom)              |       | $                    | 24,475     |   | $ | 25,613 |   | $ | 29,098 |   |
| United Kingdom                                  |       | 23,614               |       | 40,925 |   | 47,914 |   |
| Singapore                                       |       | 9,489                |       | 15,247 |   | 22,940 |   |
| Other foreign revenue                           |       | 7,761                |       | 10,678 |   | 18,674 |   |
|                                            |       | $                    | 65,339     |   | $ | 92,463 |   | $ | 118,626 |   |
| Foreign revenue as a percentage of net  revenue |       | 51.2                 | %          | 57.6 | % | 56.7 | % |

 

Our marketing efforts includesupport for our branded customers. Our branded channel partners are providedwith a full range of marketing materials, including product specificationliterature and application notes. In addition, we offer lead generationopportunities and market development funds to our key channel partners. Oursales management and engineering personnel provide support to the channelpartners and, in certain instances, visit potential customer sites to explainand demonstrate the technical advantages of our products. We maintain pressrelations both domestically and in Europe, and participate in national andregional trade shows in varying degrees both domestically and internationally.

 

**Customer Service and Support**

 

Ourtechnical support personnel are trained on our products, compatibility betweenmultiple hardware platforms, operating systems and backup, data interchange andstorage management software and are equipped to respond to customer inquiries.Additionally, our application engineers are available to solve more complexcustomer problems. Customers that need service and support can contact usthrough our toll-free telephone lines, facsimile and Internet e-mail.Application notes and user manuals can be obtained directly from our website.

 

For most products, we offera program called XchangeNOW® as part of a return-to-factory warrantywhich enables customers to receive an advance replacement unit or fieldreplacement part shipped within two business days after placing a servicerequest. The customer ships the defective unit back to us using the shippingmaterials from the replacement unit. In addition, we generally provide:

 

·                  three-year advance replacementreturn-to-factory limited warranty on our ULTAMUS RAID, REO SERIES, PowerLoader® and LoaderXpress® products;

 

·                  three-year return-to-factory limited warrantyon our Snap Server products;

 

·                  one-year advance replacement return-to-factorylimited warranty for our ARCvault 12 and 24 products; and

 

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·                  one-year on-site service limited warranty onour NEO SERIES and ARCvault 48 products, for which we contract with third-partyservice providers.

 

In May 2007, thewarranty length for NEO SERIES products was reduced from three years to oneyear. The second and third year of warranty for those NEO SERIES productsshipped prior to May 2007 will continue to be serviced under the threeyear advance replacement return-to-factory warranty through no later than thefourth quarter of fiscal 2010. As of the end of third quarter of fiscal 2007,our PowerLoader and LoaderXpress products were replaced by our ARCvault productfamily. Our PowerLoader and LoaderXpress products will continue to be servicedunder the three-year advance replacement return-to-factory warranty, but notlater than the third quarter of fiscal 2010.

 

**Research and Development**

 

We incurred research anddevelopment (R&D) costs of $9.3 million, $15.0 million and $18.8 million infiscal 2008, 2007 and 2006, respectively, representing 7.3%, 9.4% and 9.0%,respectively, of net revenue. We currently employ 60 people in our R&Ddepartment, including electrical, mechanical, software, hardware and firmwareengineers who support our products. In fiscal 2006, our development effortswere focused on three projects: (1) our ARCvault tape automation platform;(2) an ULTAMUS protected primary storage appliance based on technology weacquired in the August 2005 acquisition of Zetta Systems (which projectwas abandoned in the first quarter of fiscal 2007); and (3) the additionof scalability to our current line of REO products. In fiscal 2007, wecompleted the development of the ARCvault tape automation products, new RoHScompliant platforms for all three of our REO products, and version 4.0 of ourREO Protection OS software for the REO 1500 platform.  We also completed the sourcing andqualification of our new ULTAMUS RAID products. In fiscal 2008, our developmentefforts were focused on the development of the REO Compass product anddelivering a 64bit REO Protection OS.  Wecompleted the implementation of LTO-4 Drive Technology across all tapeautomation platforms, and in REO Protection OS 5.0 we introduced 1.0 terabyteDrives as well as hardware compression in the REO 4500c and 9100c.  We are currently developing both hardware andsoftware enhancements to our REO platforms which will incorporate datadeduplication technologies. None of our R&D expenditures arecustomer-sponsored.

 

#### **Manufacturingand Suppliers**

####  

In September 2004, weannounced a plan to outsource all of our manufacturing to Sanmina – SCICorporation, a United States third party manufacturer. We completed thistransfer in August 2005. During fiscal 2006, however, we failed to achievethe customer service levels, product quality and cost reductions we expectedfrom the outsourcing. Additionally, we incurred a significant amount ofredundant costs to support the outsourcing, which eroded our gross marginsduring the year. Consequently, we decided to bring manufacturing back to ourSan Diego facility and entered into a transition agreement with Sanmina,effective September 2006. We completed the transfer of all productionlines back to San Diego in February 2007, and accordingly our customerlead times were returned to target levels and we resolved the quality andbacklog issues that occurred during the outsourced period. We are now workingto continue to reduce costs, improve efficiencies and reduce inventory levels.

 

At our integrated factory in San Diego, California, weperform product assembly, integration and testing, while leaving component andpiece-part manufacturing to our supplier partners. Our products have a largenumber of components and subassemblies produced by outside suppliers. We dependgreatly on these suppliers for tape drives, printed circuit boards andintegrated circuits, which are essential to the manufacture of our products. Wework closely with a group of regional, national and international suppliers,which are carefully selected based on their ability to provide quality partsand components that meet our specifications, as well as meet present and futurevolume requirements. For certain items, we qualify only a single source, whichcan magnify the risk of shortages and decrease our ability to negotiate withour suppliers on the basis of price. From time to time in the past, we have notobtained as many drives as we have needed from various vendors due to driveshortages or quality issues.

 

In general, our brandedproducts are not manufactured until an order is received. The typical lead-timefor manufacturing products is three days and backlog usually is not asignificant factor to our business. At June 30, 2008, we had $1.0 millionof firm backlog orders, compared to approximately $1.2 million at June 30,2007. Our largest OEM customer, HP, requires that we maintain finished goodsinventory on hand, known as buffer stock, at any given time sufficient tosupply their forecasted requirements for the next three weeks. They provideweekly forecast information that allows us to manage both raw material andfinished goods inventories. The buffer stock is shipped into variousdistribution hubs around the world and we retain ownership of that inventoryuntil it is pulled by HP to fulfill customer orders, at which time we recordthe sale.

 

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We occupied our currentheadquarters and manufacturing buildings in March 2002. The buildings aresubject to a 12-year lease with one five-year extension option. We believe thatwe have the capacity to support unit production levels several times greaterthan our current rate of production. We maintain approximately 30% of ourdirect labor in the form of temporary staffing to accommodate normal businessfluctuations and control our staffing levels carefully to meet customerrequirements at any specific time.

 

**Competition**

 

The worldwide storage market is intensely competitiveand barriers to entry are relatively low. Our competitors vary in size fromsmall start-ups to large multi-national corporations who have substantiallygreater financial, R&D and marketing resources. In the tape automationmarket, we believe our primary competition is Quantum Corporation, but we alsoface competition from Sun StorageTek in larger scale libraries. Key competitivefactors include product features, reliability, durability, scalability andprice.

 

Ourdisk-based products currently compete with products made by Quantum, EMC, NetApp, HP, IBM, Dell,DataDomain, Nexsan, FalconStor, Infortrend, Buffalo, LaCie, Sepaton and numerous small start-ups. We believeadditional competitors are likely to enter the market. Key competitive factorsin these markets include performance, functionality, scalability, availability,interoperability, connectivity, time to market enhancements and total value ofownership.

 

The markets for all of our products are characterized bysignificant price competition, and we anticipate that our products willcontinue to face increasing price pressure.

** **

**Proprietary Rights**

 

#### **General******– We presentlyhold 27 United States patents and have 10 United States patents pending. Ingeneral, these patents have a 20-year term from the first effective filing datefor each patent. We also hold a number of foreign patents and patentapplications for certain of our products and technologies. These rights,however, may not prevent competitors from developing substantially equivalentor superior products to ours. In addition, our present and future patents maybe challenged, invalidated or circumvented, reducing or eliminating ourproprietary protection.

####  

**VR2 Technology**– We have entered into various intellectual property licensingagreements relating to our VR2 technology. These agreementsrequire the payment of royalty fees based on sales by licensees of productscontaining VR2. In certain instances, we sell to the licensee ASICchips embodying VR2 priced to include the cost of the chip plus anembedded royalty fee.

 

**Employees**

** **

Asof June 29, 2008, we had 397 employees, including 165 in sales andmarketing, 60 in research and development, 134 in manufacturing and operationsand 38 in finance, information systems, human resources and other management.There are no collective bargaining contracts covering any of the employees andwe believe that our relationship with our employees is good.

 

**Financial Information about Segments andGeographic Areas**

 

Weoperate our business in one reportable segment. For information about (1) ourrevenues from external customers, measures of profits and losses, and totalassets, and (2) our revenues from external customers and long-lived assetsbroken down by geographic area, see our consolidated financial statements andNote 1 (Operations and Summary of Significant Accounting Policies – “Segment Data” and “Information about Geographic Areas”) thereto.

 

**Additional Information**

 

Ourweb site is located at www.overlandstorage.com. We make available free ofcharge on our web site our annual report on Form 10-K, quarterly reportson Form 10-Q, current reports on Form 8-K, and amendments to thosereports filed pursuant to Section 13(a) or 15(d) of the ExchangeAct as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the Securities and Exchange Commission. Thecontents of our web site are not a part of this report.

 

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** **

**ITEM 1A. Risk Factors.**

 

*Aninvestment in our company involves a high degree of risk. In addition to theother information included in this report, you should carefully consider eachof the following risk factors in evaluating our business and prospects as wellas an investment in our company.**The risks and uncertainties described below are not the only ones weface. Additional risks and uncertainties not presently known to us or that wecurrently consider immaterial may also impair our business operations. If anyof the following risks actually occur, our business and financial results couldbe harmed. In that case the trading price of our common stock could decline.You should also refer to the other information**included or incorporated by reference in this report.*

 

**Our current cash and cash equivalents will fund our operations atcurrent levels into November 2008. We need additional funding or we willbe forced to liquidate assets and/or curtail or cease operations.  Any additional funding may dilute yourshares.  If we are unable to raiseadditional funds for operations, we may not be able to continue as a goingconcern**.

 

We need immediate and substantial cash to continue our operations atcurrent levels. We currently have no funding commitments. Management hasprojected that cash on hand will be sufficient to allow us to continue ouroperations at current levels into November 2008. We will need additionalfunding, either through debt or equity financings, or we will be forced toextend payment terms with vendors where possible, to liquidate certain assetswhere possible, and/or to suspend or curtail certain of our plannedoperations.  Any of these actions couldharm our business, results of operations and future prospects.  We anticipate we will need to raiseapproximately $10.0 million of cash and cash equivalents in the next twelvemonths to fund our operations through fiscal 2009 at current levels.

 

As a result of our need for additional financing and other factors, thereport from our independent registered public accounting firm regarding ourconsolidated financial statements for the year ended June 30, 2008includes an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern.

 

Possible funding alternatives for raising working capital are bank orasset based financing options, equity-based financing, including convertibledebt and factoring arrangements. We are in discussions with funding sources foreach of these options, but we currently have no funding commitments. If weraise additional funds by selling additional shares of our capital stock, theownership interest of our shareholders will be diluted. The amount of dilutioncould be increased by the issuance of warrants or securities with otherdilutive characteristics, such as anti-dilution clauses or price resets.

 

As of June 30, 2008, our other assets included $3.1 million ofauction rate securities, which securities have a par value of $5.0 million. Theauctions for these securities have failed since July 2007, which limitsour ability to liquidate these securities and recover their carrying value in thenear term.  We may nonetheless attempt toliquidate these securities to meet cash needs. We cannot predict whether wewill be able to liquidate these securities, and we expect that any liquidationin the near term will bring less than the value of these securities as of June 30,2008, based upon indicative bids. For example, indicative bids (i.e., onemeasure of the estimated liquidation value) from Deutsche Bank subsequent toyear-end for our ARS instruments have ranged from a high of approximately $2.8million at July 16, 2008, to a low of approximately $1.4 million at October 1,2008, the most recent bid as of the date of this report. You should review theadditional information about our liquidity and capital resources in theManagement’s Discussion and Analysis of Financial Condition and Results ofOperations section of this report.

 

If we cease to continue as a going concern, due to lack of availablecapital or otherwise, you may lose your entire investment in our company.

 

**We have a history of net losses. We expect to continueto incur net losses for some time and we may not achieve or maintainprofitability.**

** **

Wehave incurred significant operating losses in our last three fiscal years andwe anticipate continued losses during fiscal 2009. At June 30, 2008 we hadan accumulated deficit of $50.9 million. We need to generate additional revenueand improve our gross profit margins to be profitable in future periods.  We may never return to profitability, or ifwe do, we may not be able to sustain profitability on a quarterly or annualbasis.

 

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**Our financial condition andthe “going concern” opinion from our independent registered public accountingfirm may negatively impact our business.**

 

Asa result of our need for additional financing and other factors, the reportfrom our independent registered public accounting firm regarding ourconsolidated financial statements for the year ended June 30, 2008includes an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern.

 

Suchreport, and our financial condition and history of net losses, could causecurrent or potential customers to defer new orders with us or select othervendors, and may cause suppliers to require terms that are unfavorable to us.

 

**Werecorded an impairment charge to reduce the carrying value of our auction ratesecurities and we may incur additional impairment charges with respect toauction rate securities in the future.**

 

Credit concerns in the capitalmarkets have significantly reduced our ability to liquidate auction ratesecurities (ARS) that we classify as other assets on our balance sheet. As of June 30,2008, we held two ARS instruments with a par value of $5.0 million. Thesesecurities are collateralized by corporate debt obligations. Due to the failedauctions for these auction rate securities since July 2007, we recordedother-than-temporary impairment charges of $1.9 million, which reduced thevalue of our auction rate securities to their estimated fair value of$3.1 million as of June 30, 2008. An auction failure means that theparties wishing to sell their securities could not do so. If we liquidate ourauction rate securities or we determine that one or more of the assumptionsused in estimating the fair value of our auction rate securities needs to berevised, we may be required to record additional impairments in future periods.

** **

**As ourrevenue base continues to decline from our current operations, we may choose toexit or divest some or a substantial portion of our current operations to focuson fewer opportunities.**

 

Our management teamcontinuously reviews and evaluates our product portfolio, operating structureand markets to determine the future viability of our existing products andmarket positions. We may determine that the infrastructure and expensesnecessary to sustain an existing business or product offering are greater thanthe potential contribution margin that will be obtainable in the future. As aresult, we may determine that it is in our interest to exit or divest one ormore existing business or product offering. Such decisions could result in costs incurred for exit or disposalactivities and/or impairments of long-lived assets.  Moreover, if we do not identify other opportunitiesto replace discontinued products or operations, our revenues would decline,which could lead to further net losses and cause our stock price to decline.

 

**Ourbusiness has been highly dependent on sales to large OEM customers, and we arecurrently in the middle of a transition with our largest OEM customer.**

 

Hewlett-Packard Company (HP) has been our largestcustomer in recent periods, accounting for approximately 35.2%, 45.8%and 49.7% of sales in fiscal 2008, 2007 and 2006, respectively. No othercustomer accounted for more than 10.0% of sales in any year during thethree-year period ended June 30, 2008. Neither HP nor any other customer isobligated to purchase a specific amount of our products or provide bindingforecasts of purchases for any period.

 

In August 2005, weannounced that HP had selected an alternate supplier for its next-generationmid-range tape automation product. HP began purchasing the first product ofthis new line from the alternate supplier during the first quarter of calendaryear 2006. We expect HP to continue to purchase the tape automation productscurrently supplied by us for some time, but the new product will eventuallyreplace a significant portion of those purchases. We cannot predict how quicklythis transition will occur, but we believe the effect on our revenue duringfiscal 2009 may be significant.

 

**We couldincur charges for excess and obsolete inventory.**

 

The value of our inventorymay be adversely affected by changes in technology that affect our ability tosell the products in our inventory. If we do not effectively forecast andmanage our inventory, we may need to write off inventory as excess or obsolete,which in turn can adversely affect cost of sales and gross profit. We havepreviously experienced, and may in the future experience, reductions in salesof older generation products as customers delay or defer purchases inanticipation of new product introductions. We currently have establishedreserves for slow moving or obsolete inventory. The reserves we haveestablished for potential losses due to obsolete inventory may, however, proveto be inadequate and may give rise to additional charges for excess or obsoleteinventory.

 

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**If our suppliers fail to meet ourmanufacturing needs, it would delay our production and our product shipments tocustomers and negatively affect our operations.**

 

Our products have a largenumber of components and subassemblies produced by outside suppliers. We dependgreatly on these suppliers for tape drives, printed circuit boards andintegrated circuits, which are essential to the manufacture of our products. Wework closely with a group of regional, national and international suppliers,which are carefully selected based on their ability to provide quality partsand components that meet our specifications, as well as meet present and futurevolume requirements. For certain items, we qualify only a single source, whichcan magnify the risk of shortages and decrease our ability to negotiate withour suppliers on the basis of price. From time to time in the past, we have notobtained as many drives as we have needed from various vendors due to driveshortages or quality issues.  If ourvendors fail to meet our manufacturing needs, it would delay our production andour product shipments to customers and negatively affect our operations.

 

**We rely on indirect sales channels to market and sell our brandedproducts. Therefore, the loss of or deterioration in our relationship with oneor more of our distributors or resellers could negatively affect our operatingresults.**

 

Wesell all of our branded products through our network of distributors,value-added resellers or VARs, and direct marketing resellers who in turn sellour products to end users.  The successof these partners is hard to predict, particularly over time, and we have nopurchase commitments or long-term orders from them that assure us of anybaseline sales through these channels. Most of our partners carry competing product lines that they may promoteover our products.  A partner might notcontinue to purchase our products or market them effectively, and each resellerdetermines the type and amount of our products that it will purchase from usand the pricing of the products that it sells to end user customers.  Our operating results could be adverselyaffected by any number of factors including:

 

·                  achange in competitive strategy that adversely affects a partners’ willingnessor ability to distribute our products;

 

·                  thereduction, delay or cancellation of orders or the return of a significantamount of product(s);

 

·                  theloss of one or more of such partners; or

 

·                  anyfinancial difficulties of such partners that result in their inability to payamounts owed to us.

 

**We plan toreplace our ERP (Enterprise Resource Planning) System within the next severalyears, and this may be disruptive to our business.**

 

Our ERP system is approximately 11-years old, and weanticipate the need to replace it within the next several years. Transition toa new ERP system will be expensive and time consuming and, if problems occur inthe transition, our business and results of operations may be materially andadversely affected. In addition, we have modified this system significantlyduring its term of use and it is possible that we would experience asignificant system failure before we replace the system. Any such failure alsomay materially and adversely affect our business and results of operations.

 

**Ourfinancial results may fluctuate substantially for many reasons, and pastresults should not be relied on as indications of future performance.**

 

All of the markets that we serve are volatile andsubject to market shifts, which we may not be able to discern in advance. Aslowdown in the demand for workstations, mid-range computer systems, networksand servers could have a significant adverse effect on the demand for our productsin any given period. We have experienced delays in receipt of purchase ordersand, on occasion, anticipated purchase orders have been rescheduled or have notmaterialized due to changes in customer requirements. Our customers may cancelor delay purchase orders for a variety of reasons, including the reschedulingof new product introductions, changes in their inventory practices orforecasted demand, general economic conditions affecting our customers’markets, changes in our pricing or the pricing of our competitors, new productannouncements by us or others, quality or reliability problems related to ourproducts or selection of competitive products as alternate sources of supply.In particular, our ability to forecast sales to distributors, integrators andvalue-added resellers is especially limited as these customers typicallyprovide us with relatively short order lead times or are permitted to changeorders on short notice. Given that a large portion of our sales are generatedby our European channel, our first fiscal quarter (July through September)results of operations are commonly impacted by seasonally slow European orders,reflecting the summer holiday period in Europe. In addition, none of ourcustomers is obligated to purchase a specific amount of our products.

 

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Our financialresults have fluctuated and will continue to fluctuate quarterly and annuallybased on many other factors such as:

 

·                  changes incustomer mix (e.g., OEM vs. branded);

 

·                  changes in productmix;

 

·                  fluctuations inaverage selling prices;

 

·                  currency exchangefluctuations;

 

·                  increases in costsand expenses associated with the introduction of new products; and

 

·                  increases in thecost of or limitations on availability of materials.

 

Based on all of the foregoing, we believe that ourrevenue and operating results will continue to fluctuate, and period-to-periodcomparisons are not necessarily meaningful and should not be relied on asindications of future performance. Furthermore, in some future quarters, ourrevenue and operating results could be below the expectations of public marketanalysts or investors, which could result in a material adverse effect on theprice of our common stock. In addition, portions of our expenses are fixed anddifficult to reduce if revenue does not meet our expectations. These fixedexpenses magnify the adverse effect of any revenue shortfall.

 

**The market price of our common stock may bevolatile***.*

 

The market price of our common stock hasexperienced significant fluctuations since it commenced trading in February 1997.The market price of our common stock may continue to fluctuate significantly inthe future. Many factors could cause the market price of our common stock tofluctuate, including:

 

·                  our ability tomeet our working capital needs;

 

·                  announcementsconcerning us, our competitors, our customers or our industry;

 

·                  changes inearnings estimates by analysts;

 

·                  purchasingdecisions of HP and other significant customers;

 

·                  quarterlyvariations in operating results;

 

·                  the introductionof new technologies or products;

 

·                  changes in productpricing policies by us or our competitors;

 

·                  the terms of anyfinancing arrangements we enter into; and

 

·                  changes in generaleconomic conditions.

 

In addition, stock markets have experienced extremeprice and volume volatility in recent years. This volatility has had asubstantial effect on the market prices of securities of many smaller publiccompanies for reasons frequently unrelated or disproportionate to the operatingperformance of the specific companies. These market fluctuations may adverselyaffect the market price of our common stock.

 

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**We faceintense competition and price pressure, and many of our competitors havesubstantially greater resources than we do.**

 

The worldwide storage market is intenselycompetitive as a number of manufacturers of tape automation solutions andstorage management software products compete for a limited number of customers.In addition, barriers to entry are relatively low in these markets. Wecurrently participate in the mid-range of the tape backup market. In thissegment, some of our competitors have substantially greater financial and otherresources, larger research and development staffs, and more experience andcapabilities in manufacturing, marketing and distributing products. The marketsfor our products are characterized by significant price competition, and weanticipate that our products will face increasing price pressure. This pressurecould result in significant price erosion, reduced profit margins and loss ofmarket share, any of which could have a material adverse effect on ourbusiness, liquidity, results of operation and financial position.

 

**Ourbusiness is highly dependent on the continued market acceptance and usage oftape-based systems for data backup and recovery.**

 

We have historicallyderived a majority of our revenue from products based on the use of magnetictape drives for backup and recovery of digital data. Our tape-based storagesolutions now compete directly with other storage technologies, such as harddisk drives, and may face competition in the future from other emerging technologies.The prices of hard disk drives continue to decrease while capacity andperformance have increased. We expect that our tape-based products will faceincreased competition from these alternative technologies and come underincreasing price pressure. If our strategy to compete in disk-based marketsdoes not succeed, it could have a material adverse effect on our business,liquidity, results of operations and financial position.

 

**Our disk-based products involve many significant risks and may fail toachieve or maintain market acceptance.**

 

Thesuccess of our REO SERIES and ULTAMUS RAID family disk-based products isuncertain and subject to significant risks, any of which could have a materialadverse effect on our business, liquidity, results of operation and financialposition. We must commit significant resources to these new products and willcontinuously need to update and upgrade them to stay competitive. Any delay inthe commercial release of new or enhanced disk-based products could result in asignificant loss of potential revenue and may adversely impact the market priceof our common stock. Furthermore, if our disk-based products do not achievemarket acceptance or success, then the association of our brand name with theseproducts may adversely affect our reputation and our sales of other products,as well as dilute the value of our brand name.

 

**Oursuccess depends on our ability to anticipate rapid technological changes anddevelop new and enhanced products.**

 

As an advanced technology company, we are subjectto numerous risks and uncertainties, generally characterized by rapidtechnological change and intense competition. In this environment, our futuresuccess will depend on our ability to anticipate changes in technology, todevelop new and enhanced products on a timely and cost-effective basis and tointroduce, manufacture and achieve market acceptance of these new and enhancedproducts.

 

Development schedules for high technology productsare inherently subject to uncertainty. We may not meet our product developmentschedules, including those for products based on our disk-based technologies,and development costs could exceed budgeted amounts. Our business, liquidity,results of operations and financial position may be materially and adversely affectedif the products or product enhancements that we develop are delayed or notdelivered due to developmental problems, quality issues or component shortageproblems, or if our products or product enhancements do not achieve marketacceptance or are unreliable. The introduction, whether by us or ourcompetitors, of new products embodying new technologies, such as new sequentialor random access mass storage devices, and the emergence of new industrystandards could render existing products obsolete or not marketable, which mayhave a material adverse effect on our business, liquidity, results ofoperations and financial position.

 

**Ourinternational operations are important to our business and involve uniquerisks.**

 

Historically, sales to customers outside of theUnited States have represented a significant portion of our sales and we expectthem to continue representing a significant portion of sales. Sales tocustomers outside the United States are subject to various risks, including:

 

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·                  the imposition ofgovernmental controls mandating compliance with various foreign and U.S. exportlaws;

 

·                  currency exchangefluctuations and weak economic conditions in foreign markets;

 

·                  political andeconomic instability;

 

·                  traderestrictions;

 

·                  changes in tariffsand taxes;

 

·                  longer paymentcycles (typically associated with international sales); and

 

·                  difficulties instaffing and managing international operations.

 

Furthermore, we may not be able to comply withchanges in foreign standards in the future. Our inability to design productsthat comply with foreign standards could have a material adverse effect on ourbusiness, liquidity, results of operations and financial position.

 

**We aresubject to exchange rate risk in connection with our international operations.**

 

Wedo not currently engage in foreign currency hedging activities and therefore weare exposed to some level of currency risk. Our wholly-owned subsidiaries inthe United Kingdom, France and Germany incur costs which are denominated in localcurrencies. As exchange rates vary, these results when translated into U.S.dollars may vary from expectations and adversely impact overall expectedresults. A weaker U.S. dollar would result in an increase to revenue andexpenses upon consolidation, and a stronger U.S. dollar would result in adecrease to revenue and expenses upon consolidation.

 

**Our ability to compete effectively depends in parton our ability to protect our intellectual property rights effectively.**

 

We rely on a combination of patent, copyright,trademark, trade secret and other intellectual property laws to protect ourintellectual property rights. These rights may not however prevent competitorsfrom developing products that are substantially equivalent or superior to ourproducts. To the extent we have or obtain patents, such patents may notafford meaningful protection for our technology and products. Others maychallenge our patents and, as a result, our patents could be narrowed,invalidated or declared unenforceable. In addition, current or future patentapplications may not result in the issuance of patents in the United States orforeign countries. The laws of certain foreign countries may not protect our intellectualproperty to the same extent as U.S. laws. Furthermore, competitors mayindependently develop similar products, duplicate our products or, if patentsare issued to us, design around these patents.

 

Inorder to protect or enforce our patent rights, we may initiate interferenceproceedings, oppositions, or patent litigation against third parties, such asinfringement suits. These lawsuits could be expensive, take significant timeand divert management’s attention from other business concerns. The patentposition of information technology firms generally is highly uncertain,involves complex legal and factual questions, and has recently been the subjectof much litigation. No consistent policy has emerged from the U.S. Patent andTrademark Office or the courts regarding the breadth of claims allowed or thedegree of protection afforded under information technology patents.

 

**Our success will depend partly on ourability to operate without infringing on or misappropriating the proprietaryrights of others.**

 

Ourbusiness is such that we may at any time be sued for infringing the patentrights or misappropriating the proprietary rights of others. For example,during fiscal 2004 we settled a case alleging patent infringement. Intellectualproperty litigation is costly and, even if we prevail, the cost of suchlitigation could adversely affect our business, liquidity, results ofoperations and financial position. In addition, litigation is time consumingand diverts management attention and resources away from our business. If we donot prevail in any litigation, we could be required to stop the infringingactivity and/or pay substantial damages. Under some circumstances in the UnitedStates, these damages could be triple the actual damages the patent holderincurs. If we have supplied infringing products to third parties for marketingor licensed third parties to manufacture, use or market infringing products, wemay be obligated to indemnify these third parties for any damages they may berequired to pay to the patent holder and for any losses the third parties maysustain themselves as the result of lost sales or damages paid to the patentholder.

 

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Ifa third party holding rights under a patent successfully asserts aninfringement claim with respect to any of our products, we may be preventedfrom manufacturing or marketing our infringing product in the country orcountries covered by the patent we infringe, unless we can obtain a licensefrom the patent holder. Any required license may not be available to us onacceptable terms, or at all. Some licenses may be non-exclusive, and therefore,our competitors may have access to the same technology licensed to us. If wefail to obtain a required license or are unable to design around a patent, wemay be unable to market some of our products, which could have a materialadverse effect on our business, liquidity, results of operations and financialposition.

 

**We have made a number of acquisitions in the past,including our June 2008 acquisition of Snap Server, and we may makeacquisitions in the future. The failure to successfully integrate acquisitionsand successfully complete product development and launch of the relatedproducts could harm our business, financial condition and operating results.**

 

Wehave in the past and may in the future make acquisitions of complementarybusinesses, products or technologies as we implement our business strategy. Mergers andacquisitions involve numerous risks, including liabilities that we may assumefrom the acquired company, difficulties in completion of in-process productdevelopment and assimilation of the operations and personnel of the acquiredbusiness, the diversion of management’s attention from other business concerns,risks of entering markets in which we have no direct prior experience, and thepotential loss of key employees of the acquired business.

 

For example, in August 2005, we acquired ZettaSystems, whose data protection software was then incorporated into our ULTAMUSPro storage appliance that was launched in the first quarter of fiscal 2007.ULTAMUS Pro did not generate revenue subsequent to its launch, and wesubsequently discontinued the product and closed the related developmentfacility. We recognized an impairment loss of $8.4 million and a write-down of$350,000 in inventory in the first quarter of fiscal 2007 associated with thefailure of this acquisition.

 

Future mergers and acquisitions by us also mayresult in dilutive issuances of our equity securities and the incurrence ofdebt, amortization expense and potential impairment charges related tointangible assets. Any of these factors could adversely affect our business,liquidity, results of operations and financial position.

** **

**Ourwarranty reserves may not adequately cover our warranty obligations.**

 

We have established reserves for the estimatedliability associated with our product warranties. However, we could experienceunforeseen circumstances where these or future reserves may not adequatelycover our warranty obligations. For example, the failure or inadequate performanceof product components that we purchase could increase our warranty obligationsbeyond these reserves.

 

**The failure to attract,retain and motivate key personnel could have a significant adverse impact onour operations.**

 

We have experiencedsignificant changes in our senior management. In August 2007, our board ofdirectors appointed Vernon A. LoForti, who had served as our chief financialofficer since December 1995, as our new President and Chief ExecutiveOfficer. Kurt L. Kalbfleisch, who had served in our finance department since December 1994,was appointed as our vice president of finance in July 2007, and wasappointed by our board of directors to the additional position of Interim ChiefFinancial Officer in August 2007. Mr. Kalbfleisch assumed thepermanent role of Chief Financial Officer in February 2008. These changesmay be a distraction to other senior management, business operations,commercial partners and customers. Additionally, we have experienced aprolonged period of operating losses and declines in our stock price and cashposition which has affected and may continue to affect employee morale andretention. In April 2007, we reduced our workforce by 14% worldwide, andin August 2008, we further reduced our workforce by 13% worldwide. Furtherturnover, particularly among senior management, can also create distractions aswe search for replacement personnel, which could result in significantrecruiting, relocation, training and other costs, and can cause operationalinefficiencies as replacement personnel become familiar with our business andoperations. In addition, manpower in certain areas may be constrained, whichcould lead to disruptions over time. We cannot guarantee that we will continueto successfully attract or retain the management we need, or be able tomaintain an optimal workforce size. Any inability to attract, retain ormotivate such personnel or address manpower constraints as needed couldmaterially adversely affect our future operating results and financialposition. We do not currently maintain any key-man insurance for any of ouremployees.

 

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**We mayrequire a reverse stock split in order to satisfy the requirement that ourcommon stock maintain a minimum bid price of $1.00 in order to maintain listingon the NASDAQ Global Market.  If wecannot satisfy such requirement and other continued listing requirements, ourcommon stock may be delisted from the NASDAQ Global Market, and our stock pricecould be adversely affected and the liquidity of our stock and our ability toobtain financing could be impaired.**

 

On October 1, 2008, wereceived a NASDAQ Staff Determination letter notifying us that we were not incompliance with the requirement of NASDAQ Marketplace Rule 4450(a)(5) forcontinued inclusion on the NASDAQ Global Market as a result of the closing bidprice for our common stock being below $1.00 for 30 consecutive business days.This notification had no immediate effect on the listing of our common stock.

 

The NASDAQ Marketplace Rules provideus with 180 calendar days, or until March 30, 2009, to regain compliance,which will require a closing bid price for our common stock above $1.00 for aminimum of 10 consecutive business days. If we do not comply with Marketplace Rule 4450(a)(5) byMarch 30, 2009, we may be eligible to have the listing of our sharestransferred to the NASDAQ Capital Market, if on such date we meet the initiallisting requirements for the NASDAQ Capital Market, other than the minimum bidprice.  If we were eligible to anddetermined to transfer our listing to the NASDAQ Capital Market, we would havean additional period of 180 days to regain compliance with the minimum bidprice requirement for a period of at least 10 consecutive business days.  Alternatively, we could appeal a delistingdetermination to a NASDAQ Listing Qualifications Panel and thereby attempt toretain our listing on the NASDAQ Global Market.

 

We may also fail to meetother NASDAQ continued listing requirements in the future.

 

If the trading price ofour common stock does not increase to at least $1.00 per share, we plan to askour shareholders to approve a reverse stock split.  Our shareholders may not approve such areverse stock split.  If our shareholdersdo approve a reverse stock split and we elect to implement such a reverse stocksplit, we cannot predict with certainty what effect a reverse stock split willhave on the market price of our common stock, particularly over the longerterm.  Some investors may view a reversestock split negatively, which could result in a decrease in the marketcapitalization of our company.  If areverse stock split is implemented, some shareholders currently holding roundlots of one hundred shares may as a result own an odd lot of less than one hundredshares.  The sale of an odd lot mayresult in incrementally higher trading costs through certain brokers.

 

Any delisting of our common stock by NASDAQ could adversely affect ourability to attract new investors, may result in decreased liquidity of theoutstanding shares of common stock, and could reduce the price at which suchshares trade and increase the transaction costs inherent in trading such shareswith overall negative effects for our shareholders.  In addition, delisting of the common stock coulddeter broker-dealers from making a market in or otherwise seeking or generatinginterest in our common stock, and might deter certain institutions and personsfrom investing in our stock at all.

 

**Item 1B. Unresolved StaffComments.**

 

We have no unresolvedcomments from the SEC.

 

**Item 2. Properties.**

 

We own no real property and we currently lease allfacilities used in our business. Our headquarters are located in San Diego,California in a two-building light industrial complex comprising approximately 160,000square feet. The lease expires in February 2014 and can be renewed for oneadditional five-year period. This San Diego facility houses all of ourmanufacturing, research and development, and administrative functions, as wellas a major portion of sales, sales administration, marketing and customersupport.

 

As part of the Snap Server asset acquisition, we havesubleased approximately 28,000 square feet in Milpitas, California, fromAdaptec, Inc. The sublease expires in May 2010. The Milpitas facilityhouses research and development, sales and marketing.

 

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** **

**Welease a 17,000 square foot facility located in Wokingham, England, which housessales, technical support and repair services. The lease expires in January 2018.We also maintain small sales offices located close to Paris, France; Munich,Germany; China, Singapore and Korea. In August 2008, as part of ourrestructuring plan, we closed our China and Korea sales offices.**See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operation – Recent Developments.”

** **

**Item 3. Legal Proceedings.**

 

Weare from time to time involved in various lawsuits, legal proceedings or claimsthat arise in the ordinary course of business. We do not believe any such legalproceedings or claims will have, individually or in the aggregate, a materialadverse effect on our business, liquidity, results of operations and financialposition. However, litigation is subject to inherent uncertainties, and an adverseresult in these or other matters may arise from time to time that may harm ourbusiness.

 

**Item 4. Submission of Matters to a Vote of Security Holders.**

 

No matters were submitted to a vote of our securityholders during the fourth quarter of 2008.

 

**PART II**

 

**Item 5. Market for Registrant’s Common Equity, Related ShareholderMatters and Issuer Purchases of Equity Securities.**

 

Our common stock trades on The NASDAQ Global Marketunder the symbol “OVRL.” As of September 22, 2008, there wereapproximately 73 shareholders of record. We have not paid any cash dividends onour common stock and do not anticipate paying any cash dividends in theforeseeable future. The high and low sales prices of our common stock from July 3,2006 through June 29, 2008 were as follows:

 

| ** **        | ** ** | **Sales Prices** | ** ** |
|-------------------|------------|-----------------------|------------|
| ** **        | ** ** | **High**              | ** ** | **Low** | ** ** |
| Fiscal Year 2008: |       |                  |       |   |   |
| Fourth quarter    |       | $                     | 1.40       |   | $ | 0.93 |   |
| Third quarter     |       | 1.91                  |       | 1.02 |   |
| Second quarter    |       | 2.88                  |       | 1.41 |   |
| First quarter     |       | 2.63                  |       | 1.60 |   |
|              |       |                  |       |   |   |
| Fiscal Year 2007: |       |                  |       |   |   |
| Fourth quarter    |       | $                     | 4.20       |   | $ | 2.51 |   |
| Third quarter     |       | 4.78                  |       | 3.90 |   |
| Second quarter    |       | 7.01                  |       | 3.63 |   |
| First quarter     |       | 7.76                  |       | 6.10 |   |

 

Theabove quotations reflect inter-dealer prices, without retail markup, markdownor commission and may not necessarily represent actual transactions.

 

**Item 6. Selected Financial Data.**

 

Thefollowing selected financial data has been derived from our auditedconsolidated financial statements and related notes. This information should beread in conjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and with our consolidated financial statements andrelated notes appearing elsewhere in this report.

 

Theconsolidated statement of operations data for the years ended June 30,2008, 2007 and 2006, and the consolidated balance sheet data at June 30,2008 and 2007, are derived from our audited consolidated financial statementsappearing elsewhere in this report. The consolidated statement of operationsdata for the years ended June 30, 2005 and 2004, and the consolidated balancesheet data at June 30, 2006, 2005 and 2004, are derived from our auditedconsolidated financial statements that are not included in this report. Thehistorical results are not necessarily indicative of the results to be expectedin any future period.

 

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The following table summarizes selected financialdata (in thousands, except per share amounts):

 
| ** **                                         | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Consolidated Statement of Operations Data:**     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                        |       | $                    | 127,700    |   | $ | 160,443 |   | $ | 209,038 |   | $ | 235,687 |   | $ | 238,139 |   |
| Gross profit                                       |       | 28,056               |       | 24,343 |   | 46,446 |   | 60,917 |   | 64,654 |   |
| (Loss) income from operations                      |       | (30,458              | )          | (44,845 | ) | (25,931 | ) | 3,524 |   | 15,598 |   |
| (Loss) income before income taxes                  |       | (31,627              | )          | (43,836 | ) | (23,311 | ) | 5,068 |   | 16,199 |   |
| Net (loss) income                                  |       | (32,025              | )          | (44,111 | ) | (19,486 | ) | 4,578 |   | 10,625 |   |
| Net (loss) income per share (1):                   |       |                 |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                    | (2.51      | ) | $ | (3.45 | ) | $ | (1.42 | ) | $ | 0.33 |   | $ | 0.79 |   |
| Diluted                                            |       | $                    | (2.51      | ) | $ | (3.45 | ) | $ | (1.42 | ) | $ | 0.32 |   | $ | 0.74 |   |
|                                               |       |                 |       |   |   |   |   |   |   |   |   |
| **Consolidated Balance Sheet Data:**               | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents and short-term  investments |       | $                    | 9,651      |   | $ | 22,825 |   | $ | 62,512 |   | $ | 76,887 |   | $ | 69,657 |   |
| Working capital                                    |       | 12,585               |       | 39,566 |   | 76,381 |   | 110,363 |   | 103,244 |   |
| Total assets                                       |       | 62,590               |       | 88,053 |   | 144,769 |   | 164,554 |   | 144,851 |   |
| Note payable                                       |       | 1,432                |       | — |   | — |   | — |   | — |   |
| Shareholders’ equity                          |       | 18,183               |       | 49,110 |   | 95,438 |   | 121,494 |   | 113,514 |   |

 

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(1)          SeeNote 1 to our consolidated financial statements for an explanation of sharesused in computing net (loss) income per share.

 

**Item 7. Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

 

*This report contains certain statements of a forward-looking naturethat involve risks, uncertainties and assumptions that are difficult topredict. Words and expressions reflecting optimism, satisfaction ordisappointment with current prospects, as well as words such as “believe,” “hopes,”“intends,” “estimates,” “expects,” “projects,” “plans,” “anticipates” andvariations thereof, identify forward-looking statements, but their absence doesnot mean that a statement is not forward-looking. Such forward-lookingstatements are not guarantees of performance and our actual results coulddiffer materially from those contained in such statements. Factors that couldcause or contribute to such differences include the inherent and significantrisks of integrating a new acquisition, possible delays in new productintroductions and shipments; market acceptance of our new product offerings;the ability to maintain strong relationships with branded channel partners; thetiming and market acceptance of new product introductions by competitors;worldwide information technology spending levels; unexpected shortages of criticalcomponents; rescheduling or cancellation of customer orders; loss of a majorcustomer; general competition and price pressures in the marketplace; ourability to control costs and expenses; and general economic conditions. Theseforward-looking statements speak only as of the date of this report and weundertake no obligation to publicly update any forward-looking statements toreflect new information, events or circumstances after the date of this report.**You are cautioned thatsuch statements are only predictions and actual events or results may differmaterially. In evaluating such statements, you are urged to specificallyconsider various factors identified in this report, including the matters setforth below under the caption “Risk Factors,” in Part I, Item 1A of thisreport, any of which could cause actual results to differ materially from thoseindicated by such forward-looking statements.*

 

We are an innovativeprovider of smart, affordable data protection appliances that help small andmedium-sized businesses and distributed enterprises ensure theirbusiness-critical data is “constantly protected, readily available and alwaysthere.”  Our portfolio of data protectionappliances includes the following:

 

·                  the Snap Server® networked and desktop storage appliances;

·                  the ULTAMUSTM RAID family of nearline data protectionappliances;

·                  the REO SERIES® of disk-based backup and recovery appliances;and

·                  the NEO SERIES® and ARCvault family of tape backup and archiveappliances.

 

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Ourproducts span all three tiers of data storage (nearline data protectionappliances, disk-based backup and recovery and tape automation) and enable usto offer our customers an end-to-end data protection solution. End-users of ourproducts include mid-range businesses, as well as distributed enterprisecustomers represented by divisions and operating units of large multi-nationalcorporations, governmental organizations, universities and other non-profitinstitutions operating in a broad range of industry sectors. See the “Business”section in Part I, Item 1 of this report for more information about ourbusiness, products and operations.

 

**Overview**

 

Thisoverview discusses matters on which our management primarily focuses inevaluating our financial position and operating performance.

 

*Generationof revenue*. We generate the vast majority of our revenue fromsales of our data protection appliances. The balance of our revenue is providedby selling spare parts, selling maintenance contracts and rendering relatedservices and earning royalties on our licensed technology. Historically, themajority of our sales have been generated through private label arrangementswith original equipment manufacturers (OEMs), and the remainder have been madethrough commercial distributors, direct market resellers (DMRs) and value addedresellers (VARs) in our branded channel. However, our strategy moving forwardis to focus heavily on the delivery of new and expanded products to our brandedchannel, which historically has produced higher gross margins in comparison toOEM business.

 

*Decliningsales to HP.*In August 2005, our largest OEM customer,Hewlett Packard Company (HP), notified us that it had selected an alternatesupplier for its next-generation mid-range tape automation products. HP beganpurchasing the first product of this new line from the alternate supplierduring the first quarter of calendar year 2006. Although we believe thatsales to HP will continue to decline, HP has recently relaunched the tapeautomation products supplied by us with support for HP’s new LTO-4 tape drives,which may slow the rate of replacement of our supplied products by thealternate supplier’s product. Revenue from HP in fiscal 2008 decreased 39.0%compared to fiscal 2007, and decreased 29.3% from fiscal 2007 to fiscal 2006.

 

*Impairmentof long-lived assets.* In the fourth quarter of fiscal 2008,we recorded an impairment charge of $7.4 million related to property andequipment. As discussed in Note 2 to the consolidated financial statements,management performed an impairment analysis of its long-lived assets, excludingthe long-lived assets from the recently completed Snap Server acquisition (see Note3 to the consolidated financial statements), as of June 30, 2008, due tothe our continued operating and cash flow losses in 2008 and our forecasts for2009 and beyond.  We concluded that thecarrying amount of the primary asset group was not recoverable and animpairment loss should be recognized.

 

*Recentsetbacks.* During fiscal 2008, we experienced lower thananticipated revenue for a number of reasons including:

 

·                  During the firstthree quarters of fiscal 2008, we were focused on re-building our sales team.This process took longer than anticipated and as a result had a negative impacton sales. As noted below, although sales and marketing expenses were lower thanprior year, this was at the detriment of branded channel revenue.

 

·                  We experienced adelay in the launch of our REO® 9500D product, which was not released until November 2007.

 

*Previoussetbacks.*During fiscal 2007, we experienced significantsetbacks related to the outsourcing of our manufacturing to Sanmina-SCI Corporation (Sanmina), oursupply contract with Dell Computer (Dell), and the commercialization of thetechnology we acquired from Zetta Systems, Inc. (Zetta):

 

·                  In September 2004, we announced a plan tooutsource all of our manufacturing to Sanmina, a U.S. third party manufacturer.We completed this transfer in August 2005. During fiscal 2006, however, we failed toachieve the customer service levels, product quality and cost reductions weexpected from the outsourcing. Additionally, we incurred a significant amountof redundant costs to support the outsourcing, which eroded our gross marginsduring the year. Consequently, we decided to bring manufacturing back to ourSan Diego facility and entered into a transition agreement with Sanminaeffective September 2006. In February 2007, we completed the transferof all production lines back to San Diego; and in the first quarter of fiscal2008, we completed the purchase of the remaining inventory under the transitionagreement.

 

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·                  In October 2005,we announced that we would supply Dell with our next generation tape librarythat was under development (ARCvault). We spent considerable resources duringthe ensuing year to complete the development of this tape library and to meetDell’s specifications and other requirements. In October 2006, we werenotified by Dell of its intent to terminate the supply agreement. Shipments ofthe tape libraries had not yet commenced at that date but were expected tobegin shortly.

 

·                  In August 2006,after a year of development, we launched our ULTAMUS Pro product whichincorporated the technology we acquired from Zetta. We had planned tofacilitate our entry into the primary protected disk market with ULTAMUS Pro,but this product failed to achieve market acceptance. In October 2006, wediscontinued our research and development efforts on the Zetta technology, andrecorded an impairment charge of $8.4 million in the first quarter of fiscal2007.

 

Related in large part to the overall decline in HPrevenue, we reported net revenue of $127.7 million for fiscal 2008, comparedwith $160.4 million for fiscal 2007. The decline in net revenue resulted in anet loss of $32.0 million, or $2.51 per share, for fiscal 2008 compared to a net loss of$44.1 million, or $3.45 per share, for fiscal 2007.

 

*Positive trends.*Despite thedisappointing financial results in recent quarters, we have achieved a numberof financial and operational objectives, some of which we believe will assistus in our efforts to regain profitability:

 

·                  Operatingexpenses continued to decrease compared to fiscal 2007 and fiscal 2006 due tothe completion of a number of material-intensive development projects and continued strictexpense control efforts. Operating expenses for the years ended June 30,2008, 2007 and 2006 were $58.5 million (including a $1.3 million charge forsoftware code which we expect to incorporate into a new product currently underdevelopment and a $7.4 million impairment charge on long-lived assets), $69.2million and $72.4 million, respectively.

 

·                  Generaland administrative (G&A) expense has continued to decrease throughcontinued strict expense control efforts. G&A expense totaled $10.1million, $13.4 million and $14.6 million for fiscal 2008, fiscal 2007 andfiscal 2006, respectively.

 

·                  Researchand development (R&D) expense, including the $1.3 million charge (in thesecond quarter of fiscal 2008) for software code which we expect to incorporateinto a new product currently under development, decreased to $9.3 million from$15.0 million in fiscal 2007 and $18.8 million in fiscal 2006. The decrease inR&D expense is primarily attributed to completion of labor intensiveprojects during late fiscal 2007 and early fiscal 2008.

 

·                  Sales andmarketing expenses decreased to $31.6 million from $32.4 million in fiscal 2007and $37.9 million is fiscal 2006. The decrease is primarily attributed to areduced sales force as we rebuilt our sales force through our third quarter offiscal 2008.

 

·                  During fiscal2008, we increased inventory turns while decreasing inventory levels. Wecontinue to target reducing inventory levels and push toward higher inventoryturns.

 

·                  Having completedthe transfer of manufacturing back to our headquarters in San Diego in February 2007,our product lead times have been reduced to target levels and we believe thatwe have regained our reputation for timely delivery of quality products. Wealso have resolved the backlog issues that arose during the outsourced period.

 

·                  In fiscal 2008,we launched three new products: the REO 4500c, in late September 2007; theREO 9100c, in October 2007; and the REO 9500D, in November 2007. Wehave additional REO products scheduled for launch through fiscal 2009. Weexpect these new REO products to contribute to an improvement in branded salesin future periods.

 

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·                  In June 2008,we acquired the Snap Server NAS business from Adaptec, Inc., including thebrand and all assets related to the Snap Server networked and desktop storageappliances. The purchase price, excluding transaction costs, was $3.6 million,with approximately $2.2 million paid in cash upon the closing of thetransaction, the remainder to be paid in 12 months. The Snap Server productline broadens our capabilities by adding distributed NAS while alsostrengthening central and remote office data protection. We believe theacquisition will enable us to address the $1.4 billion SMB NAS market, whichaccording to IDC continues to grow by at least 15% annually.

 

*Liquidityand capital resources.* Historically, our primary source ofliquidity has been cash generated from operations. However, in fiscal 2008, weincurred a net loss of $32.0 million and the balance of cash, cash equivalentsand short-term investments declined by $13.1 million (approximately $1.9million of which relates to an impairment of our auction rate securities andapproximately $3.1 million of which relates to the reclassification of ourauction rate securities to other assets) compared to the balance at June 30,2007. At June 30, 2008, we had $9.7 million of cash, cash equivalents andshort-term investments, compared to $22.8 million at June 30, 2007. Wehave no unused source of liquidity at this time. Cash management andpreservation will continue to be a top priority. However, we expect to incurnegative operating cash flows during the remainder of calendar 2008 as weintroduce and market our new products, including our Snap Server appliances.

 

We are currently exploring funding alternatives to enable us tocontinue our operations and execute our strategy. Possible funding alternativeswe are exploring include bank or asset based financing, equity or equity-basedfinancing, including convertible debt, and factoring arrangements.  We arein discussions with funding sources for each of these options, but we currentlyhave no funding commitments.  Management projects that our current cashand investments on hand will be sufficient to allow us to continue ouroperations at current levels only into November 2008. If we are unable toobtain additional funding, we will be forced to liquidate certain assets wherepossible, and/or to suspend or curtail certain of our planned operations. Anyof these actions could harm our business, results of operations and futureprospects.  We anticipate we will need to raise approximately $10.0million of cash and cash equivalents to fund our operations through fiscal 2009at planned levels.

 

As a result of our need for additional financing and other factors, thereport from our independent registered public accounting firm regarding ourconsolidated financial statements for the year ended June 30, 2008includes an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern.

 

Our plans to raise working capital are first to pursue bank and assetbased financing options; however, we may not be able to obtain such financingon favorable terms, or at all. If we are unable to obtain such financing, ourplans are to pursue an equity or equity-based financing, including convertibledebt, which also may not be available on terms favorable to us or at all.  If we raise additional funds by sellingadditional shares of our capital stock, the ownership interest of ourshareholders will be diluted.  The amountof dilution could be increased by the issuance of warrants or securities withother dilutive characteristics, such as anti-dilution clauses or price resets.

 

As noted above, as of June 30,2008, our other assets included $3.1 million of auction rate securities, whichsecurities have a par value of $5.0 million. The auctions for these securitieshave failed since July 2007, which limits our ability to liquidate thesesecurities and recover their carrying value in the near term.  We may nonetheless attempt to liquidate thesesecurities to meet cash needs. We cannot predict whether we will be able toliquidate these securities, and we expect that any liquidation in the near termwill bring less than the value of these securities as of June 30, 2008,based upon subsequent indicative bids. For example, indicative bids (i.e., onemeasure of the estimated liquidation value) from Deutsche Bank subsequent toyear-end for our ARS instruments have ranged from a high of approximately $2.8million at July 16, 2008, to a low of approximately $1.4 million at October 1,2008, the most recent bid as of the date of this report.

 

*Industry trends.*Historically,magnetic tape has been used for all forms of data backup and recovery, becausemagnetic tape was, and still is, the only cost-effective, “removable,” highcapacity storage media that can be taken off-site to ensure that data issafeguarded in case of disaster. For a number of years now, we have held amarket-leading position in mid-range tape automation with our flagship NEOproducts, and sales of tape automation appliances have represented more than63.0% of our revenue for each of the last three fiscal years. In fiscal 2007,we launched ARCvault, our new tape automation platform. Revenue from ARCvaultproducts represented 9.6% and 7.1% of total net revenue for fiscal 2008 andfiscal 2007, respectively. Although we expect that tape solutions will continueto be the anchor of the data protection strategy at most companies, tape backupis time consuming and often unreliable and inefficient. The process ofrecovering data from tape is also time consuming and inefficient. Ultimately,we expect that tape will be relegated to an archival role for less-frequentlyaccessed data, and that companies will focus more on disk-based solutionsmoving forward.

 

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**Recent Developments**

 

·                  In April 2008,we announced the appointment of Ravi Pendekanti as our Vice President ofWorldwide Marketing, a position that had been vacant since October 2007.In August 2008, Mr. Pendekanti’s role was expanded to include VicePresident of Worldwide Sales.

 

·                  In August 2008,we reduced our employee workforce by 13% worldwide, or by 53 employees, inaccordance with our initiatives to reduce costs and restructure our workforce.Severance costs, including COBRA, related to the terminated employees areestimated to be $340,000 and will be recorded and paid in our first and secondquarters of fiscal 2009.

 

 **CriticalAccounting Policies and Estimates**

 

Our discussion and analysis of our financial positionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of consolidatedfinancial statements requires that we make estimates and judgments that affectthe reported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent liabilities. On an on-going basis, we evaluate ourestimates, including, but not limited to, those related to revenue recognition,available-for-sale securities, share-based compensation, bad debts,inventories, intangible and other long-lived assets, warranty obligations,income taxes and restructuring charges. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

We believe the following accounting policies affect ourmore significant judgments and estimates used in the preparation of ourconsolidated financial statements.

 

###### ***RevenueRecognition***

######  

Revenuefrom sales of products is recognized when persuasive evidence of an arrangementexists, the price is fixed or determinable, collectibility is reasonablyassured and delivery has occurred. Under this policy, revenue on direct productsales (excluding sales to distributors and certain OEM customers) is recognizedupon shipment of products to our customers. These customers are not entitled toany specific right of return or price protection, except for any defectiveproduct that may be returned under our warranty policy. Title and risk of losstransfer to the customer when the product leaves our dock. Product sales todistribution customers are subject to certain rights of return, stock rotationprivileges and price protection. Because we are unable to estimate our exposurefor returned product or price adjustments, revenue from shipments to thesecustomers is not recognized until the related products are in turn sold to theultimate customer by the distributor. As part of our existing agreements withcertain OEM customers, we ship products to various distribution hubs around theworld and retain ownership of that inventory until it is pulled by these OEMcustomers to fulfill their customer orders, at which time revenue isrecognized. For products in which software is more than incidental, werecognize revenue in accordance with Statement of Position (SOP) No. 97-2,*Software Revenue Recognition*.

 

When there are multiple elements in an arrangement, we allocate revenueto the separate elements based on relative fair value, provided we have fairvalue for all elements of the arrangement. If in an arrangement we have fairvalue for undelivered elements but not the delivered element, we defer the fairvalue of the undelivered element(s) and the residual revenue is allocatedto the delivered element(s). Undelivered elements typically include services.Revenue from extended warranty and product service contracts is initiallydeferred and recognized as revenue ratably over the contract period.

 

Wehave various royalty arrangements with independent service providers that sellour product and also sell and provide service on our product. These independentservice providers pay a royalty fee for service contracts in place, on ourproduct. The royalty fee is calculated by us for the units covered in thequarter, and agreed to by the service provider, based upon the monthly fee foreach unit covered by the independent service provider. In addition, we receiveroyalties from HP, for licensing of our Protection OS software. Revenue isrecognized based upon quarterly reporting from HP related to the number ofunits sold.

 

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Wehave various licensing agreements relating to our Variable Rate Randomizer (VR2®) technology with third parties. As consideration for licensing our VR2 technology, the licensees pay us a royalty fee for sales of theirproducts that incorporate our VR2 technology.On a periodic basis, the licensees provide us with reports that include thequantity of units, subject to royalty, sold to their end users. We record theroyalty when reported to us by the licensee, generally in the period duringwhich the licensee ships the products containing VR2 technology.In certain instances, the customer has elected to purchase from us theApplications Specific Integrated Circuit (ASIC) chips embodying VR2, which are priced to include the cost of the chip plus an embedded royaltyfee; and revenue on ASIC chip sales is recorded as product revenue when earned,which under our FOB origin terms is upon shipment, of the underlying ASIC chipincorporating the VR2 technology to the customer.

 

***Available-for-SaleSecurities***

 

Available-for-salesecurities are recorded at fair value, and temporary unrealized holding gainsand losses are recorded, net of tax, as a separate component of shareholders’equity. Unrealized losses are charged against net earnings when a decline infair value is determined to be other-than-temporary. In accordance withEmerging Issues Task Force Issue No. 03-1 and FSP FAS 115-1 and124-1, *The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments,*we reviewseveral factors to determine whether a loss is other-than-temporary. Thesefactors include but are not limited to (i) the length of time a securityis in an unrealized loss position, (ii) the extent to which fair value isless than cost, (iii) the financial condition and near term prospects ofthe issuer and, (iv) our intent and ability to hold the security for aperiod of time sufficient to allow for any anticipated recovery in fair value.Realized gains and losses are accounted for on the specific identificationmethod.

 

We hold two auction ratesecurities (ARS) which are collateralized by corporate debt obligations. Theseauction rate securities are intended to provide liquidity via an auctionprocess that resets the applicable interest rate at predetermined intervals,usually every 30 days. Since July 2007, our auction rate securitieshave experienced failed auctions and are considered to have experienced another-than-temporary decline in fair value. An auction failure means that theparties wishing to sell their securities could not do so. Subsequent to fiscalyear end 2008, the two ARS instruments held by us were downgraded by FitchRatings from AAA to A+ and A, respectively.

 

Significantjudgment is required in determining the fair value of investments when noquoted prices exist. As allowed by Statement of Financial Standards (SFAS) No. 115,we elected to estimate the fair value of the auction rate securities using adiscounted cash flow analysis. Taking into consideration the security terms theassumptions used by us included estimates of (i) when a successful auctionwould occur or the securities would be redeemed, (ii) a discount ratecommensurate with the implied risk associated with holding the securities,including consideration of the recent ratings downgrades, and (iii) futureexpected cash flow streams. If the auctions continue to fail, or we determinethat one or more of the assumptions used in the estimate needs to be revised,we may be required to record an additional impairment on these securities inthe future.

 

Asnoted above, as of June 30, 2008, our other assets included $3.1 millionof auction rate securities, which securities have a par value of $5.0 million.The auctions for these securities have failed since July 2007, whichlimits our ability to liquidate these securities and recover their carryingvalue in the near term.  Our estimate ofthe fair value of the auction rate securities is based on the probabilityweighted expected future cash flows associated with the investments asindicated. We may nonetheless attempt to liquidate these securities to meetcash needs. We cannot predict whether we will be able to liquidate thesesecurities, and we expect that any liquidation in the near term will bring lessthan the value of these securities, as of June 30, 2008, based uponsubsequent indicative bids. For example, indicative bids (i.e., one measure ofthe estimated liquidation value) from Deutsche Bank subsequent to year-end forour ARS have ranged from a high of approximately $2.8 million at July 16,2008 to a low of approximately $1.4 million at October 1, 2008, the mostrecent bid as of the date of this report. We do not believe this currentestimate of the liquidation value represents the estimated fair value of theinstruments as of the end our fiscal year. The indicative bids are not based onactive markets or orderly transactions between market participants. However, itis possible that we may be required to record additional impairments to theseinvestments in future periods.

 

25

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###### ***Share-BasedCompensation***

######  

Share-based compensation expense can be significant toour results of operations, even though no cash is used for such expense. Indetermining period expense associated with unvested options, we estimate the fairvalue of each option at the date of grant. We use the Black-Scholes optionpricing model to determine the fair value of the award. This model requires theinput of highly subjective assumptions, including the expected volatility ofour stock and the expected term the average employee will hold the option priorto the date of exercise. In addition, we estimate pre-vesting forfeitures forshare-based awards that are not expected to vest. We primarily use historicaldata to determine the inputs and assumptions to be used in the Black-Scholespricing model. Changes in these inputs and assumptions could occur and couldmaterially affect the measure of estimated fair value and make it difficult tocompare the results in future periods to our current results.

 

A 10% change in our share-based compensation for theyear ended June 30, 2008, would have affected net losses by approximately$0.1 million in fiscal 2008.

 

###### ***Allowancefor Doubtful Accounts***

######  

We estimate our allowance for doubtful accounts based onan assessment of the collectibility of specific accounts and the overallcondition of the accounts receivable portfolio. When evaluating the adequacy ofthe allowance for doubtful accounts, we analyze specific trade and otherreceivables, historical bad debts, customer credits, customer concentrations,customer credit-worthiness, current economic trends and changes in customers’payment terms and/or patterns. If the financial condition of our customers wereto deteriorate, resulting in an impairment of their ability to make additionalpayments, then we may need to make additional allowances. Likewise, if wedetermine that we could realize more of our receivables in the future thanpreviously estimated, we would adjust the allowance to increase income in theperiod we made this determination. We review the allowance for doubtfulaccounts on a quarterly basis and record adjustments as considered necessary.Generally, our allowance for doubtful accounts is based on specificidentification of amounts outstanding greater than 90 days from invoice date.If we fail to identify an account as doubtful, or if we identify an account asuncollectible that is later collected, our results could vary.

 

###### ***InventoryValuation***

######  

We record inventories at the lower of cost or market. Weassess the value of our inventories periodically based upon numerous factorsincluding expected product or material demand, current market conditions,technological obsolescence, current cost and net realizable value. Ifnecessary, we adjust our inventory for obsolete or unmarketable inventory equalto the difference between the cost of the inventory and the estimated marketvalue. If actual market conditions are less favorable than what we projected,we may need to record additional inventory adjustments and adverse purchasecommitments.

 

###### ***BusinessAcquisitions and Intangible Assets***

######  

Ourbusiness acquisitions typically result in recognition of intangible assets(acquired technology), which affect the amount of current and future periodcharges and amortization expenses, and in certain cases non-recurring chargesassociated with in-process research and development (IPR&D). We amortizeour definite-lived intangible assets using the straight-line method over theirestimated useful lives, while IPR&D is recorded as a non-recurring chargeon the acquisition date.

 

Thedetermination of the value of these components of a business combination, aswell as associated asset useful lives, requires management to make variousestimates and assumptions. Critical estimates in valuing intangible assets mayinclude but are not limited to: future expected cash flows from product salesand services, maintenance agreements, and acquired development technologies andpatents or trademarks; expected costs to develop the IPR&D into commerciallyviable products and estimated cash flows from projects when completed; theacquired company’s brand awareness and market position, as well as assumptionsabout the period of time the acquired products and services will continue to beused in our product portfolio; and discount rates. Management’s estimates offair value and useful lives are based upon assumptions believed to bereasonable, but which are inherently uncertain and unpredictable. Unanticipatedevents and circumstances may occur and assumptions may change. Estimates usingdifferent assumptions could also produce significantly different results.

 

###### ***Impairmentof Long-Lived Assets***

######  

Wetest for recoverability of long-livedassets whenever events or changes in circumstances indicate the carrying valuemay not be recoverable. When the carrying value is not considered recoverable,an impairment loss, for the amount by which the carrying value of a long-livedasset exceeds its fair value, is recognized with an offsetting reduction in thecarrying value of the related asset(s). In such circumstances, we may incurmaterial charges relating to the impairment of such asset. 

 

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Fair value is generally determined based onthe estimated future discounted cash flows over the remaining useful life ofthe asset or asset group using a discount rate determined by management to becommensurate with the risk inherent in our current business model. During thefourth quarter of fiscal 2008, we recorded a $7.4 million impairment related toour property and equipment. See “Fiscal 2008 Compared to Fiscal 2007 -Impairment of Long-Lived Assets” under the discussion of “Results of Operations”below. The estimated fair value of these assets was determined using the incomeapproach which is based on a discounted cash flow analysis, as well asconsideration of the estimated value that could be realized upon sale. Theassumptions used by us included estimates of (i) projected cash flows fora period approximating the remaining estimated useful life of the asset group, (ii) adiscount rate commensurate with the implied risk in an investment in us and therisk of the underlying cash flows and (iii) an estimate of enterprisevalue.

 

Duringthe first quarter of fiscal 2007, we recorded an $8.4 million impairment chargerelated to acquired technology. See “Fiscal 2007 Compared to Fiscal 2006 -Impairment of Long-Lived Assets” under the discussion of “Results of Operations”below. If our future results aresignificantly different than forecasted, we may be required to further evaluateits long-lived assets for recoverability and such analysis could result in animpairment charge in a future period.

 

The assumptions supporting the cash flows, includingthe discount rates, are determined using management’s best estimates as of thedate of the impairment review. If these estimates or their related assumptionschange in the future, we may be required to record impairment charges for theseassets and future results of operations could be adversely affected.

 

###### ***Warranty Obligations***

######  

The Company provides for estimated future costs of warranty obligations in accordance with Financial Accounting StandardsBoard (FASB) Statement No. 5, *Accounting forContingencies,* and discloses those obligations as required by FASBInterpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*.

 

Forreturn-to-factory and on-site warranties, we accrue for warranty costs at thetime revenue is recognized based on contractual rights and on the historicalrate of claims and costs to provide warranty services. If we experience anincrease in warranty claims above historical experience or our costs to providewarranty services increase, we may be required to increase our warrantyaccrual. The impact of theses unforeseen increases may have an adverse impacton our gross margins in subsequent periods. Similarly, if we experience adecrease in warranty claims or our costs to provide services decline, we may berequired to decrease our warranty accrual which may have a favorable impact onour gross margins in subsequent periods.

 

Inaddition, if we experience a decline in our historical warranty claims, due tolower return rates or repair costs, the impact on gross margin would befavorable.

 

###### ***Income Tax Provision and Uncertain Tax Positions***

######  

The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes generally represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when a judgment is made that it is considered more likely than not that a tax benefit will not be realized. A decision to record a valuation allowance results in an increase in income tax expense or a decrease in income tax benefit (as we had in fiscal 2006). If the valuation allowance is released in a future period, income tax expense will be reduced accordingly.

 

Significant judgment is required in determining ourconsolidated income tax provision and evaluating our U.S. and foreign tax positions.In July 2006, the FASB issued Interpretation 48,*Accounting for Uncertainty in Income Taxes* (FIN No. 48),which became effective for us beginning July 2, 2007. FIN No. 48addressed the determination of how tax benefits claimed or expected to be claimedon a tax return should be recorded in the financial statements. Under FIN No. 48,we must recognize the tax benefit from an uncertain tax position only if it ismore likely than not that the tax position will be sustained on examination bythe taxing authorities, based on the technical merits of the position. The taxbenefits recognized in the financial statements from such a position aremeasured based on the largest benefit that has a greater than 50% likelihood ofbeing realized upon ultimate resolution (audit). The impact of our reassessmentof tax positions in accordance with FIN No. 48 did not have a materialimpact on our results of operations, financial position or liquidity. If we areunable to uphold our position upon audit, it may impact our liquidity, resultsof operations or financial position.

 

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Thecalculation of tax liabilities involves dealing with uncertainties in theapplication of complex global tax regulations. We recognize liabilities foranticipated tax audit issues in the U.S. and other tax jurisdictions based on (1) theguidance in FIN No. 48 and (2) our estimates of whether, and theextent to which, additional taxes will be due. If payment of these amountsultimately proves to be unnecessary, the reversal of the liabilities wouldresult in tax benefits being recognized in the period when we determine theliabilities are no longer necessary. If the estimate of tax liabilities provesto be less than the ultimate assessment, a further charge to expense wouldresult.

 

***Restructuring Charges***

 

InAugust 2008 and over the past several years, we recorded restructuringcharges related to the realignment and restructuring of our businessoperations. These charges represent expenses incurred in connection withcertain cost reduction programs and acquisition integrations that we haveimplemented and consist of the cost of involuntary termination benefits,separation benefits and facilities charges.

 

Thecharges for severance and exit costs require the use of estimates, primarilyrelated to the amount of severance and related benefits to be paid and the costof exiting facilities.

 

Weaccount for restructuring charges in accordance with Statement of FinancialAccounting Standards (SFAS) No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*. SFAS No. 146requires that a liability for a cost associated with an exit or disposalactivity be recognized when the liability is incurred rather than at the dateof an entity’s commitment to an exit plan. SFAS No. 146 establishes fairvalue as the objective for initial measurement of the liability. Restructuringcharges we have incurred under SFAS No. 146 in recent years includeseverance and facilities charges.

 

**Results of Operations**

 

The following tables set forth certain financialdata as a percentage of net revenue:

 

| ** **                                | ** ** | **Fiscal Year** | ** ** |
|-------------------------------------------|------------|----------------------|------------|
| ** **                                | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                               |       | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of revenue                           |       | 78.0                 |       | 84.8 |   | 77.8 |   |
| Gross profit                              |       | 22.0                 |       | 15.2 |   | 22.2 |   |
| Operating expenses:                       |       |                 |       |   |   |   |   |
| Sales and marketing                       |       | 24.8                 |       | 20.2 |   | 18.1 |   |
| Research and development                  |       | 7.3                  |       | 9.4 |   | 9.0 |   |
| General and administrative                |       | 7.9                  |       | 8.4 |   | 7.0 |   |
| Impairment of long-lived assets           |       | 5.8                  |       | 5.2 |   | — |   |
| In-process research and development       |       | —               |       | — |   | 0.5 |   |
|                                      |       | 45.8                 |       | 43.2 |   | 34.6 |   |
| Loss from operations                      |       | (23.8                | )          | (28.0 | ) | (12.4 | ) |
| Other (expense) income, net               |       | (0.9                 | )          | 0.7 |   | 1.2 |   |
| Loss before income taxes                  |       | (24.7                | )          | (27.3 | ) | (11.2 | ) |
| Provision for (benefit from) income taxes |       | 0.4                  |       | 0.2 |   | (1.9 | ) |
| Net loss                                  |       | (25.1                | )%         | (27.5 | )% | (9.3 | )% |

 

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A summary of the sales mix by product follows:

 

| ** **              | ** ** | **Fiscal Year** | ** ** |
|-------------------------|------------|----------------------|------------|
| ** **              | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Tape based products:    |       |                 |       |   |   |   |   |
| NEO Series              |       | 53.5                 | %          | 66.2 | % | 68.8 | % |
| ARCvault family         |       | 9.6                  |       | 7.1 |   | — |   |
| Other (1)               |       | —               |       | 1.2 |   | 7.4 |   |
|                    |       | 63.1                 |       | 74.5 |   | 76.2 |   |
| Service                 |       | 16.2                 |       | 10.3 |   | 5.1 |   |
| Spare parts and other   |       | 10.7                 |       | 8.0 |   | 10.8 |   |
| Disk based products (2) |       | 9.4                  |       | 6.4 |   | 6.5 |   |
| VR2                     |       | 0.6                  |       | 0.8 |   | 1.4 |   |
|                    |       | 100.0%               |       | 100.0 | % | 100.0 | % |

 

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| (1) Fiscal 2006  includes revenue associated with our PowerLoader® and LoaderXpress® products discontinued in fiscal 2007. |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                |
| (2) Includes REO  SERIES and ULTAMUS RAID family products.                                                                                     |

 

**Fiscal 2008 Compared to Fiscal 2007**

 

***Net Revenue****.*Net revenue decreased to $127.7 millionduring fiscal 2008 from $160.4 million during fiscal 2007, a decrease ofapproximately $32.7 million, or 20.4%. The decline was primarily the result ofanticipated lower OEM revenue, specifically from HP, reflecting the previouslyannounced transition by HP to an alternate supplier. In our branded channel,the decrease in net revenue was attributable to decreased volumes across allchannels.

 

*Product Revenue*

 

Netproduct revenue decreased to $106.0 million during fiscal 2008 from $142.4million during fiscal 2007, a decrease of $36.4 million, or 25.6%.

 

Netproduct revenue from OEM customers decreased to $46.5 million during fiscal2008 from $77.3 million during fiscal 2007. The decrease of $30.8 million, or39.8%, is primarily associated with declining sales to HP. Net revenue from HPrepresented approximately 35.2% of total net revenue during fiscal 2008compared to 45.8% of total net revenue during fiscal 2007.

 

Netproduct revenue from Overland branded products, excluding service revenue,decreased to $59.8 million during fiscal 2008 from $65.3 million during fiscal2007. The decrease of approximately $5.5 million, or 8.4%, was primarilyassociated with (i) a decrease of $6.5 million from NEO products and (ii) adecrease of $1.8 million due to the discontinuation of our Power Loader andLoaderXpress products. These decreases were offset by an increase in revenuefrom ARCvault products of $0.9 million and ULTAMUS products of $2.3 million.The sales of our ULTAMUS products have not yet achieved expected sales volumes.

 

*Service Revenue*

 

Netservice revenue increased to $20.6 million during fiscal 2008 from $16.5million during fiscal 2007. The increase of $4.1 million, or 24.8%, isassociated with (i) a $3.6 million increase associated with an increase inthe number of service contracts sold due to increased focus in this area and (ii) a$0.5 million increase in of out-of warranty services provided, primarily to HP.

 

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*Royalty Fees*

 

Netroyalty fees decreased to $1.1 million during fiscal 2008 from $1.5 millionduring fiscal 2007. The decrease of approximately $0.4 million, or 26.7%, isprimarily associated with lower VR(2) royalties, partially offset by otherroyalty fees. VR(2) royalties during fiscal 2008 totaled approximately $0.8million compared to $1.4 million during fiscal 2007.

 

***Gross Profit****.*****Overall gross profit increased to $28.1 millionduring fiscal 2008 from $24.3 million during fiscal 2007, an increase of approximately$3.8 million, or 15.6%.

 

*Product Revenue*

 

Productgross profit increased to $17.7 million, or 16.7%, for fiscal 2008 compared to$16.4 million, or 11.5%, for fiscal 2007. The increase in product gross profitis associated primarily with (i) a $0.7 million decrease in amortizationexpense because of the fiscal 2007 impairment of the Zetta acquired technologyand (ii) decreases in the amount of additional inventory reserves requiredin fiscal 2008 compared to fiscal 2007.

 

*Service Revenue*

 

Servicegross profit of $9.2 million for fiscal 2008 increased from $6.4 million forfiscal 2007. The increase in service gross profit of $2.8 million, or 43.8%, isprimarily associated with an increase in warranty contracts recognized infiscal 2008 compared to fiscal 2007, as noted above.

 

***Stock-Based Compensation***. During fiscal 2008, we had share-basedcompensation expense of $1.0 million compared to a net reversal, or benefit, of$75,000 of share-based compensation in fiscal 2007. The increase of approximately$1.1 million is primarily due to a one time grant of approximately 1.5 millionshare options in August 2007 to executive officers and key employees as aretention tool.  These options vestmonthly for one year and are expected to result in increased share-basedcompensation expense through the first quarter of fiscal 2009.

 

Share-basedcompensation was allocated as follows (in thousands):

 
| ** **                 | ** ** | **Fiscal Year** | ** ** |
|----------------------------|------------|----------------------|------------|
| ** **                 | ** ** | **2008**             | ** ** | **2007** | ** ** | **Change** | ** ** |
|                       |       |                 |       |   |   |   |   |
| Cost of product revenue    |       | $                    | 134        |   | $ | 6 |   | $ | 128 |   |
| Sales and marketing        |       | 353                  |       | (251 | ) | 604 |   |
| Research and development   |       | 148                  |       | (99 | ) | 247 |   |
| General and administrative |       | 413                  |       | 269 |   | 144 |   |
|                       |       | $                    | 1,048      |   | $ | (75 | ) | $ | 1,123 |   |

 

***Sales and Marketing Expense****.*Sales and marketing expense was $31.6 millionduring fiscal 2008, compared to $32.4 million during fiscal 2007. The decreaseof approximately $0.8 million, or 2.5%, is primarily due to (i) a decreaseof approximately $0.9 million in employee and related expenses (includingtravel and sales commissions) related to a decrease in average headcount duringthe first three quarters of fiscal 2008 by 12 employees in connection with ourfiscal 2007 restructurings and the realignment of our sales force (as of yearend the average headcount was comparable to the prior year), (ii) a $1.0million reduction in severance primarily associated with the fiscal 2007restructurings, and (iii) a $0.3 million reduction in new product salesdevelopment expense due to decreased product launch activities in the currentyear. These decreases were offset by (i) an increase of $0.6 million inshare-based compensation expense associated with options granted in August 2007(compared to a net reversal of share-based compensation expense in the secondquarter of fiscal 2007 which was associated with awards canceled prior tovesting in excess of previous estimates), (ii) an increase of $0.6 millionin promotion and advertising expense due to the launch of new products, and (iii) anincrease of $0.4 million in trade show expense.

 

***Research and Development Expense****.*Research and development (R&D) expensewas $9.3 million during fiscal 2008, compared to $15.0 million during fiscal2007. The decrease of approximately $5.7 million, or 38.0%, is primarily due to(i) a decrease of approximately $3.8 million in employee and relatedexpenses (from a decrease in average headcount by 20 employees) related to ourfiscal 2007 restructurings, (ii) a $0.3 million reduction in severanceprimarily associated with the fiscal 2007 restructurings, and (iii) adecrease of $3.0 million in material-intensive product development expenses dueto the completion of scheduled R&D projects. These decreases were offset by(i) a $1.3 million charge for software code that we expect to incorporateinto a new product that is currently under development, and (ii) anincrease of $0.2 million in share-based compensation expense associated withoptions granted in August 2007 (compared to a net reversal of share-basedcompensation expense in fiscal 2007).

 

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***General and Administrative Expense****.*General and administrative expense was $10.1million during fiscal 2008, compared to $13.4 million during fiscal2007. The decrease of approximately $3.3 million, or 24.6%, is primarilydue to (i) a decrease of $1.4 million in employee and related expenses(from a decrease in average headcount by nine employees) related to our fiscal2007 restructurings, (ii) a decrease of $0.9 million in audit, tax andconsulting fees related to the material weakness we reported at the end offiscal 2006, (iii) a decrease of approximately $0.6 million in severanceexpense, which expense was higher in fiscal 2007 due to the termination of ourformer president and chief executive officer, (iv) a decrease of $0.2million in bad debt expense, and (v) a decrease of $0.1 million in legalfees which were higher in fiscal 2007 due to the termination of our formerpresident and chief executive officer and the termination of our agreement withour third party manufacturer. These reductions were offset by an increase of$0.1 million in share-based compensation expense associated with optionsgranted in August 2007.

 

***Impairment of Long-Lived Assets****.* In the fourth quarter of fiscal 2008, werecorded an impairment charge of $7.4 million related to property andequipment. As discussed in Note 2 to the consolidated financial statements,management performed an impairment analysis of its long-lived assets, excludingthe long-lived assets from the recently completed Snap Server acquisition (see Note3 to the consolidated financial statements), as of June 30, 2008, due tothe our continued operating and cash flow losses in 2008 and our forecasts for2009 and beyond.  We concluded that thecarrying amount of this asset group was not recoverable and an impairment lossof $7.4 million was recognized as of June 30, 2008. In the first quarter offiscal 2007, we recorded an impairment charge of $8.4 million related to thetechnology acquired from Zetta Systems, Inc. (Zetta) in August 2005.As discussed in Note 2 to the consolidated financial statements, managementperformed an impairment analysis of the technology acquired from Zetta, inaccordance with SFAS No. 144, and concluded that the asset was notrecoverable and that an impairment loss should be recognized as of September 30,2006. The full amount of the remaining Zetta intangible asset balance as of September 30,2006, or $8.4 million, was recorded as an impairment of acquired technology inthe first quarter of fiscal 2007.

 

***Interest Income, net****.*During fiscal 2008, we generated net interestincome of $0.8 million compared to $1.7 million during the same period of theprior fiscal year. The decrease of approximately $0.9 million or 52.9% is dueto lower cash and investment balances when compared to the same period infiscal 2007, and lower interest rates earned on such balances.

 

***Other Expense, net.***During fiscal 2008, we incurred otherexpense, net, of $2.0 million compared to $0.7 million during fiscal 2007. Theincrease of approximately $1.3 million in other expense, net, is primarilyassociated with a $1.7 million increase in realized losses on investmentsrelated to impairment charges under FSP FAS 115-1 and 124-1. The increase wasoffset by a reduction of approximately $0.3 million in realized currency exchangelosses incurred in fiscal 2008 compared to fiscal 2007.

 

***Provision for Income Taxes.*** We recorded income tax expense of $0.4million during fiscal 2008 compared to $0.3 million during fiscal 2007. Theincrease of approximately $0.1 million is primarily due to higher earnings inthe foreign subsidiaries.

 

**Fiscal2007 Compared to Fiscal 2006**

 

***Net Revenue****.*Net revenue decreased to $160.4 millionduring fiscal 2007 from $209.0 million during fiscal 2006, a decrease ofapproximately $48.6 million, or 23.2%. The decline was primarily the result oflower sales to HP, but decreases in net revenue in our branded sales channelwere also consistent throughout all of the regions (Americas, EMEA and APAC),partially offset by an increase in service revenue.

 

*Product Revenue*

 

Netproduct revenue decreased to $142.4 million during fiscal 2007 from $196.5million during fiscal 2006, a decrease of $54.1 million, or 27.5%.

 

Netproduct revenue from OEM customers decreased to $77.3 million during fiscal2007 from $112.0 million during fiscal 2006. The decrease of $34.7 million, or31.0%, is primarily associated with declining sales to HP. Net revenue from HPrepresented approximately 45.8% of total net revenue during fiscal 2007compared to 49.7% of total net revenue during fiscal 2006.

 

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Netproduct revenue from Overland branded products, excluding service revenue,decreased to $65.3 million during fiscal 2007 from $83.4 million during fiscal2006. The decrease of approximately $18.1 million, or 21.7%, was primarilyassociated with (i) a $13.1 million decrease in revenue due to thediscontinuation of our PowerLoader and LoaderXpress products, (ii) a $12.1million decrease in our NEO product sales and (iii) a $3.9 million decreasein our REO product sales, primarily due to a limited supply of RoHS-compliantproduct which affected sales in Europe. These decreases were partially offsetby $11.4 million of net product revenue generated from sales of our ARCvaultproduct which we introduced in early fiscal 2007.

 

*Service Revenue*

 

Netservice revenue increased to $16.5 million during fiscal 2007 from $10.7million during fiscal 2006. The increase of $5.8 million or 54.2% is associatedwith (i) a $2.9 million increase associated with an increase in the numberof service contracts sold due to increased focus in this area and (ii) a$3.0 million increase in of out-of warranty services provided, primarily to HP.

 

*Royalty Fees*

 

Netroyalty fees decreased to $1.5 million during fiscal 2007 from $1.8 millionduring fiscal 2006. The decrease of approximately $0.3 million or 16.7% isprimarily associated with lower VR(2) royalties occurring in fiscal 2007,partially offset by other royalty fees. VR(2) royalties during fiscal 2007totaled approximately $1.4 million compared to $1.8 million during fiscal 2006.

 

***Gross Profit****.*****Overall gross profit decreased to $24.3 millionduring fiscal 2007 from $46.4 million during fiscal 2006, a decrease ofapproximately $22.1 million, or 47.6%.

 

*Product Revenue*

 

Productgross profit decreased to $16.4 million, or 11.5%, for fiscal 2007 compared to$40.2 million, or 20.5%, for fiscal 2006. The increase in product gross profitis associated primarily with (i) significant under absorption ofmanufacturing costs arising from the transition of manufacturing back to SanDiego and (ii) a $2.6 million increase in reserves taken for obsoleteinventory. These increases were slightly offset by a $2.0 million decrease inamortization expense because of the impairment of the Zetta acquiredtechnology. In addition, product gross profit was affected by decreased salesacross all channels, especially OEM.

 

*Service Revenue*

 

Servicegross profit for fiscal 2007 of $6.4 million increased from $4.4 million forfiscal 2006. The increase in service gross profit of $2.0 million, or 46.0%, isprimarily associated with an increase in service revenue in fiscal 2007 fromfiscal 2006, as noted above and related increases in outside repair costs.

 

***Stock-Based Compensation***. During fiscal 2007, we had a net reversal,or benefit, of $75,000 compared to $2.0 million of share-based compensationcharges in fiscal 2006. The net reversal in fiscal 2007 resulted fromsignificant pre-vesting forfeitures (in excess of amounts previously estimated)related to the forfeiture of options and restricted shares previously grantedto two executives and individuals terminated as part of the October 2006and April 2007 restructurings. The pre-vesting forfeitures resulted in thereversal of previously recognized share-based compensation expense and suchreversal exceeded the amount of expense recorded for other awards during fiscal2007.

 

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Share-basedcompensation was allocated as follows (in thousands):

 
| ** **                 | ** ** | **Fiscal Year** | ** ** |
|----------------------------|------------|----------------------|------------|
| ** **                 | ** ** | **2007**             | ** ** | **2006** | ** ** | **Change** | ** ** |
|                       |       |                 |       |   |   |   |   |
| Cost of product revenue    |       | $                    | 6          |   | $ | 13 |   | $ | (7 | ) |
| Sales and marketing        |       | (251                 | )          | 621 |   | (872 | ) |
| Research and development   |       | (99                  | )          | 206 |   | (305 | ) |
| General and administrative |       | 269                  |       | 1,170 |   | (901 | ) |
|                       |       | $                    | (75        | ) | $ | 2,010 |   | $ | (2,085 | ) |

 

***Sales and Marketing Expense****.*Sales and marketing expense was $32.4 millionduring fiscal 2007, compared to $37.9 million during fiscal 2006. The decreaseof approximately $5.5 million, or 14.5%, is primarily due to (i) adecrease of approximately $4.4 million in employee and related expenses(including travel and sales commissions) associated with a decrease in averageheadcount by 26 employees associated with our fiscal 2007 restructurings andrealignment of our sales force, (ii) a $872,000 reduction in share-basedcompensation expense associated with a reversal of awards that canceled priorto vesting and a reduction of related expense under FIN No. 28 associatedwith our accelerated amortization methodology, (iii) a $667,000 decreasein contractor fees related to cost reduction initiatives and (iv) a$523,000 reduction in public relations expenses related to reduced promotionalspending. These reductions were partially offset by an increase of $1.1 millionin severance associated with our fiscal 2007 restructurings and other severancerecorded in the first quarter of fiscal 2007.

 

***Research and Development Expense****.*Research and development (R&D) expensewas $15.0 million during fiscal 2007, compared to $18.8 million during fiscal2006. The decrease of approximately $3.8 million, or 20.2%, is primarily due to(i) a $3.0 million decrease in employee and related expenses associatedwith a decrease in average headcount by 27 employees primarily associated withthe closing of the office near Seattle, Washington, the April 2007reduction in workforce and completion of scheduled R&D projects, (ii) anet decrease of $508,000 in development materials and tooling and demonstrationitems as a result of fewer continuing R&D projects, and (iii) adecrease of $305,000 of share-based compensation expense associated with areversal of awards that canceled prior to vesting and a reduction of relatedexpense under FIN No. 28 associated with our accelerated amortizationmethodology. These cost savings were partially offset by a $290,000 increase inseverance primarily associated with our fiscal 2007 restructurings.

 

***General and Administrative Expense****.*General and administrative expense was $13.4million during fiscal 2007, compared to $14.6 million during fiscal2006. The decrease of approximately $1.2 million, or 8.2%, is primarilydue to (i) a $901,000 reduction in share-based compensation expenseassociated with a reversal of awards that canceled prior to vesting and areduction of related expense under FIN No. 28 associated with ouraccelerated amortization methodology, and (ii) a $761,000 net reduction inlegal fees. Our legal fees in fiscal 2006 were higher as a result of theaccumulation of our shares by a competitor and related issues. These expensereductions were offset by (i) increased severance expenses ofapproximately $449,000 primarily related to the termination of our formerpresident and chief executive officer, and (ii) a $198,000 increase in baddebt expense.

 

***Impairment of Long-Lived Assets****.* In the first quarter of fiscal 2007, werecorded an impairment charge of $8.4 million related to the technologyacquired from Zetta Systems, Inc. (Zetta) in August 2005. Asdiscussed in Note 2 to the consolidated financial statements, managementperformed an impairment analysis of the technology acquired from Zetta, inaccordance with SFAS No. 144, and concluded that the asset was notrecoverable and that an impairment loss should be recognized as of September 30,2006. The full amount of the remaining intangible asset balance as of September 30,2006, or $8.4 million, was recorded as an impairment of acquired technology inthe first quarter of fiscal 2007.

 

***In-Process Research and Development***.****During fiscal2006, a portion of the fair value of the assets acquired from Zetta was assignedto in-process research and development. We had no similar transactions infiscal 2007.

 

***Interest Income, net****.*During fiscal 2007, we generated net interestincome of $1.7 million compared to $2.8 million during the same period of theprior fiscal year. The decrease of approximately $1.1 million or 39.3% is dueto lower cash and investment balances when compared to the same period infiscal 2006.

 

33

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***Other Income (Expense), net.***During fiscal 2007, we incurred net otherexpense of $698,000 compared to $139,000 during fiscal 2006. The increase inother net expense is primarily associated with (i) an increase of $262,000in realized losses on foreign currency transactions due to a weakening of thedollar compared to the euro and the British pound, and (ii) an increase inrealized losses on our short-term investments to $264,000 in fiscal 2007 from$23,000 in fiscal 2006. Fiscal 2007 includes a $157,000 impairment charge underFSP FAS 115-1 and 124-1, with no comparable charge in fiscal 2006.

 

***Provision for (Benefit from) Income Taxes.*** We recorded income tax expense of $275,000during fiscal 2007 compared to an income tax benefit of $3.8 million duringfiscal 2006. The change of approximately $4.1 million is primarily due to taxbenefit recorded in fiscal 2006 for losses that were carried back to prioryears’ tax returns for refund claims. Fiscal 2007 tax expense is primarily dueto tax expense related to earnings in our foreign operations.

 

**Liquidityand Capital Resources**

 

At June 30, 2008, we had $9.7 million of cash,cash equivalents and short-term investments, compared to $22.8 million at June 30, 2007. We have nounused source of liquidity at this time.

 

Historically, our primary source of liquidity hasbeen cash generated from operations. However, we have incurred net losses forover the last three fiscal years and negative cash flows for our last twofiscal years. As of or for the year ended June 30, 2008, we had anaccumulated deficit of $50.9 million, incurred a net loss of $32.0 million andthe balance of cash, cash equivalents and short-term investments declined by$13.1 million (approximately$1.9 million of which relates to an impairment of our auction rate securitiesand $3.1 million of which relates to the reclassification of our auction ratesecurities as other assets) compared to thebalance at June 30, 2007.  Weoperate in a highly competitive market characterized by rapidly changingtechnology. During fiscal 2009, we expect to continue to incur losses as weintroduce and market our new products.

 

We are currentlyexploring funding alternatives to enable us to continue our operations andexecute our strategy. Possible funding alternatives we are exploring includebank or asset based financing, equity or equity-based financing, includingconvertible debt, and factoring arrangements.  We are in discussions withfunding sources for each of these options, but we currently have no fundingcommitments.  Management projects that our current cash and investments onhand will be sufficient to allow us to continue our operations at currentlevels only into November 2008. If we are unable to obtain additionalfunding, we will be forced to liquidate certain assets where possible, and/orto suspend or curtail certain of our planned operations. Any of these actionscould harm our business, results of operations and future prospects.  Weanticipate we will need to raise approximately $10.0 million of cash and cashequivalents to fund our operations through fiscal 2009 at planned levels.

 

As a result of our need for additional financing and other factors, thereport from our independent registered public accounting firm regarding ourconsolidated financial statements for the year ended June 30, 2008includes an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern.

 

Our plans to raise working capital are first to pursue bank and assetbased financing options; however, we may not be able to obtain such financingon favorable terms, or at all. If we are unable to obtain such financing, ourplans are to pursue an equity or equity-based financing, including convertibledebt, which also may not be available on terms favorable to us or at all.  If we raise additional funds by sellingadditional shares of our capital stock, the ownership interest of ourshareholders will be diluted.  The amountof dilution could be increased by the issuance of warrants or securities withother dilutive characteristics, such as anti-dilution clauses or price resets.If we are unable to obtain debt or equity financing in amounts sufficient tofund our operations in fiscal 2009 fully, we expect we will be forced tosuspend or curtail certain of our operations, which could harm our business,results of operations, and future prospects.

 

As of June 30, 2008, our other assets included$3.1 million of auction rate securities, which securities have a par value of$5.0 million. The auctions for these securities have failed since July 2007,which limits our ability to liquidate these securities and recover theircarrying value in the near term.  We maynonetheless attempt to liquidate these securities to meet cash needs. We cannotpredict whether we will be able to liquidate these securities, and we expectthat any liquidation in the near term will bring less than the value of thesesecurities, as of June 30, 2008, based upon subsequent indicative bids.For example, indicative bids (i.e., one measure of the estimated liquidationvalue) from Deutsche Bank subsequent to year-end for our ARS have ranged from ahigh of approximately $2.8 million at July 16, 2008 to a low ofapproximately $1.4 million at October 1, 2008, the most recent bid as ofthe date of this report.

 

34

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During fiscal 2008, we used cashin operating activities of approximately $5.2 million compared to $34.2 millionin fiscal 2007 and cash provided from operating activities of $7.3 million infiscal 2006. The change fromfiscal 2007 to 2008 of $29.0 million is primarily attributed to our decreasednet loss and decreases in our accounts receivable balance compared to fiscal2007. From fiscal 2006 to 2007, there was a change of $41.5 million in cashused in operating activities. This change was primarily attributable to ourincreased net loss, offset by a non-cash impairment of acquired technology of$8.4 million.

 

Duringfiscal 2008, we used cash in investing activities of $4.0 million compared tocash provided by investing activities in fiscal 2007 and 2006 of $33.7 millionand $16.0 million, respectively. During fiscal 2008, we used $2.5 million toacquire Snap Server. During fiscal 2007 and 2006 we liquidated some of ourinvestments to support our operations. In fiscal 2006, we used $8.9 million toacquire Zetta with no other similar acquisitions in fiscal 2007. During fiscal2008, 2007 and 2006, capital expenditures totaled $0.6 million, $3.2 millionand $4.0 million, respectively. During fiscal 2008, such expenditures wereprimarily associated with tooling to support new product development. Duringfiscal 2007, such expenditures were primarily associated with computers,machinery and equipment to support new product development and transitioningmanufacturing in-house. During fiscal 2006, capital expenditures were comprisedprimarily of software and tooling equipment.

 

Duringfiscal 2008, we had minimal cash activity in our financing activities comparedto cash used in our financing activities of $2.6 million and $8.5 millionduring fiscal 2007 and 2006, respectively. During fiscal 2007 and 2006, we usedcash of $2.7 million and $10.8 million, respectively, to repurchase 373,000shares and 1.3 million shares of our common stock. These uses of cash wereoffset by proceeds from the issuance of common stock under our 1996 ESPP and2006 ESPP and upon exercise of stock options for proceeds of $142,000 and $2.3million in fiscal 2007 and 2006, respectively. Proceeds from the issuance ofcommon stock under our 1996 ESPP and 2006 ESPP and upon exercise of stock optionshave decreased due to the decrease in our stock price since fiscal 2005 and thediscount used in determining the purchase price under our ESPP.

 

InOctober 2005, our board of directors expanded our share repurchase programto allow for the purchase of up to 2.5 million shares of our common stock onthe open market or through negotiated transactions. In October 2006, ourboard of directors terminated our share repurchase program and there were noshare repurchases after the first quarter of fiscal 2007. During fiscal 2007and fiscal 2006, an aggregate of approximately 373,000 shares and 1.3 millionshares were repurchased at a cost of approximately $2.7 million and $10.8million, respectively.

 

**Off-Balance Sheet Arrangements**

 

We have no off-balance sheet arrangements orsignificant guarantees to third parties that are not fully recorded in ourconsolidated balance sheets or fully disclosed in the notes to our consolidatedfinancial statements.

 

**Contractual Obligations**

 

The followingschedule summarizes our contractual obligations to make future payments atJune 30, 2008 (in thousands)**:**

 
| **Contractual Obligations**  | ** ** | **Total**  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **After 5  years** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **              | ** ** |
| Operating lease obligations (1)   |       | $          | 22,713     |                            | $          | 4,211              |       | $                  | 7,518      |                    | $          | 7,252 |   | $ | 3,732 |   |
| Purchase obligations (2)          |       | 9,773      |       | 9,629                           |       | 144                |       |               |       |                    |       |
| Total contractual obligations (3) |       | $          | 32,486     |                            | $          | 13,840             |       | $                  | 7,662      |                    | $          | 7,252 |   | $ | 3,732 |   |

 

----

| (1)    | Represents contractual lease obligations under  non-cancellable operating leases on our San Diego, CA; Milpitas, CA;  Wokingham, England; Paris, France; China and Singapore facilities                                                                                                                                                                                                                                                                        |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| (2)    | Represents purchase orders for inventory and  non-inventory items entered into prior to June 30, 2008, with purchase  dates extending beyond July 1, 2008. The obligations are not necessarily  non-cancellable.                                                                                                                                                                                                                                     |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| (3)    | Liabilities associated with uncertain tax  provisions, currently estimated at $363,000 (including interest), are not  included in the table above as we cannot reasonably estimate when, if ever,  an amount would be paid to a government agency. Ultimate settlement of these  liabilities is dependent on factors outside of our control, such as  examinations by each agency and expiration of statues of limitation for  assessment of additional taxes. |

 

35

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**Inflation**

 

Inflationhas not had a significant impact on our operations during the periodspresented. Historically we have been able to pass on to our customers increasesin raw material prices caused by inflation. If at any time we cannot pass onsuch increases, our margins could suffer. Our exposure to the effects ofinflation could be magnified by the concentration of OEM business, where ourmargins tend to be lower.

 

**RecentlyIssued Accounting Pronouncements**

 

SeeNote 1 to our consolidated financial statements.

 

**Item7A. Quantitative and Qualitative Disclosures about Market Risk.**

 

Market risk represents the risk of loss that mayimpact our financial position, results of operations or cash flows due toadverse changes in financial and commodity market prices and rates. We areexposed to market risk in the areas of changes in U.S. interest rates andchanges in foreign currency exchange rates as measured against the U.S. dollar.These exposures are directly related to our normal operating and fundingactivities. Historically, we have not used derivative instruments or engaged inhedging activities.

 

***Interest Rate Risk.***Allof our fixed income investments are classified as available-for-sale andtherefore reported on the balance sheet at market value. Changes in the overalllevel of interest rates affect our interest income that is generated from ourinvestments. In the fourth quarter of fiscal 2008, the auction rate securities’(ARS) estimated fair value of $3.1 million was reclassified to other assets inthe accompanying consolidated balance sheets. Thesesecurities, although not mortgage-backed, have experienced failed auctionsprimarily as a result of the impact sub prime mortgages have had on liquidityin the credit markets.

 

ARS instruments – Forfiscal 2008, interest income was $0.2 million with ARS investments yielding anannual average of 4.8% on a worldwide basis. The interest rate level was downapproximately 50 basis points from 5.3% in fiscal 2007. Assuming consistentinvestment levels, if interest rates were to fluctuate (increase or decrease)by 10% or 48 basis points, we would expect a corresponding fluctuation in ourinterest income of approximately $23,000 during fiscal 2009.

 

Cash equivalents and short-term investments — Forfiscal 2008, total interest income was $0.6 million with investments yieldingan annual average of 4.2% on a worldwide basis. The interest rate level wasdown approximately 70 basis points from 4.9% in fiscal 2007. Assumingconsistent investment levels, if interest rates were to fluctuate (increase ordecrease) by 10% or 42 basis points, we would expect a correspondingfluctuation in our interest income of approximately $60,000 during fiscal 2009.

 

The table below presents the cash, cash equivalentsand short-term investment balances and related weighted-average interest ratesat the end of fiscal 2008. The cash, cash equivalents and short-term investmentbalances approximate fair value (inthousands):

 
| ** **                | ** ** | **Approximate  Market Value** | ** ** | **Weighted-Average  Interest Rate** | ** ** |
|---------------------------|------------|------------------------------------|------------|------------------------------------------|------------|
|                      |       |                               |       |                                     |       |
| Cash and cash equivalents |       | $                                  | 8,437      |                                     | 2.7        | % |
| Short-term investments:   |       |                               |       |                                     |       |
| Less than 1 year          |       | —                             |       | —                                   |       |
| Due in 1 – 2 years   |       | 258                                |       | 4.0                                      | %          |
| Due in 2 – 5 years   |       | —                             |       | —                                   |       |
| Due after 5 years         |       | 956                                |       | 3.4                                      | %          |
|                      |       | $                                  | 9,651      |                                     | 3.0        | % |

 

The table above includes the U.S. dollar equivalent ofcash and cash equivalents, including $150,000 and $432,000 equivalentsdenominated in the British pound and the euro, respectively.

 

36

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***Foreign Currency Risk.***Weconduct business on a global basis and essentially all of our products sold ininternational markets are denominated in U.S. dollars. Historically, exportsales have represented a significant portion of our sales and are expected tocontinue to represent a significant portion of sales.

 

Our wholly-owned subsidiaries in the United Kingdom,France and Germany incur costs which are denominated in local currencies. Asexchange rates vary, these results when translated into U.S. dollars may varyfrom expectations and adversely impact overall expected results. The effect ofexchange rate fluctuations on our results during fiscal 2008 was not material.

 

**Item 8.Financial Statements and Supplementary Data.**

 

Ourconsolidated financial statements and supplementary data required by this itemare set forth at the pages indicated in Item 15(a)(1) and 15(a)(2),respectively.

 

**Item 9.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure.**

 

Notapplicable.

 

**Item9A. Controls and Procedures.**

 

**Not applicable.**

 

**Item9A(T). Controls and Procedures.**

 

**DisclosureControls and Procedures**

** **

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rules 13a-15(e)  and 15d-15(e) under the Exchange Act.Based on this evaluation, our principal executive officer and our principalfinancial officer concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this annual report.

 

**Internal ControlOver Financial Reporting**

** **

*Management’sReport on Internal Control Over Financial Reporting*

 

Management is responsiblefor establishing and maintaining adequate internal control over our financialreporting. In order to evaluate the effectiveness of internal control overfinancial reporting, as required by Section 404 of the Sarbanes-Oxley Act,management has conducted an assessment, including testing, using the criteriain Internal Control — Integrated Framework, issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO). Our system ofinternal control over financial reporting is designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.

 

Based on our evaluationunder the framework in Internal Control — Integrated Framework, our ChiefExecutive Officer and Chief Financial Officer concluded that our internalcontrol over financial reporting was effective as of June 29, 2008.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. In addition, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions and that the degree ofcompliance with the policies or procedures may deteriorate.

 

This annual report does notinclude an attestation report of our independent registered public accountingfirm regarding internal control over financial reporting. Our internal controlover financial reporting was not subject to attestation by our independentregistered public accounting firm pursuant to temporary rules of the SECthat permit us to provide only management’s report in this annual report.

 

37

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This report on internalcontrol over financial reporting shall not be deemed to be filed for purposesof Section 18 of the Exchange Act, or otherwise subject to the liabilitiesof that section, and is not incorporated by reference into any filing of ourcompany, whether made before or after the date hereof, regardless of anygeneral incorporation language in such filing.

 

**Changes in Internal Control overFinancial Reporting**

 

Therewere no changes in our internal control over financial reporting during thefiscal quarter ended June 29, 2008 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Item9B. Other Information.**

 

Notapplicable.

 

**PART III**

 

**Item10. Directors, Executive Officers and Corporate Governance.**

 

Theinformation required by this item is included under the captions entitled “Electionof Directors,” “Executive Officers,” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our proxy statement to be filed for our 2008Annual Meeting of Shareholders and is incorporated herein by reference.

 

Wehave adopted the Overland Storage, Inc. Code of Business Conduct andEthics, a Code that applies to our directors, officers and employees. A copy ofthe Code of Business Conduct and Ethics is publicly available on our website atwww.overlandstorage.com. If we make any substantive amendments to the Code ofBusiness Conduct and Ethics or grant any waiver from a provision of the codeapplying to our principal executive officer or our principal financial oraccounting officer, we will disclose the nature of such amendment or waiver onour website or in a report on Form 8-K.

 

**Item11. Executive Compensation.**

 

Theinformation required by this item will be contained in our proxy statement tobe filed for our 2008 Annual Meeting of Shareholders and is incorporated hereinby reference.

 

**Item12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters.**

 

The information required by this item will becontained in our proxy statement to be filed for our 2008 Annual Meeting ofShareholders and is incorporated herein by reference.

 

**Item13. Certain Relationships and Related Transactions, and Director Independence.**

 

Theinformation required by this item will be contained in our proxy statement tobe filed for our 2008 Annual Meeting of Shareholders and is incorporated hereinby reference.

 

**Item14. Principal Accounting Fees and Services.**

 

Theinformation required by this item will be contained in our proxy statement tobe filed for our 2008 Annual Meeting of Shareholders and is incorporated hereinby reference.

 

38

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**PART IV**

 

**Item15. Exhibits, Financial Statement Schedules.**

 

(a)(1) **Financial Statements**.The following consolidated financial statements of Overland Storage, Inc.and report of independent registered public accounting firm are included in aseparate section of this report at the page numbers so indicated:

 

Report ofIndependent Registered Public Accounting Firm

ConsolidatedBalance Sheets as of June 30, 2008 and 2007

ConsolidatedStatement of Operations for the Years Ended June 30, 2008, 2007 and 2006

ConsolidatedStatement of Shareholders’ Equity and Comprehensive Loss for Years Ended June 30,2008, 2007 and 2006

ConsolidatedStatement of Cash Flows for the Years Ended June 30, 2008, 2007 and 2006

Notes toConsolidated Financial Statements

 

(a)(2) **Financial Statement Schedules.**

 

Schedulesnot listed above have been omitted because they are not applicable or are notrequired or the information required to be set forth therein is included in theconsolidated financial statements or notes thereto.

 

(a)(3) **Exhibits**

 
| 2.1    |   | Asset Purchase Agreement dated June 27, 2008  between Overland and Adaptec, Inc. (incorporated by reference to the  Company’s Form 8-K filed July 3, 2008). ++                                                      |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                         |
| 3.1    |   | Amended and Restated Articles of Incorporation (incorporated  by reference to the Company’s Form 10-K filed September 27, 2002).                                                                                              |
|   |   |                                                                                                                                                                                                                                         |
| 3.2    |   | Certificate of Amendment of Articles of  Incorporation (incorporated  by reference to the Company’s Form 10-Q filed February 10,  2006).                                                                                      |
|   |   |                                                                                                                                                                                                                                         |
| 3.3    |   | Amended and Restated Bylaws (incorporated by  reference to the Company’s Form 8-K filed August 26, 2005).                                                                                                                     |
|   |   |                                                                                                                                                                                                                                         |
| 3.4    |   | Certificate of Amendment of Bylaws (incorporated by  reference to the Company’s Form 8-K filed April 30, 2007).                                                                                                               |
|   |   |                                                                                                                                                                                                                                         |
| 4.1    |   | Specimen stock certificate (incorporated by reference  to the Company’s Form 10-K filed September 27, 2002).                                                                                                                  |
|   |   |                                                                                                                                                                                                                                         |
| 4.2    |   | Shareholder Rights Agreement dated August 22,  2005 between Overland and Wells Fargo Bank, N.A., as Transfer Agent  (incorporated by reference to the Company’s Form 8-K filed  August 26, 2005).                        |
|   |   |                                                                                                                                                                                                                                         |
| 10.1   |   | San Diego Headquarters Facility Lease dated  October 12, 2000 between Overland and LBA-VIF One, LLC (incorporated by  reference to the Company’s Form 10-Q filed February 14, 2001).                                     |
|   |   |                                                                                                                                                                                                                                         |
| 10.2   |   | First Amendment to Lease dated January 18, 2001  between Overland and LBA Overland, LLC, as successor-in-interest to LBA-VIF  One, LLC (incorporated by reference to the Company’s Form 10-K filed  September 28, 2001). |
|   |   |                                                                                                                                                                                                                                         |
| 10.3   |   | Second Amendment to Lease dated March 8, 2001  between Overland and LBA Overland, LLC (incorporated by reference to the  Company’s Form 10-K filed September 28, 2001).                                                  |
|   |   |                                                                                                                                                                                                                                         |
| 10.4   |   | Product Purchase Agreement No. 1585-042103  dated July 31, 2003 between Overland and Hewlett Packard Company  (incorporated by reference to the Company’s Form 10-Q filed  February 10, 2004). +               |

 

39

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| 10.5   |   | Addendum to Product Purchase Agreement No. 1585-042103 effective  July 30, 2006 between Overland and Hewlett Packard Company (incorporated  by reference to the Company’s Form 10-K filed September 15, 2006).                        |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                           |
| 10.6   |   | Addendum to Product Purchase Agreement between  Overland and Hewlett-Packard Company dated December 15, 2007  (incorporated by reference to the Company’s Form 10-Q filed May 1,  2008). +                                                 |
|   |   |                                                                                                                                                                                                                                                           |
| 10.7   |   | Manufacturing Services Agreement between Overland  Storage, Inc. and Sanmina-SCI Corporation effective as of  November 23, 2004 (incorporated  by reference to the Company’s Form 10-Q filed February 11, 2005).  +                   |
|   |   |                                                                                                                                                                                                                                                           |
| 10.8   |   | Amendment No. 1 to Manufacturing  Services Agreement between Overland Storage, Inc. and Sanmina-SCI  Corporation effective as of May 30, 2005 (incorporated by reference to the Company’s  Form 10K filed September 15, 2005). + |
|   |   |                                                                                                                                                                                                                                                           |
| 10.9   |   | Transition Amendment dated September 29, 2006  between Overland Storage, Inc. and Sanmina-SCI Corporation (incorporated  by reference to the Company’s Form 10-Q filed November 8, 2006). +                                           |
|   |   |                                                                                                                                                                                                                                                           |
| 10.10  |   | Second Transition Amendment between Overland and  Sanmina-SCI Corporation dated June 29, 2007 (incorporated by reference  to the Company’s Form 10-Q filed May 1, 2008).+                                                                  |
|   |   |                                                                                                                                                                                                                                                           |
| 10.11* |   | Form of Indemnification Agreement entered into  between Overland and each of its directors and officers (incorporated by  reference to the Company’s Form 10-Q filed February 13, 2002).                                                   |
|   |   |                                                                                                                                                                                                                                                           |
| 10.12* |   | Form of Amended and Restated Retention  Agreement dated September 27, 2007 between Overland and Michael  Gawarecki, Kurt Kalbfleisch and Robert Scroop (incorporated by reference to the Company’s  Form 8-K filed October 1, 2007).  |
|   |   |                                                                                                                                                                                                                                                           |
| 10.13* |   | Amended and Restated Retention Agreement dated  September 27, 2007 between Overland and Vernon A. LoForti (incorporated by reference to the Company’s  Form 8-K filed October 1, 2007).                                                    |
|   |   |                                                                                                                                                                                                                                                           |
| 10.14* |   | Amended and Restated Retention Agreement between  Overland and Robert Farkaly dated September 27, 2007 (incorporated by  reference to the Company’s Form 10-Q filed November 2, 2007).                                                     |
|   |   |                                                                                                                                                                                                                                                           |
| 10.15* |   | Retention Agreement entered into between Overland  and Ravi Pendakanti dated April 4, 2008.                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                           |
| 10.16* |   | Employment letter between Overland and Robert  Farkaly dated April 20, 2007 (incorporated by reference to the Company’s  Form 10-Q filed November 2, 2007).                                                                                |
|   |   |                                                                                                                                                                                                                                                           |
| 10.17* |   | Employment letter between Overland and Kurt L.  Kalbfleisch dated July 23, 2007 (incorporated by reference to the  Company’s Form 10-Q filed November 2, 2007).                                                                            |
|   |   |                                                                                                                                                                                                                                                           |
| 10.18* |   | Employment letter between Overland and Ravi  Pendekanti dated April 4, 2008 (incorporated by reference to the  Company’s Form 10-Q filed May 1, 2008).                                                                                     |
|   |   |                                                                                                                                                                                                                                                           |
| 10.19* |   | Amended and Restated Employment Agreement dated  September 27, 2007 with Vernon A. LoForti (incorporated by reference to the Company’s  Form 8-K filed October 1, 2007).                                                                   |
|   |   |                                                                                                                                                                                                                                                           |
| 10.20* |   | Separation Agreement between Overland and Robert  Scroop dated February 14, 2008 (incorporated by reference to the Company’s Form 8-K filed  February 15, 2008).                                                                           |
|   |   |                                                                                                                                                                                                                                                           |
| 10.21* |   | Amendment dated July 9, 2008 to Separation  Agreement between Overland and Robert Scroop.                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                           |
| 10.22* |   | Severance Agreement and General Release dated  August 27, 2008 between Overland and Robert Farkaly.                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                           |
| 10.23* |   | Second Amendment to 1995 Stock Option Plan  (incorporated by reference to the Company’s Form S-8 Registration  Statement No. (333-41754) filed July 19, 2000).                                                                             |

 

40

----

 
| 10.24*                       |   | Form of Stock Option Agreement for options  granted under the 1995 Stock Option Plan (incorporated by reference to the  Company’s Form 10-K filed September 28, 2001).                                                                                                                                                          |
|------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.25*                       |   | First Amendment to 1997 Executive Stock Option Plan  (incorporated by reference to the Company’s Form S-8 Registration  Statement No. (333-41754) filed July 19, 2000).                                                                                                                                                         |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.26*                       |   | Form of Stock Option Agreement for options  granted under the 1997 Executive Stock Option Plan (incorporated by reference  to the Company’s Form 10-K filed September 28, 2001).                                                                                                                                                |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.27*                       |   | 2000 Stock Option Plan, as amended and restated  (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                                                                                                                                                                                   |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.28*                       |   | Form of Notice of Stock Option Award and Stock  Option Award Agreement for options granted under 2000 Stock Option Plan  (incorporated by reference to the Company’s Form 10-Q filed May 15,  2001).                                                                                                                            |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.29*                       |   | 2001 Supplemental Stock Option Plan (incorporated by  reference to the Company’s Form S-8 Registration Statement No. (333-75060)  filed December 13, 2001).                                                                                                                                                                     |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.30*                       |   | Form of Notice of Stock Option Award and Stock  Option Award Agreement for options granted under 2001 Supplemental Stock  Option Plan (incorporated by reference to the Company’s Form 10-K filed  September 27, 2002).                                                                                                         |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.31*                       |   | Amended and Restated 2003 Equity Incentive Plan (incorporated by reference to the Company’s  Form 8-K filed November 16, 2007).                                                                                                                                                                                                      |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.32*                       |   | Form of Stock Option Agreement for options  granted to senior officers under the 2003 Equity Incentive Plan (incorporated by reference to the Company’s  Form 10-Q filed February 10, 2004).                                                                                                                                    |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.33*                       |   | Form of Stock Option Agreement for options  granted to outside directors under the 2003 Equity Incentive Plan (incorporated by reference to the Company’s  Form 10-Q filed February 10, 2004).                                                                                                                                  |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.34*                       |   | Form of Standard Stock Option Agreement for  options granted under the 2003 Equity Incentive Plan (incorporated by reference to the Company’s  Form 10-Q filed February 10, 2004).                                                                                                                                              |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.35*                       |   | Form of Restricted Stock Agreement for  restricted stock granted under the 2003 Equity Incentive Plan (incorporated by reference to the  Company’s Form 10K filed September 15, 2005).                                                                                                                                          |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.36*                       |   | 2006 Employee Stock Purchase Plan (incorporated by  reference to the Company’s Form S-8 Registration Statement  No. (333-139064) filed December 1, 2006).                                                                                                                                                                       |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.37*                       |   | Form of Stock Option Cancellation Agreement  dated September 27, 2007 between Overland and Robert Degan, Robert  Farkaly, W. Michael Gawarecki, Kurt L. Kalbfleisch, Vernon A. LoForti, Scott  McClendon, Michael Norkus and Robert Scroop (incorporated by reference to the Company’s  Form 10-Q filed February 1, 2008). |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
| 10.38*                       |   | Summary Sheet of Director and Executive Officer  Compensation.                                                                                                                                                                                                                                                                                      |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
|     21.1 |   | Subsidiaries of the Company.                                                                                                                                                                                                                                                                                                                        |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
|     23.1 |   | Consent of PricewaterhouseCoopers LLP, Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                                              |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
|     24.1 |   | Power of Attorney (included on signature page).                                                                                                                                                                                                                                                                                                     |
|                         |   |                                                                                                                                                                                                                                                                                                                                                |
|     31.1 |   | Certification of Vernon A. LoForti, President and  Chief Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of  the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                     |

 

41

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|     31.2 |   | Certification  of Kurt L. Kalbfleisch, Vice President of Finance and Chief Financial  Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the  Exchange Act , 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, executed by Vernon A.  LoForti, President and Chief Executive Officer, and Kurt L. Kalbfleisch, Vice  President of Finance and Chief Financial Officer. |

 

----

| +      |   | Portions  of this exhibit have been omitted pursuant to a request for confidential  treatment and the non-public information has been filed separately with the  SEC.                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                               |
| ++     |   | Certain schedules and similar attachments have been  omitted pursuant to Item 601(b)(2) of Regulation S-K. A copy of the  omitted schedules and similar attachments will be provided supplementally to  the SEC upon request. |
|   |   |                                                                                                                                                                                                                               |
| *      |   | Management contract or compensation plan or  arrangement.                                                                                                                                                                          |

 

42

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
|                              |   | OVERLAND STORAGE, INC.                |
|------------------------------|--------|---------------------------------------|
|                         |   |                                  |
| Dated: October 14, 2008 |   | By:                                   | /s/ VERNON A. LoFORTI |
|                         |   | Vernon A. LoForti                     |
|                         |   | President and Chief Executive Officer |

 

### **POWER OF ATTORNEY**

 

Each person whose signature appears below constitutesand appoints Vernon A. LoForti and Kurt L. Kalbfleisch, jointly and severally,as his attorney-in-fact, each with the power of substitution, for him in anyand all capacities, to sign any amendments to this annual report on Form 10-Kand to file the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that each of said attorneys-in-fact, or his substitute orsubstitutes, may do or cause to be done by virtue hereof. Pursuant to therequirements of the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| Signature               | ** ** | **Title**                          | ** ** | **Date**              |
|-------------------------|------------|------------------------------------|------------|-----------------------|
|                    |       |                               |       |                  |
| /s/ VERNON A. LoFORTI   |       | President, Chief Executive Officer |       | October 14, 2008 |
| Vernon A. LoForti       |       | and Director                       |       |                  |
|                    |       | (Principal Executive Officer)      |       |                  |
|                    |       |                               |       |                  |
| /s/ KURT L. KALBFLEISCH |       | Vice President of Finance          |       | October 14, 2008 |
| Kurt L. Kalbfleisch     |       | and Chief Financial Officer        |       |                  |
|                    |       | (Principal Financial               |       |                  |
|                    |       | and Accounting Officer)            |       |                  |
|                    |       |                               |       |                  |
| /s/ ROBERT A. DEGAN     |       | Director                           |       | October 14, 2008 |
| Robert A. Degan         |       |                               |       |                  |
|                    |       |                               |       |                  |
| /s/ NORA DENZEL         |       | Director                           |       | October 14, 2008 |
| Nora Denzel             |       |                               |       |                  |
|                    |       |                               |       |                  |
| /s/ ERIC KELLY          |       | Director                           |       | October 14, 2008 |
| Eric Kelly              |       |                               |       |                  |
|                    |       |                               |       |                  |
| /s/ SCOTT McCLENDON     |       | Chairman of the Board              |       | October 14, 2008 |
| Scott McClendon         |       |                               |       |                  |
|                    |       |                               |       |                  |
| /s/ WILLIAM MILLER      |       | Director                           |       | October 14, 2008 |
| William Miller          |       |                               |       |                  |
|                    |       |                               |       |                  |
| /s/ MICHAEL NORKUS      |       | Director                           |       | October 14, 2008 |
| Michael Norkus          |       |                               |       |                  |

 

43

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### **Report of Independent RegisteredPublic Accounting Firm**

 

Tothe Board of Directors and Shareholders of Overland Storage, Inc.

 

Inour opinion, the consolidated financial statements listed in the indexappearing under Item 15(a)(1) present fairly, in all material respects,the financial position of Overland Storage, Inc. and its subsidiaries at June 29,2008 and July 1, 2007, and the results of their operations and their cashflows for each of the three years in the period ended June 29, 2008 inconformity with accounting principles generally accepted in the United Statesof America. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits. We conducted our audits of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion.

 

Asdiscussed in Note 1 to the consolidated financial statements, the Companychanged its method of accounting for share-based payments during the year endedJuly 2, 2006.

 

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to theconsolidated financial statements, the Company has incurred losses and negativecash flows from operations that raise substantial doubt about the Company’sability to continue as a going concern. Management’s plans in regard to thesematters are also described in Note 1. The consolidated financial statements donot include any adjustments that might result from the outcome of thisuncertainty.

 

PricewaterhouseCoopers LLP

San Diego, California

October 13, 2008

 

44

----

 

**OVERLAND STORAGE, INC.**

**CONSOLIDATED BALANCE SHEETS**

(in thousands)

 
| ** **                                                                                                                                               | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                               | ** ** | **2008**          | ** ** | **2007** | ** ** |
| **Assets**                                                                                                                                               |       |              |       |   |   |
| Current assets:                                                                                                                                          |       |              |       |   |   |
| Cash and cash equivalents                                                                                                                                |       | $                 | 8,437      |   | $ | 17,503 |   |
| Short-term investments                                                                                                                                   |       | 1,214             |       | 5,322 |   |
| Accounts receivable, less allowance for  doubtful accounts of $396 and $374 as of June 30, 2008 and 2007,  respectively                             |       | 15,814            |       | 22,572 |   |
| Inventories                                                                                                                                              |       | 17,126            |       | 20,556 |   |
| Deferred tax assets                                                                                                                                      |       | —            |       | 185 |   |
| Other current assets                                                                                                                                     |       | 8,566             |       | 6,953 |   |
| Total current assets                                                                                                                                     |       | 51,157            |       | 73,091 |   |
|                                                                                                                                                     |       |              |       |   |   |
| Property and equipment, net                                                                                                                              |       | 1,139             |       | 11,052 |   |
| Intangible assets, net                                                                                                                                   |       | 5,483             |       | 1,731 |   |
| Other assets                                                                                                                                             |       | 4,811             |       | 2,179 |   |
| Total assets                                                                                                                                             |       | $                 | 62,590     |   | $ | 88,053 |   |
|                                                                                                                                                     |       |              |       |   |   |
| **Liabilities and Shareholders’ Equity**                                                                                                            |       |              |       |   |   |
| Current liabilities:                                                                                                                                     |       |              |       |   |   |
| Accounts payable                                                                                                                                         |       | $                 | 7,203      |   | $ | 8,094 |   |
| Accrued liabilities                                                                                                                                      |       | 20,150            |       | 15,773 |   |
| Accrued payroll and employee compensation                                                                                                                |       | 3,801             |       | 3,122 |   |
| Income taxes payable                                                                                                                                     |       | 58                |       | 402 |   |
| Accrued warranty                                                                                                                                         |       | 5,928             |       | 6,134 |   |
| Note payable                                                                                                                                             |       | 1,432             |       | — |   |
| Total current liabilities                                                                                                                                |       | 38,572            |       | 33,525 |   |
|                                                                                                                                                     |       |              |       |   |   |
| Deferred tax liabilities                                                                                                                                 |       | —            |       | 185 |   |
| Other long-term liabilities                                                                                                                              |       | 5,835             |       | 5,233 |   |
| Total liabilities                                                                                                                                        |       | 44,407            |       | 38,943 |   |
|                                                                                                                                                     |       |              |       |   |   |
| Commitments and contingencies (Note 12)                                                                                                                  |       |              |       |   |   |
|                                                                                                                                                     |       |              |       |   |   |
| Shareholders’ equity:                                                                                                                               |       |              |       |   |   |
| Common stock, no par value, 45,000 shares  authorized; 12,764 and 12,748 shares issued and outstanding, as of  June 30, 2008 and 2007, respectively |       | 68,915            |       | 67,841 |   |
| Accumulated other comprehensive income                                                                                                                   |       | 197               |       | 91 |   |
| Accumulated deficit                                                                                                                                      |       | (50,929           | )          | (18,822 | ) |
| Total shareholders’ equity                                                                                                                          |       | 18,183            |       | 49,110 |   |
| Total liabilities and shareholders’ equity                                                                                                          |       | $                 | 62,590     |   | $ | 88,053 |   |

 

See accompanying notes to consolidated financial statements.

 

45

----

 

**OVERLAND STORAGE, INC.**

##### **CONSOLIDATED STATEMENT OFOPERATIONS**

(in thousands, except per share amounts)

 
| ** **                                    | ** ** | **Fiscal Year** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net revenue:                                  |       |                 |       |   |   |   |   |
| Product revenue                               |       | $                    | 105,954    |   | $ | 142,416 |   | $ | 196,527 |   |
| Service revenue                               |       | 20,628               |       | 16,501 |   | 10,680 |   |
| Royalty fees                                  |       | 1,118                |       | 1,526 |   | 1,831 |   |
|                                          |       | 127,700              |       | 160,443 |   | 209,038 |   |
| Cost of product revenue                       |       | 88,219               |       | 126,003 |   | 156,298 |   |
| Cost of service revenue                       |       | 11,425               |       | 10,097 |   | 6,294 |   |
| Gross profit                                  |       | 28,056               |       | 24,343 |   | 46,446 |   |
|                                          |       |                 |       |   |   |   |   |
| Operating expenses:                           |       |                 |       |   |   |   |   |
| Sales and marketing                           |       | 31,614               |       | 32,391 |   | 37,940 |   |
| Research and development                      |       | 9,349                |       | 14,999 |   | 18,752 |   |
| General and administrative                    |       | 10,117               |       | 13,387 |   | 14,564 |   |
| Impairment of long-lived assets               |       | 7,434                |       | 8,411 |   | — |   |
| In-process research and development           |       | —               |       | — |   | 1,121 |   |
|                                          |       | 58,514               |       | 69,188 |   | 72,377 |   |
| Loss from operations                          |       | (30,458              | )          | (44,845 | ) | (25,931 | ) |
|                                          |       |                 |       |   |   |   |   |
| Other income (expense):                       |       |                 |       |   |   |   |   |
| Interest income                               |       | 828                  |       | 1,709 |   | 2,771 |   |
| Interest expense                              |       | (5                   | )          | (2 | ) | (12 | ) |
| Other expense, net                            |       | (1,992               | )          | (698 | ) | (139 | ) |
| Loss before income taxes                      |       | (31,627              | )          | (43,836 | ) | (23,311 | ) |
| Provision for (benefit from) income taxes     |       | 398                  |       | 275 |   | (3,825 | ) |
| Net loss                                      |       | $                    | (32,025    | ) | $ | (44,111 | ) | $ | (19,486 | ) |
|                                          |       |                 |       |   |   |   |   |
| Net loss per share:                           |       |                 |       |   |   |   |   |
| Basic and diluted                             |       | $                    | (2.51      | ) | $ | (3.45 | ) | $ | (1.42 | ) |
|                                          |       |                 |       |   |   |   |   |
| Shares used in computing net loss per  share: |       |                 |       |   |   |   |   |
| Basic and diluted                             |       | 12,759               |       | 12,799 |   | 13,716 |   |

 

See accompanying notes to consolidated financial statements.

 

46

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**OVERLAND STORAGE, INC.**

**CONSOLIDATED STATEMENT OFSHAREHOLDERS’ EQUITY AND COMPREHENSIVE LOSS**

(in thousands)

 
| ** **                                                                        | ** ** | **Common Stock** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Deferred**           | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Total  Shareholders’** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **                                                                        | ** ** | **Shares**            | ** ** | **Amount**                            | ** ** | **(Loss) Income** | ** ** | **Compensation**                     | ** ** | **Deficit)**                  | ** ** | **Equity** | ** ** |
|                                                                              |       |                  |       |                                  |       |                   |       |                                 |       |                          |       |   |   |
| Balance at June 30, 2005                                                     |       | 14,123                |       | $                                     | 77,494     |                   | $          | (312                                 | )          | $                             | (463       | ) | $ | 44,775 |   | $ | 121,494 |   |
| Reverse deferred compensation upon adoption  of SFAS No. 123(R)              |       | —                |       | (463                                  | )          | —                 |       | 463                                  |       | —                        |       | — |   |
| Stock option and purchase plans                                                   |       | 349                   |       | 2,258                                 |       | —                 |       | —                               |       | —                        |       | 2,258 |   |
| Issuance of restricted stock, net                                                 |       | 61                    |       | —                                |       | —                 |       | —                               |       | —                        |       | — |   |
| Repurchase of common stock                                                        |       | (1,303                | )          | (10,804                               | )          | —                 |       | —                               |       | —                        |       | (10,804 | ) |
| Share-based compensation expense                                                  |       | —                |       | 2,011                                 |       | —                 |       | —                               |       | —                        |       | 2,011 |   |
| Comprehensive loss:                                                               |       |                  |       |                                  |       |                   |       |                                 |       |                          |       |   |   |
| Net loss                                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | (19,486                       | )          | (19,486 | ) |
| Foreign currency translation                                                      |       | —                |       | —                                |       | 136                    |       | —                               |       | —                        |       | 136 |   |
| Unrealized loss on short-term investments                                         |       | —                |       | —                                |       | (171                   | )          | —                               |       | —                        |       | (171 | ) |
| Total comprehensive loss                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | —                        |       | (19,521 | ) |
| Balance at June 30, 2006                                                     |       | 13,230                |       | 70,496                                |       | (347                   | )          | —                               |       | 25,289                        |       | 95,438 |   |
| Stock option and purchase plans                                                   |       | 26                    |       | 142                                   |       | —                 |       | —                               |       | —                        |       | 142 |   |
| Cancellation of restricted stock                                                  |       | (135                  | )          | —                                |       | —                 |       | —                               |       | —                        |       | — |   |
| Repurchase of common stock                                                        |       | (373                  | )          | (2,722                                | )          | —                 |       | —                               |       | —                        |       | (2,722 | ) |
| Share-based compensation benefit                                                  |       | —                |       | (75                                   | )          | —                 |       | —                               |       | —                        |       | (75 | ) |
| Comprehensive loss:                                                               |       |                  |       |                                  |       |                   |       |                                 |       |                          |       |   |   |
| Net loss                                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | (44,111                       | )          | (44,111 | ) |
| Foreign currency translation                                                      |       | —                |       | —                                |       | 154                    |       | —                               |       | —                        |       | 154 |   |
| Reclassification adjustment for unrealized  loss on available-for-sale securities |       | —                |       | —                                |       | 284                    |       | —                               |       | —                        |       | 284 |   |
| Total comprehensive loss                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | —                        |       | (43,673 | ) |
| Balance at June 30, 2007                                                     |       | 12,748                |       | 67,841                                |       | 91                     |       | —                               |       | (18,822                       | )          | 49,110 |   |
| Adoption of FIN No. 48                                                       |       | —                |       | —                                |       | —                 |       | —                               |       | (82                           | )          | (82 | ) |
| Stock option and purchase plans                                                   |       | 16                    |       | 26                                    |       | —                 |       | —                               |       | —                        |       | 26 |   |
| Share-based compensation expense                                                  |       | —                |       | 1,048                                 |       | —                 |       | —                               |       | —                        |       | 1,048 |   |
| Comprehensive loss:                                                               |       |                  |       |                                  |       |                   |       |                                 |       |                          |       |   |   |
| Net loss                                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | (32,025                       | )          | (32,025 | ) |
| Foreign currency translation                                                      |       | —                |       | —                                |       | 92                     |       | —                               |       | —                        |       | 92 |   |
| Unrealized gain on short-term investments                                         |       | —                |       | —                                |       | 14                     |       | —                               |       | —                        |       | 14 |   |
| Total comprehensive loss                                                          |       | —                |       | —                                |       | —                 |       | —                               |       | —                        |       | (31,919 | ) |
| Balance at June 30, 2008                                                     |       | 12,764                |       | $                                     | 68,915     |                   | $          | 197                                  |       | $                             | —     |   | $ | (50,929 | ) | $ | 18,183 |   |

 

See accompanying notes to consolidated financial statements.

 

47

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**OVERLAND STORAGE, INC.**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

(in thousands)

 
| ** **                                                                                                 | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                 | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Operating activities:**                                                                                  | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                                                   |       | $                    | (32,025    | ) | $ | (44,111 | ) | $ | (19,486 | ) |
| Adjustments to reconcile net loss to cash  (used in) provided by operating activities:                     |       |                 |       |   |   |   |   |
| Impairment of long-lived assets                                                                            |       | 7,434                |       | 8,411 |   | — |   |
| Depreciation and amortization                                                                              |       | 4,821                |       | 5,630 |   | 6,884 |   |
| Deferred tax provision                                                                                     |       | —               |       | (146 | ) | (1,429 | ) |
| Provision for losses on accounts receivable                                                                |       | 127                  |       | 368 |   | 159 |   |
| Acquired in-process research and  development                                                              |       | —               |       | — |   | 1,121 |   |
| Share-based compensation                                                                                   |       | 1,048                |       | (75 | ) | 2,011 |   |
| Realized (gains) loss on investments                                                                       |       | (19                  | )          | 107 |   | 23 |   |
| Other-than-temporary impairment on investments                                                             |       | 1,902                |       | 157 |   | — |   |
| Amortization of discount on short-term  investments                                                        |       | —               |       | 28 |   | 122 |   |
| Loss on disposal of property and equipment                                                                 |       | 3                    |       | 19 |   | 17 |   |
| Changes in operating assets and  liabilities, net of effects of acquisition:                               |       |                 |       |   |   |   |   |
| Accounts receivable                                                                                        |       | 6,631                |       | 7,381 |   | 7,223 |   |
| Inventories                                                                                                |       | 5,013                |       | (5,578 | ) | 4,130 |   |
| Accounts payable and accrued liabilities                                                                   |       | 824                  |       | (8,135 | ) | 3,324 |   |
| Accrued payroll and employee compensation                                                                  |       | 520                  |       | (1,155 | ) | 282 |   |
| Other assets and liabilities, net                                                                          |       | (1,485               | )          | 2,902 |   | 2,875 |   |
| Net cash (used in) provided by operating  activities                                                       |       | (5,206               | )          | (34,197 | ) | 7,256 |   |
|                                                                                                       |       |                 |       |   |   |   |   |
| **Investing activities:**                                                                                  | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of short-term investments                                                                        |       | (8,100               | )          | (48,525 | ) | (69,878 | ) |
| Proceeds from maturities of short-term  investments                                                        |       | 4,670                |       | 77,754 |   | 95,922 |   |
| Proceeds from sales of short-term  investments                                                             |       | 2,551                |       | 7,709 |   | 2,832 |   |
| Capital expenditures                                                                                       |       | (603                 | )          | (3,202 | ) | (3,972 | ) |
| Cash payments to acquire Snap Server                                                                       |       | (2,496               | )          | — |   | — |   |
| Net cash payments to acquire the stock of  Zetta Systems, Inc                                         |       | —               |       | — |   | (8,857 | ) |
| Net cash (used in) provided by investing  activities                                                       |       | (3,978               | )          | 33,736 |   | 16,047 |   |
|                                                                                                       |       |                 |       |   |   |   |   |
| **Financing activities:**                                                                                  | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from the exercise of stock options  and the sale of stock under the employee stock purchase plans |       | 26                   |       | 142 |   | 2,258 |   |
| Repurchase of common stock                                                                                 |       | —               |       | (2,722 | ) | (10,804 | ) |
| Net cash provided by (used in) financing  activities                                                       |       | 26                   |       | (2,580 | ) | (8,546 | ) |
| Effect of exchange rate changes on cash                                                                    |       | 92                   |       | 229 |   | 60 |   |
| Net (decrease) increase in cash and cash  equivalents                                                      |       | (9,066               | )          | (2,812 | ) | 14,817 |   |
| Cash and cash equivalents, beginning of  year                                                              |       | 17,503               |       | 20,315 |   | 5,498 |   |
| Cash and cash equivalents, end of year                                                                     |       | $                    | 8,437      |   | $ | 17,503 |   | $ | 20,315 |   |
|                                                                                                       |       |                 |       |   |   |   |   |
| **Supplemental disclosure of cash flow  information:**                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for income taxes                                                                                 |       | $                    | 485        |   | $ | 355 |   | $ | 735 |   |
| Cash paid for interest                                                                                     |       | $                    | 5          |   | $ | 2 |   | $ | 9 |   |
| **Non-cash investing activities:**                                                                         | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Change in net unrealized gain on short-term  investments                                                   |       | $                    | 14         |   | $ | 355 |   | $ | 171 |   |
| Capital expenditures received not paid as  of year end                                                     |       | $                    | 82         |   | $ | — |   | $ | 709 |   |
| Reclass auction rate securities to other  assets                                                           |       | $                    | 3,118      |   | $ | — |   | $ | — |   |
| **Non-cash financing activities:**                                                                         |       |                 |       |   |   |   |   |
| Issuance of note payable to acquire Snap  Server                                                           |       | $                    | 1,432      |   | $ | — |   | $ | — |   |

 

See accompanying notes to consolidated financial statements

 

48

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**OVERLAND STORAGE, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1 –OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**General**

 

OverlandStorage, Inc. (We, Overland or the Company) was incorporated on September 8,1980, under the laws of the State of California. For more than 27 years we have delivered data protection solutionsdesigned for backup and recovery to ensure business continuity. Historically,we have focused on delivering a portfolio of tape automation solutionsincluding loader and library systems designed for small and medium-sizedbusiness computing environments.

 

The Company operates and reports using a 52-53 weekfiscal year with each quarter ending on the Sunday closest to the calendarquarter. For ease of presentation, the Company’s fiscal years are considered toend on June 30. For example, references to fiscal 2008, 2007 and 2006refer to the fiscal years ended June 29, 2008, July 1, 2007 and July 2,2006, respectively. Fiscal 2008, 2007 and 2006 each contained 52 weeks.

 

Duringthe fourth quarter of fiscal 2006, the Company recorded certain amountsrelating to prior 2006 quarters and prior years resulting in a reduction of itsnet loss by $313,000 ($0.03 per share) and $324,000 ($0.02 per share) for thequarter and year ended July 2, 2006, respectively. The Company concludedthat the amounts were not material to any previously-reported annual or interimperiod nor was the cumulative amount material to the current fiscal year. Assuch, the amounts were recorded in the fourth quarter of fiscal 2006 and priorperiods were not restated.

 

We have incurred losses for our last three fiscalyears and negative cash flows for our last two fiscal years. As of June 30,2008, we had an accumulated deficit of $50.9 million. During fiscal 2008 weincurred a net loss of $32.0 million and the balance of cash, cash equivalentsand short-term investments declined to $9.7 million or by $13.1 millioncompared to the balance at June 30, 2007. We operate in a highlycompetitive market characterized by rapidly changing technology. We have no other unused sources of liquidityat this time. During fiscal 2009, we expectto continue to incur losses as we introduce and market our new products.

 

We need immediate and substantial cash to continue our operations atcurrent levels. We currently have no funding commitments. Management hasprojected that cash on hand will be sufficient to allow us to continue ouroperations at current levels into November 2008. We will need additionalfunding, either through debt or equity financings, or we will be forced toextend payment terms with vendors where possible, to liquidate certain assetswhere possible, and/or to suspend or curtail certain of our plannedoperations.  Any of these actions couldharm our business, results of operations and future prospects.  We anticipate we will need to raiseapproximately $10.0 million of cash and cash equivalents in the next twelvemonths to fund our operations through fiscal 2009 at current levels.

 

Our recurring losses from operations, negative cash flows, andaccumulated deficit and need for additional financing raise substantial doubtabout our ability to continue as a going concern. Our consolidated financialstatements have been prepared on a going concern basis, which contemplates therealization of assets and the satisfaction of liabilities in the normal courseof business.  We need to generateadditional revenue and improve our gross profit margins to be profitable infuture periods.  We may never return toprofitability, or if we do, we may not be able to sustain profitability on aquarterly or annual basis.

 

                                                             Possible funding alternatives, for raisingworking capital, are bank or asset based financing options equity-basedfinancing, including convertible debt and factoring arrangements. We are indiscussions with funding sources for each of these options but we currentlyhave no funding commitments. If we raise additional funds by selling additionalshares of our capital stock, the ownership interest of our shareholders will bediluted.  The amount of dilution could beincreased by the issuance of warrants or securities with other dilutivecharacteristics, such as anti-dilution clauses or price resets.

 

As of June 30, 2008, our other assets included$3.1 million of auction rate securities, which securities have a par value of$5.0 million.  The auctions for thesesecurities have failed since July 2007, which limits our ability toliquidate these securities and recover their carrying value in the nearterm.  Our estimate of the fair value ofthe auction rate securities is based on the probability weighted expectedfuture cash flows associated with the investments. We may nonetheless attemptto liquidate these securities to meet cash needs. We cannot predict whether wewill be able to liquidate these securities, and 

 

49

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we expect that any liquidation in the near term will bring less thanthe value of these securities, as of June 30, 2008, based upon subsequentindicative bids. For example, indicative bids (i.e., one measure of theestimated liquidation value) from Deutsche Bank subsequent to year-end for ourARS have ranged from a high of approximately $2.8 million at July 16, 2008to a low of approximately $1.4 million at October 1, 2008, the most recentbid as of the date of this report.  We donot believe this current estimate of the liquidation value represents theestimated fair value of the instruments as of the end our fiscal year. The indicativebids are not based on active markets or orderly transactions between marketparticipants. However, it is possible that we may be required to recordadditional impairments to these investments in future periods

 

**Principles of Consolidation**

 

Theconsolidated financial statements include the accounts of the Company and itswholly-owned subsidiaries, Overland Storage (Europe) Ltd., Overland StorageSARL, Overland Storage GmbH, Okapi Acquisition Co., Inc. (dissolvedeffective July 5, 2007), Zetta Systems, Inc., and Overland StorageExport Limited (dissolved effective July 3, 2007). All significantintercompany accounts and transactions have been eliminated.

 

**ManagementEstimates and Assumptions**

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and reported amounts ofrevenue and expenses during the reporting period. Estimates have been preparedon the basis of the most current and best available information and actualresults could differ from those estimates. Significant estimates made bymanagement include valuation of available-for-sale securities, share-basedcompensation, allowance for doubtful accounts, inventory valuation, valuationof intangible assets, impairment of long-lived assets, warranty obligations andthe valuation allowance on deferred tax assets, among others.

 

**RevenueRecognition**

 

Revenuefrom sales of products is recognized when persuasive evidence of an arrangementexists, the price is fixed or determinable, collectibility is reasonablyassured and delivery has occurred. Under this policy, revenue on direct productsales (excluding sales to distributors and certain OEM customers) is recognizedupon shipment of products to our customers. These customers are not entitled toany specific right of return or price protection, except for any defectiveproduct that may be returned under our warranty policy. Title and risk of losstransfer to the customer when the product leaves our dock. Product sales todistribution customers are subject to certain rights of return, stock rotationprivileges and price protection. Because we are unable to estimate our exposurefor returned product or price adjustments, revenue from shipments to thesecustomers is not recognized until the related products are in turn sold to theultimate customer by the distributor. As part of our existing agreements withcertain OEM customers, we ship products to various distribution hubs around theworld and retain ownership of that inventory until it is pulled by these OEMcustomers to fulfill their customer orders, at which time revenue isrecognized. For products where software is more than incidental to of ourproducts, we recognize revenue in accordance with Statement of Position (SOP) No. 97-2,*Software Revenue Recognition*.

 

When there are multiple elements in an arrangement, we allocate revenueto the separate elements based on relative fair value, provided we have fairvalue for all elements of the arrangement. If we have fair value forundelivered elements but not the delivered element in an arrangement, we deferthe fair value of the undelivered element(s) and the residual revenue isallocated to the delivered element(s). Undelivered elements typically includeservices. Revenue from extended warranty and product service contracts isinitially deferred and recognized as revenue ratably over the contract period.

 

Wehave various royalty arrangements with independent service providers that sellour product and also sell and provide service on our product. These independentservice providers pay a royalty fee for service contracts in place, on ourproduct. The royalty fee is calculated by Overland for the units covered in thequarter, and agreed to by the service provider, based upon the monthly fee foreach unit covered by the independent service provider. In addition, we receiveroyalties from HP, for licensing of our Protection OS software. Revenue isrecognized based upon quarterly reporting from HP related to the number ofunits sold.

 

50

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We have various licensing agreements relating to our Variable RateRandomizer (VR2) technologywith third parties. As consideration for licensing our VR2 technology,the licensees pay us a royalty fee for sales or their products that incorporateour VR2 technology. On a periodic basis, thelicensees provide us with reports that include the quantity of units, subjectto royalty, sold to their end users. We record the royalty when reported to usby the licensee, generally in the period during which the licensee ships theproducts containing VR2 technology. In certaininstances, the customer has elected to purchase from us the ApplicationsSpecific Integrated Circuit (ASIC) chips embodying VR2,which are priced to include the cost of the chip plus an embedded royalty fee;and revenue on ASIC chip sales is recorded as product revenue when earned,which under our FOB origin terms is upon shipment of the underlying ASIC chipincorporating the VR2 technology to thecustomer.

 

**Warranty and Extended Warranty**

 

TheCompany records a provision for estimated future warranty costs for both thereturn-to-factory and on-site warranties. If future actual costs to repair wereto differ significantly from estimates, the impact of these unforeseen costs orcost reductions would be recorded in subsequent periods.

 

Separatelypriced extended on-site warranties are offered for sale to customers of allproduct lines. The Company contracts with third-party service providers toprovide service relating to all on-site warranties. Extended warranty revenueand amounts paid in advance to outside service organizations are deferred andrecognized as service revenue and cost of service, respectively, over theperiod of the service agreement.

 

Changes in the liability for product warranty anddeferred revenue associated with extended warranties were as follows (inthousands):

 
| ** **                                                   | ** ** | **Product  Warranty** | ** ** | **Deferred  Revenue** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
|                                                         |       |                  |       |                  |       |
| Liability at June 30, 2006                              |       | $                     | 5,407      |                  | $          | 8,822 |   |
| Settlements made during the period                           |       | (1,810                | )          | (9,709                | )          |
| Change in liability for warranties issued  during the period |       | 2,731                 |       | 12,337                |       |
| Change in liability for preexisting  warranties              |       | (194                  | )          | 3                     |       |
| Liability at June 30, 2007                              |       | 6,134                 |       | 11,453                |       |
| Acquired during the period (Snap Server)                     |       | 465                   |       | 2,380                 |       |
| Settlements made during the period                           |       | (2,121                | )          | (13,340               | )          |
| Change in liability for warranties issued  during the period |       | 1,713                 |       | 16,751                |       |
| Change in liability for preexisting  warranties              |       | (263                  | )          | 4                     |       |
| Liability at June 30, 2008                              |       | $                     | 5,928      |                  | $          | 17,248 |   |

 

#### **Shippingand Handling**

####  

Amountsbilled to customers for shipping and handling are included in product sales andcosts incurred related to shipping and handling are included in cost ofrevenue.

 

#### **AdvertisingCosts**

####  

Advertising costs are expensed as incurred.Advertising expenses for fiscal 2008, 2007 and 2006 were $0.5 million, $0.6million and $0.7 million, respectively.

 

**Research and Development Costs**

 

Researchand development costs are expensed as incurred. Software development costs areexpensed until technological feasibility has been established, at which timeany additional costs are capitalized in accordance with Financial AccountingStandards Board (FASB) Statement of Financial Standards (SFAS) No. 86, *Accounting for the Costs of Software to be Sold, Leased or OtherwiseMarketed*. Because we believe our current process for developingsoftware is essentially completed concurrently with the establishment oftechnological feasibility, which occurs upon the completion of a working model,no costs were capitalized during fiscal 2008 and 2006. Amounts capitalized infiscal 2007 were not material.

 

51

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**Segment Data**

 

TheCompany reports segment data based on the management approach. The managementapproach designates the internal reporting that is used by management formaking operating and investment decisions and evaluating performance as thesource of the Company’s reportable segments. The Company uses one measurementof profitability and does not disaggregate its business for internal reporting.Based on the criteria of SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*, the Company has determinedthat it operates in one segment providing data storage solutions for mid-rangebusinesses and distributed enterprises. The Company discloses information aboutproducts and services, geographic areas and major customers.

 

#### **Informationabout Products and Services**

####  

The following table summarizes net revenue by product (in thousands):

 
| ** **              | ** ** | **Fiscal Year** | ** ** |
|-------------------------|------------|----------------------|------------|
| ** **              | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Tape based products:    |       |                 |       |   |   |   |   |
| NEO SERIES              |       | $                    | 68,197     |   | $ | 106,129 |   | $ | 143,745 |   |
| ARCvault family         |       | 12,296               |       | 11,430 |   | 3 |   |
| Other (1)               |       | 47                   |       | 1,909 |   | 15,435 |   |
|                    |       | 80,540               |       | 119,468 |   | 159,183 |   |
| Service                 |       | 20,628               |       | 16,501 |   | 10,680 |   |
| Spare parts and other   |       | 13,718               |       | 12,887 |   | 22,628 |   |
| Disk based products (2) |       | 12,015               |       | 10,228 |   | 13,603 |   |
| VR(2)                   |       | 799                  |       | 1,359 |   | 2,944 |   |
|                    |       | $                    | 127,700    |   | $ | 160,443 |   | $ | 209,038 |   |

 

----

(1)          Fiscal2006 includes revenue associated with our PowerLoader and LoaderXpress productsdiscontinued in fiscal 2007.

 

(2)          IncludesREO SERIES and ULTAMUS RAID family products.

 

52

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#### ** Information about Geographic Areas**

####  

The Company markets its products domestically andinternationally, with its principal international market being Europe. Revenueis attributed to the location to which the product was shipped. Long-livedassets are based on location of domicile.

 

The following table summarizes net revenue and long-lived assets bygeographic area (in thousands):

 
| ** **              | ** ** | **Net Revenue** | ** ** | **Long-Lived  Assets** | ** ** |
|-------------------------|------------|----------------------|------------|------------------------|------------|
| **Fiscal 2008**         |       |                 |       |                   |       |
| United States           |       | $                    | 62,361     |                   | $          | 1,041 |   |
| United Kingdom          |       | 23,614               |       | 98                     |       |
| Rest of Europe          |       | 24,475               |       | —                 |       |
| Singapore               |       | 9,489                |       | —                 |       |
| Other foreign countries |       | 7,761                |       | —                 |       |
|                    |       | $                    | 127,700    |                   | $          | 1,139 |   |
| **Fiscal 2007**         |       |                 |       |                   |       |
| United States           |       | $                    | 67,980     |                   | $          | 10,334 |   |
| United Kingdom          |       | 40,925               |       | 707                    |       |
| Rest of Europe          |       | 25,613               |       | 11                     |       |
| Singapore               |       | 15,247               |       | —                 |       |
| Other foreign countries |       | 10,678               |       | —                 |       |
|                    |       | $                    | 160,443    |                   | $          | 11,052 |   |
| **Fiscal 2006**         |       |                 |       |                   |       |
| United States           |       | $                    | 90,412     |                   | $          | 10,318 |   |
| United Kingdom          |       | 47,914               |       | 689                    |       |
| Rest of Europe          |       | 29,098               |       | 19                     |       |
| Singapore               |       | 22,940               |       | —                 |       |
| Other foreign countries |       | 18,674               |       | —                 |       |
|                    |       | $                    | 209,038    |                   | $          | 11,026 |   |

 

**Cash Equivalents and Investments**

 

Highlyliquid investments with insignificant interest rate risk and originalmaturities of three months or less, when purchased, are classified as cashequivalents. Cash equivalents are comprised of money market funds. The carryingamounts approximate fair value due to the short maturities of theseinstruments.

 

Investmentswith maturities greater than three months (but less than one year), whenpurchased, are classified as short-term investments. The Company manages itscash equivalents and short-term investments as a single portfolio of highlymarketable securities, all of which are intended to be available for theCompany’s current operations. As such, all of the Company’s short-terminvestments are classified as available-for-sale and are reported at fairvalue, generally as determined by quoted market prices, with any unrealizedgains and losses (see Note 4), net of tax, recorded as a separate component ofaccumulated other comprehensive income (loss) in shareholders’ equity. The costof securities sold is based on the specific identification method.

 

As of June 30, 2008,the Company held auction rate securities, purchased as highly rated (AAA)investment grade securities, with a par value of$5.0 million which are collateralized by corporate debt obligations. Subsequentto fiscal year end 2008, the two auction rate instruments (ARS) held by theCompany were downgraded by Fitch Ratings from AAA to A+ and A, respectively. These securities, although not mortgage-backed, haveexperienced failed auctions primarily as a result of the impact sub primemortgages have had on liquidity in the credit markets. As a result, the Companyrecognized other-than-temporary impairment losses in fiscal 2008 ofapproximately $1.9 million, pre-tax, on these investments to reduce thevalue to their estimated fair value of $3.1 million as of June 30,2008 (Note 4). The impairment losses arerecorded in other expense, net, in the consolidated statement of operations. Asallowed by SFAS No. 115, *Accounting For CertainInvestments in Debt and Equity Securities*, the Company elected toestimate the fair value of the auction rate securities using a discountedcash flow analysis. Taking into consideration the security terms theassumptions used by us included estimates of (i) when a 

 

53

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successful auction would occur or the securities would be redeemed, (ii) adiscount rate commensurate with the implied risk associated with holding thesecurities including, consideration of the recent ratings downgrades, and (iii) futureexpected cash flow streams. If the auctionscontinue to fail, or the Company determines that one or more of the assumptionsused in the estimate needs to be revised, the Company may be required to recordan additional impairment on these securities in the future.

 

Duringfiscal 2007, investments in auction rate securities were recorded, inshort-term investments, at cost, which approximated fair value due to theirvariable interest rates, which typically reset every 30 days. In the fourthquarter of fiscal 2008, the auction rate securities’ estimated fair value of$3.1 million was reclassified to other assets in the accompanying consolidatedbalance sheets.

 

**Accounts Receivable and Allowance for Doubtful Accounts**

 

TheCompany records accounts receivable at invoice amount and does not chargeinterest thereon. The Company estimates itsallowance for doubtful accounts based on an assessment of the collectibility ofspecific accounts and the overall condition of the accounts receivableportfolio. When evaluating the adequacy of the allowance for doubtful accounts,the Company analyzes specific trade and other receivables, historical baddebts, customer credits, customer concentrations, customer credit-worthiness,current economic trends and changes in customers’ payment terms and/orpatterns. The Company reviews the allowance for doubtful accounts on aquarterly basis and records adjustments as considered necessary. Customeraccounts are written-off against the allowance for doubtful accounts when anaccount is considered uncollectible.

 

**Inventories**

 

Inventories are stated at the lower of cost(first-in-first-out method) or market.

 

#### **Propertyand Equipment**

####  

Propertyand equipment are recorded at cost. The Company also capitalizes qualifyinginternal use software costs incurred during the application development stage.Depreciation expense is computed using the straight-line method. Leaseholdimprovements are depreciated over the shorter of the remaining estimated usefullife of the asset or the term of the lease. Estimated useful lives are asfollows:

 
| Machinery and equipment         |   | 3-5 years |
|---------------------------------|--------|-----------|
| Furniture and fixtures          |   | 5 years   |
| Computer equipment and software |   | 1-5 years |

 

Expendituresfor normal maintenance and repair are charged to expense as incurred, andimprovements are capitalized. Upon the sale or retirement of property orequipment, the asset cost and related accumulated depreciation are removed fromthe respective accounts and any gain or loss is included in the results ofoperations.

 

#### **Long-LivedAssets**

####  

TheCompany evaluates the recoverability of long-lived assets, including propertyand equipment and certain identifiable intangible assets, in accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets.*  The Company tests for recoverability whenever events or changes incircumstances indicate the carrying value may not be recoverable. We considerthe following events or changes as potential triggers ofnon-recoverability:

 

·                  significantunderperformance relative to historical or projected future operating results;

 

·                  significantchanges in the manner of use of the assets or the strategy for our overallbusiness;

 

·                  significantdecrease in the market value of the assets; and

 

·                  significantnegative industry or economic trends.

 

54

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When the carrying value is not considered recoverable,an impairment loss, for the amount by which the carrying value of a long-livedasset exceeds its fair value, is recognized with an offsetting reduction in thecarrying value of the related asset(s). During the fourth quarter of fiscal2008, the Company recorded a $7.4 million impairment related to property andequipment. The Company recorded an impairment charge of $8.4 million in thefirst quarter of fiscal 2007. If the Company’s future results are significantlydifferent than forecasted, the Company may be required to further evaluate itslong-lived assets for recoverability and such analysis could result in animpairment charge in a future period.

 

Fair value is generally determined based on theestimated future discounted cash flows over the remaining useful life of theasset using a discount rate determined by management to be commensurate withthe risk inherent in the Company’s current business model.

####  

#### **DeferredRent**

####  

Rent expense is recorded on a straight-line basis overthe term of the lease. The difference between rent expense and amounts paidunder the lease agreements is recorded in other liabilities in the accompanyingconsolidated balance sheets.

 

**Foreign Currency Translation**

 

The financial statements of foreign subsidiaries, forwhich the functional currency is the local currency, are translated into U.S.dollars using the exchange rate at the balance sheet date for assets andliabilities and a weighted-average exchange rate during the year for revenue,expenses, gains and losses. Translation adjustments are recorded as accumulatedother comprehensive income within shareholders’ equity. Gains or losses fromforeign currency transactions are recognized currently in income. Suchtransactions resulted in a loss of $121,000, $448,000 and $186,000 for fiscal2008, 2007 and 2006, respectively.

 

#### **IncomeTaxes**

####  

The Company provides for income taxes utilizing the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes generally represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when a judgment is made that it is considered more likely than not that a tax benefit will not be realized. A decision to record a valuation allowance results in an increase in income tax expense or a decrease in income tax benefit (as we had in fiscal 2006). If the valuation allowance is released in a future period, income tax expense will be reduced accordingly.

 

The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, *Accounting for Income Taxes*, and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN No. 48, the impact of an uncertain income tax position must be recognized at the largest amount that is “more likely than not” to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.

 

#### **AccumulatedOther Comprehensive (Loss) Income**

####  

Comprehensive(loss) income for the Company includes net (loss) income, foreign currencytranslation adjustments and unrealized gains on available-for-sale securities,which are charged or credited to accumulated other comprehensive income withinshareholders’ equity.

 

55

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For fiscal 2008, 2007 and2006, the components of accumulated other comprehensive (loss) income were asfollows (in thousands):

 
| ** **                                                 | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                 | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                       |       |                 |       |   |   |   |   |
| Foreign currency translation adjustments                   |       | $                    | 183        |   | $ | 91 |   | $ | (63 | ) |
| Unrealized gain (loss) on short-term  investments (Note 4) |       | 14                   |       | — |   | (284 | ) |
| Total accumulated other comprehensive  income (loss)       |       | $                    | 197        |   | $ | 91 |   | $ | (347 | ) |

 

#### **Concentrationof Credit Risks**

####  

Financial instruments which potentially subject the Company toconcentrations of credit risk consist primarily of cash equivalents, short-terminvestments and trade accounts receivable, which are generally notcollateralized. The Company limits its exposure to credit loss by placing itscash equivalents and short-term investments with high quality financialinstitutions and investing in high quality short-term debt instruments. TheCompany performs ongoing credit evaluations of its customers, generally requiresno collateral and maintains allowances for potential credit losses and salesreturns.

 

The Company’s largest single customer accounted for approximately35.2%, 45.8% and 49.7% of sales in fiscal 2008, 2007 and 2006, respectively,and approximately 23.2%, 39.5% and 36.8% of accounts receivable as of June 30,2008, 2007 and 2006, respectively. No other customer accounted for 10.0% ormore of sales in any of the three years presented.

 

#### **FairValue of Financial Instruments**

####  

The Company’s financial instruments consist of cashequivalents, short-term investments, ARS instruments in other assets, accountsreceivable, accounts payable and note payable. Investments in debt securities,other than auction rate securities, are recorded at fair value based on quotedmarket prices for those securities. See Note 4 for discussion of the fair valueof the ARS instruments. The carrying amounts of other instruments approximatefair value because of their short-term maturities.

 

**Net Loss per Share**

 

Basicnet loss per share is computed based on the weighted-average number of sharesof common stock outstanding during the period. Diluted net loss per share iscomputed based on the weighted-average number of shares of common stockoutstanding during the period increased by the weighted-average number ofdilutive common stock equivalents outstanding during the period, using thetreasury stock method. Dilutive securities are comprised of options granted andrestricted stock awards issued under the Company’s stock option plans and employeestock purchase plan (ESPP) share purchase rights. For all periods presented,there is no difference in the number of shares used to calculate basic anddiluted shares outstanding due to the Company’s net loss position.

 

Anti-dilutive common stock equivalents excluded fromthe computation of diluted net loss per share were as follows (in thousands):

 
| ** **                                          | ** ** | **Fiscal Year** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|
| ** **                                          | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                          | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Options outstanding and ESPP share purchase  rights |       | 2,550                |       | 2,044 |   | 2,632 |   |
| Restricted stock awards outstanding                 |       | —               |       | 21 |   | 144 |   |

 

**Change in Accounting Principle and Share-Based Compensation**

 

The Company adopted SFAS No. 123 (revised 2004)(123(R)), *Share-Based Payment*, on July 4,2005. Upon adoption of SFAS No. 123(R), deferred compensation previouslyrecognized in the balance sheet for fiscal 2005 was reversed in fiscal 2006with the offsetting decrease in common stock. Compensation costs associatedwith the deferred compensation were recorded to expense over the requisiteservice period associated with the restricted stock.

 

56

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TheCompany’s share-based compensation plans are described in Note 10. Prior to theadoption of SFAS No. 123(R) on July 4, 2005, the Company accountedfor share-based awards issued to employees, directors and officers under thoseplans under the recognition and measurement principles of Accounting PrinciplesBoard (APB) No. 25, *Accounting for StockIssued to Employees*, and related interpretations. Generally, noshare-based employee compensation expense was recognized for stock optiongrants, as all options granted under those plans had an exercise price equal tothe fair market value of the underlying common stock at the date of grant.Similarly, no compensation expense had been recognized for purchase rightsunder the Company’s Employee Stock Purchase Plans (ESPP).****Compensationexpense related to issuances of restricted stock awards with service conditionswas generally recognized based on the fair value less amounts paid byemployees, if any. Compensation expense related to restricted stock awards withmarket conditions was recognized when satisfaction of the market condition wasdeemed probable by management. The Company accounts for stock option grants andsimilar equity instruments granted to non-employees under the fair valuemethod, in accordance with Emerging Issues Task Force (EITF) IssueNo. 96-18, *Accounting for Equity Instruments That areIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods or Services*and SFAS No. 123(R).

 

Asnoted above, in the first quarter of fiscal 2006, the Company adopted SFASNo. 123(R), which requires companies to measure the cost of employeeservices received in exchange for an award of an equity instrument based on thegrant-date fair value of the award, using the modified prospective method. TheCompany uses the Black-Scholes option pricing model to estimate the fair valueof its options on the measurement date. The cost is recognized over therequisite service period (usually the vesting period) for the estimated numberof instruments where service is expected to be rendered. The Company electedthe alternative transition method described in FASB Staff Position No. FAS123(R)-3, *Transition Election Related to Accounting for theTax Effects of Share-Based Payment Awards*, for purposes of calculatingthe pool of excess tax benefits available to absorb tax short falls recognizedsubsequent to adoption of SFAS No. 123(R).

 

Thefair value of restricted stock awards with service conditions is equal to thefair value of the stock on the date of issuance. The fair value of restrictedstock awards with market conditions is determined through use of a latticemodel. Compensation expense related to issuances of restricted stock awardswith service conditions is recorded at fair value less amounts paid by employees,if any, and application of an estimated forfeiture rate. Compensation expenserelated to issuances of restricted stock awards with market conditions isrecorded at estimated fair value for the number of employees expected tocomplete the requisite service period.

 

Compensationexpense associated with option and restricted stock awards with graded vestingis recognized in accordance with FASB Interpretation (FIN) No. 28, **Accounting forStock Appreciation Rights and Other Variable Stock Option or Award Plans—aninterpretation of APB Opinions No. 15 and 25****.**

 

Duringfiscal 2008, the Company recorded share-based compensation expense ofapproximately $1.0 million, in the accompanying consolidated statement ofoperations. During fiscal 2007, the Company recorded a net benefit of $75,000in share-based compensation associated with awards forfeiting prior to theirvesting in excess of the amount previously estimated. During fiscal 2006, theCompany recorded share-based compensation expense of approximately $2.0 millionin the accompanying consolidated statement of operations.

 

**RecentlyIssued Accounting Pronouncements**

 

In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*,which defines fair value, establishes a framework for measuring fair value inaccounting principles generally accepted in the United States of America andexpands disclosure about fair value measurements. SFAS No. 157 iseffective for fiscal years beginning after November 15, 2007 (fiscal 2009for the Company), except that the effective date of SFAS No. 157 isdeferred for one year (fiscal 2010 for the Company) as it relates tononfinancial assets and nonfinancial liabilities required to be disclosed atfair value on a nonrecurring basis. Management is currently evaluating theimpact, if any, SFAS No. 157 will have on the Company’s consolidatedfinancial position, results of operations and cash flows.

 

In February 2007, the FASB issued SFASNo. 159, *The Fair Value Option for Financial Assets and Financial Liabilities includingan amendment of FASB Statement No. 115,*which permits an entityto choose to elect irrevocably fair value on a contract-by-contract basis asthe initial and subsequent measurement attribute for many financial assets andliabilities and certain other items including insurance contracts. Entitieselecting the fair value option would be required to recognize changes in fairvalue in earnings and to expense upfront cost and fees associated with the itemfor which the fair value option is elected. The provisions of SFAS No. 159 are effective for fiscal years beginning afterNovember 15, 2007 (fiscal 2009 for the Company). Management is currentlyevaluating the impact, if any, SFAS No. 159 will have on the Company’sconsolidated financial position, results of operations and cash flows.

 

57

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InDecember 2007, the FASB issued SFAS No. 141 (revised 2007), *Business Combinations* (SFAS No. 141(R)),which replaces SFAS No. 141. SFASNo. 141(R) establishesprinciples and requirements for how an acquirer in a business combination:(i) recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, and any controlling interest;(ii) recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase; and (iii) determines whatinformation to disclose to enable users of the financial statements to evaluatethe nature and financial effects of the business combination. SFAS No. 141(R) is to be applied prospectively to businesscombinations for which the acquisition date is on or after an entity’s fiscalyear that begins after December 15, 2008 (fiscal 2010 for the Company).Management is currently evaluating the impact, if any, SFAS No. 141(R) willhave on the Company’s consolidated financial position, results of operationsand cash flows.

 

From time to time, new accounting pronouncements areissued by the FASB that are adopted by the Company as of the specifiedeffective date. Unless otherwise discussed, management believes that the impactof recently issued standards, which are not yet effective, will not have amaterial impact on the Company’s consolidated financial statements uponadoption.

 

**NOTE 2— ASSET IMPAIRMENT AND COMPANY RESTRUCTURINGS**

 

***Asset Impairment***

 

Inaccordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*, the Company evaluatedits long-lived assets, other than the long-lived assets from the recentlycompleted Snap Server acquisition (Note 3), for impairment as of June 30, 2008(Overland legacy assets), due to the Company’s continued operating and cashflow losses in 2008 and the Company’s forecasts for 2009 and beyond. TheCompany concluded that the carrying amount of this asset group was notrecoverable and an impairment loss should be recognized. An impairment chargetotaling $7.4 million, related to property and equipment, was recorded in thefourth quarter of 2008. After the impairment, total property and equipment,including property and equipment acquired from Adaptec, is recorded at itsestimated fair value of $1.2 million. The estimated fair value of the Overlandlegacy assets was determined using the income approach which is based on adiscounted cash flow analysis, as well as consideration of the estimated valuethat could be realized upon sale. The assumptions used by us included estimatesof (i) projected cash flows for a period approximating the remaining estimateduseful life of the asset group, (ii) a discount rate commensurate with theimplied risk in an investment in the Company and the risk of the underlyingcash flows and (iii) an estimate of enterprise value.

 

InAugust 2005, the Company acquired all of the outstanding stock of ZettaSystems, Inc. (Zetta). Zetta developed data protection software that wasincorporated into the Company’s ULTAMUSTM Pro storage appliance which waslaunched in the first quarter of fiscal 2007. ULTAMUS Pro did not generaterevenue subsequent to its launch. On October 25, 2006, the Company’s Board ofDirectors approved the closure of the Zetta-related software development officenear Seattle, Washington and the elimination of the ULTAMUS Pro product fromfuture forecasts and sales commission goals.

 

Inaccordance with SFAS No. 144, the Company evaluated the acquired technologyintangible asset for impairment as of September 30, 2006, due to thesignificant underperformance of the ULTAMUS Pro product subsequent to itslaunch. Based on the Company’s revised forecasts, the Company concluded thatthe carrying amount of the asset was not recoverable and an impairment lossshould be recognized. An impairment charge equal to the remaining intangibleasset balance of $8.4 million was recorded in the first quarter of 2007, as theacquired technology was not considered to have any remaining value. Inaddition, in the first quarter of 2007, the Company recorded a write-down of$350,000 to cost of product sales against specific inventory associated withthe ULTAMUS Pro product because it could no longer be used in production.

 

***Restructurings***

 

*Outsourceof Manufacturing Operations*

 

In September 2004, in order to enhance itsstrategic competitiveness and increase its flexibility, the Company announced aplan to outsource all of its manufacturing to Sanmina – SCI Corporation(Sanmina), a U.S. third party manufacturer. In November 2004, the contract withSanmina was finalized and all manufacturing employees were notified oftermination dates and benefits. Under the restructuring plan, the Companyterminated 82 employees.

 

58

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TheCompany completed the transfer of all of its manufacturing operations inAugust 2005. In fiscal 2005, the Company recorded $2.1 million to cost ofrevenue in pre-tax charges for severance costs related to the outsourcing andother obligations. In fiscal 2006, the Company recorded $770,000 in pre-taxcharges to cost of revenue for other obligations related to the outsourcing,including a charge of $704,000 for the estimated fair value of the liabilityassociated with leased warehouse space that the Company permanently ceasedusing in December 2005.

 

InJune 2006, the Company decided to terminate the relationship with Sanmina andreturn manufacturing to San Diego. As a result, the Company recorded a pre-taxcredit of $536,000, in the fourth quarter, to reverse the remaining excessfacilities liability previously recorded.

 

*October2006 Reduction of Workforce*

 

Inthe second quarter of fiscal 2007, the Company recorded $962,000 in severancefor the termination of 28 employees in connection with an October 2006reduction in workforce. In the third quarter of fiscal 2007, the Companyrecorded a net adjustment of $36,000 to severance for foreign employees whosesettlements were estimated at the end of the second quarter of fiscal 2007. Asof June 30, 2007, all severance was paid. Severance charges are included insales and marketing expense and research and development expense in theaccompanying consolidated statement of operations.

 

TheOctober 2006 reduction in workforce included a closure of the Company’s leasedsoftware development facility near Seattle, Washington, which lease expired onOctober 31, 2007. In the third quarter of fiscal 2007, the Company recorded acharge of $42,000 to research and development expense for the estimated fairvalue of the liability associated with this location that the Company ceasedusing in March 2007.

 

*April2007 Cost Reductions and Restructuring of Workforce*

 

InApril 2007, the Company announced that it reduced its employee workforce by 14%worldwide, or 54 employees, in accordance with the Company’s initiatives toreduce costs and restructure its workforce. Severance related to the terminatedemployees was $758,000. Severance charges are included in sales and marketing expense,research and development expense and general and administrative expense in theaccompanying consolidated statement of operations.

 

Thefollowing table summarizes the activity and balances of accrued restructuringcharges through fiscal 2008 (in thousands):

 

| ** **                    | ** ** | **Employee  Related** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-----------------------|------------|----------------|------------|-----------|------------|
|                          |       |                  |       |           |       |      |       |
| Balance at June 30, 2006      |       | $                     | —     |           | $          | —    |       | $ | — |   |
| Accrued restructuring charges |       | 1,720                 |       | 42             |       | 1,762     |       |
| Cash payments                 |       | (1,631                | )          | (18            | )          | (1,649    | )          |
| Adjustment                    |       | (36                   | )          | —         |       | (36       | )          |
| Balance at June 30, 2007      |       | 53                    |       | 24             |       | 77        |       |
| Cash payments                 |       | (53                   | )          | (24            | )          | (77       | )          |
| Balance at June 30, 2008      |       | $                     | —     |           | $          | —    |       | $ | — |   |

 

**NOTE 3– ACQUISITIONS**

 

InAugust 2005, the Company acquired all of the outstanding stock of Zettafor total consideration of approximately $9.2 million in cash, including$154,000 in direct acquisition costs. The acquisition was made principally toenable the Company’s entry into the primary data storage market. The results ofoperations of Zetta were included in our consolidated results of operationsbeginning August 2005.

 

Inthe first quarter of fiscal 2007, the Company recorded an impairment charge of$8.4 million related to the unamortized Zetta acquired technology as ofSeptember 30, 2007 (see Note 2) and closed the Washington office.

 

59

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Thepurchase consideration was allocated as follows (in thousands):

 

| Current assets                                              |   | $      | 252    |   |
|-------------------------------------------------------------|--------|--------|--------|--------|
| Non-current assets                                          |   | 757    |   |
| Acquired technology                                         |   | 11,874 |   |
| Acquired in-process research and  development               |   | 1,121  |   |
| Current liabilities                                         |   | (94    | )      |
| Deferred tax liabilities and other  non-current liabilities |   | (4,756 | )      |
| Total consideration                                         |   | $      | 9,154  |   |

 

OnJune 27, 2008, we acquired the Snap Server® network attached storage(NAS) business (Snap Server) from Adaptec, Inc., including the brand and allassets related to the Snap Server networked and desktop storage appliances. Thenet purchase price was $3.9 million (including $349,000 in direct acquisitioncosts), with approximately $2.2 million paid in cash upon the closing of thetransaction, and the remaining $1.4 million to be paid in cash in 12 months.The acquisition was made principally to broaden the Company’s capabilities byadding distributed NAS while also strengthening central and remote office dataprotection. The acquisition added 47 employees to the Company’s headcount.

 

Thepurchase price allocation is subject to adjustment pending final inventoryvaluation. The Company expects the final allocation to be completed withinfiscal 2009.

 

Thepurchase consideration was allocated as follows (in thousands):

 

| Inventories                                   |   | $      | 1,582  |   |
|-----------------------------------------------|--------|--------|--------|--------|
| Property and equipment                        |   | 262    |   |
| Customer contracts and related  relationships |   | 2,501  |   |
| Acquired technology (core and existing)       |   | 1,731  |   |
| Trade names and trade marks                   |   | 1,251  |   |
| Accrued liabilities                           |   | (1,789 | )      |
| Warranty reserve                              |   | (465   | )      |
| Other long-term liabilities                   |   | (1,145 | )      |
| Total consideration                           |   | $      | 3,928  |   |

 

Assuming the acquisition ofSnap Server had occurred on July 1, 2007 and 2006, the pro forma unauditedresults of operations would have been as follows (in thousands):

 

| ** **           | ** ** | **June 30,** | ** ** |
|----------------------|------------|-------------------|------------|
| ** **           | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                 |       |              |       |   |   |
| Revenue              |       | $                 | 149,600    |   | $ | 188,503 |   |
| Loss from operations |       | (37,520           | )          | (54,733 | ) |
| Net loss             |       | (39,087           | )          | (53,999 | ) |
| Net loss per share:  |       |              |       |   |   |
| Basic and diluted    |       | $                 | (3.06      | ) | $ | (4.22 | ) |

 

The above pro formaunaudited results of operations do not include pro forma adjustments relatingto costs of integration or post-integration cost reductions that may beincurred or realized by the Company in excess of actual amounts incurred orrealized through June 30, 2008. The consolidated statement of operations forthe year ended June 30, 2008 includes the operations of Snap Server from thedate of acquisition.

 

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**NOTE 4– SHORT-TERM AND OTHER INVESTMENTS**

 

Thefollowing table summarizes short-term investments by security type (inthousands):

 

**June30, 2008**

 
| ** **                  | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------|------------|---------------------|------------|------------------------------|------------|--------------------------------|------------|
|                        |       |                |       |                         |       |                           |       |
| Asset-backed securities     |       | $                   | 1,200      |                         | $          | 14                             |       | $ | 1,214 |   |
| Auction rate securities (1) |       | —              |       | —                       |       | —                         |       |
|                        |       | $                   | 1,200      |                         | $          | 14                             |       | $ | 1,214 |   |

 

----

(1)In the fourth quarter of fiscal 2008, auction rate securities were reclassifiedto other assets in the accompanying consolidated balance sheets.

 

**June30, 2007**

 
| ** **              | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Estimated  Fair  Value** | ** ** |
|-------------------------|------------|---------------------|------------|------------------------------|------------|----------------------------|------------|
|                    |       |                |       |                         |       |                       |       |
| Asset-backed securities |       | $                   | 4,322      |                         | $          | —                     |       | $ | 4,322 |   |
| Auction rate securities |       | 1,000               |       | —                       |       | 1,000                      |       |
|                    |       | $                   | 5,322      |                         | $          | —                     |       | $ | 5,322 |   |

 

Thefollowing table summarizes the contractual maturities of the Company’sshort-term investments (in thousands):

 

| ** **               | ** ** | **June 30,** | ** ** |
|--------------------------|------------|-------------------|------------|
| ** **               | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                     |       |              |       |   |   |
| Less than one year       |       | $                 | —     |   | $ | — |   |
| Due in one to two years  |       | 258               |       | — |   |
| Due in two to five years |       | —            |       | 329 |   |
| Due after five years     |       | 956               |       | 4,993 |   |
|                     |       | $                 | 1,214      |   | $ | 5,322 |   |

 

Asset-backedsecurities have been allocated within the contractual maturities table basedupon the set maturity date of the security. Realized gains and losses onshort-term investments are included in other income (expense), net, in theaccompanying consolidated statement of operations.

 

Thefollowing table summarizes gross realized gains and gross realized losses onthe Company’s short-term investments (in thousands):

 

| ** **                                   | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                         |       |                 |       |   |   |   |   |
| Realized gains                               |       | $                    | 35         |   | $ | — |   | $ | 1 |   |
| Realized losses                              |       |                 |       |   |   |   |   |
| Realized from sale of short-term investments |       | (16                  | )          | (107 | ) | (24 | ) |
|                                         |       | $                    | 19         |   | $ | (107 | ) | $ | (23 | ) |

 

Inaccordance with FASB Staff Position (FSP) FAS 115-1 and 124-1, *The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments,* the Company performed a review of its investmentsthat were in an unrealized loss position during fiscal 2008 and fiscal 2007.Based upon this review, management determined the losses to beother-than-temporary and recorded impairment losses of approximately $1.9million and $157,000, pre-tax, on its investments, including ARS instruments,during fiscal 2008 and 2007, respectively. This impairment is recorded in otherincome (expense), net, in the accompanying consolidated statements ofoperations. In the fourth quarter of fiscal 2008, the Company reclassified $3.1million of auction rate securities to other assets as a result of failedauctions in fiscal 2008.

 

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Asof June 30, 2008, the Company held auction rate securities, purchased ashighly rated (AAA) investment grade securities, with a par value of $5.0million which are collateralized by corporate debt obligations. Subsequent tofiscal year end 2008, the two ARS instruments held by the Company weredowngraded by Fitch Ratings from AAA to A+ and A, respectively. Thesesecurities, although not mortgage-backed, have experienced failed auctionsprimarily as a result of the impact sub prime mortgages have had on liquidityin the credit markets. As a result, the Company recognized other-than-temporaryimpairment losses in fiscal 2008 of approximately $1.9 million, pre-tax, onthese investments to reduce the value to their estimated $3.1 million as ofJune 30, 2008. The impairment losses are recorded in other expense, net, in theaccompanying consolidated statement of operations. As allowed by SFASNo. 115, *Accounting for Certain Investments in Debtand Equity Securities*, the Company elected to estimate the fairvalue of the auction rate securities using a discounted cash flow analysis.Taking into consideration the security terms the assumptions used by usincluded estimates of (i) when a successful auction would occur or thesecurities would be redeemed, (ii) a discount rate commensurate with theimplied risk associated with holding the securities including consideration ofthe recent ratings downgrades and (iii) future expected cash flow streams.If the auctions continue to fail, or the Company determines that one or more ofthe assumptions used in the estimate needs to be revised, the Company may berequired to record an additional impairment on these securities in the future.

 

TheCompany estimates of the fair value of the auction rate securities is based onthe probability weighted expected future cash flows associated with theinvestments as indicated. The Company may attempt to liquidate these securitiesto meet cash needs. The Company cannot predict whether the Company will be ableto liquidate these securities, and we expect that any liquidation in the nearterm will bring less than the value of these securities, as of June 30, 2008,based upon subsequent indicative bids. For example, indicative bids (i.e., onemeasure of the estimated liquidation value) from Deutsche Bank subsequent toyear-end for our ARS have ranged from a high of approximately $2.8 million atJuly 16, 2008 to a low of approximately $1.4 million at October 1, 2008, themost recent bid as of the date of this report. The Company does not believethis current estimate of the liquidation value represents the estimated fairvalue of the instruments as of the end of fiscal 2008. The indicative bids arenot based on active markets or orderly transactions between marketparticipants. However, it is possible that the Company may be required torecord additional impairments to these investments in future periods.

 

**NOTE 5 –COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS**

 

The following table summarizes inventories (inthousands):

 
| ** **      | ** ** | **June 30,** | ** ** |
|-----------------|------------|-------------------|------------|
| ** **      | ** ** | **2008**          | ** ** | **2007** | ** ** |
|            |       |              |       |   |   |
| Raw materials   |       | $                 | 9,383      |   | $ | 11,539 |   |
| Work in process |       | 710               |       | 1,134 |   |
| Finished goods  |       | 7,033             |       | 7,883 |   |
|            |       | $                 | 17,126     |   | $ | 20,556 |   |

 

Thefollowing table summarizes other current assets (in thousands):

 
| ** **                            | ** ** | **June 30,** | ** ** |
|---------------------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                                  |       |              |       |   |   |
| Prepaid third-party service contracts |       | $                 | 5,988      |   | $ | 4,760 |   |
| Prepaid insurance and services        |       | 977               |       | 1,108 |   |
| VAT & sales tax receivable        |       | 602               |       | — |   |
| Income tax receivable                 |       | 523               |       | 613 |   |
| Non-trade accounts receivable         |       | 172               |       | 158 |   |
| Other                                 |       | 304               |       | 314 |   |
|                                  |       | $                 | 8,566      |   | $ | 6,953 |   |

 

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The following table summarizes property andequipment (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                                      |       |              |       |   |   |
| Computer equipment                        |       | $                 | 454        |   | $ | 12,945 |   |
| Machinery and equipment                   |       | 444               |       | 7,930 |   |
| Leasehold improvements                    |       | 218               |       | 4,167 |   |
| Furniture and fixtures                    |       | 23                |       | 1,466 |   |
|                                      |       | 1,139             |       | 26,508 |   |
| Accumulated depreciation and amortization |       | —            |       | (15,456 | ) |
|                                      |       | $                 | 1,139      |   | $ | 11,052 |   |

 

Prior to the impairment oflong-lived assets, depreciation and amortization expense for property andequipment was $3.1 million, $3.2 million and $2.4 million, in fiscal 2008, 2007and 2006, respectively. The amounts in the table above have been reduced forthe impairment charge discussed in Note 2.

 

Thefollowing table summarizes accrued liabilities (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                                      |       |              |       |   |   |
| Deferred revenue – Service contracts |       | $                 | 13,066     |   | $ | 7,752 |   |
| Accrued expenses                          |       | 3,196             |       | 4,338 |   |
| Third-party service contracts payable     |       | 1,708             |       | 1,879 |   |
| Deferred revenue – Distributors      |       | 1,446             |       | 1,047 |   |
| Accrued market development funds          |       | 641               |       | 575 |   |
| VAT & sales taxes payable        |       | —            |       | 165 |   |
| Other                                     |       | 93                |       | 17 |   |
|                                      |       | $                 | 20,150     |   | $ | 15,773 |   |

 

Thefollowing table summarizes other long-term liabilities (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                                      |       |              |       |   |   |
| Deferred revenue – Service contracts |       | $                 | 4,340      |   | $ | 3,701 |   |
| Deferred rent                             |       | 1,283             |       | 1,245 |   |
| Other                                     |       | 212               |       | 287 |   |
|                                      |       | $                 | 5,835      |   | $ | 5,233 |   |

 

As of fiscal 2008 and 2007, the accounts receivablebalances consist entirely of accounts receivable trade balances, net ofallowance for doubtful accounts.

 

The following table summarizes the changes inallowance for doubtful accounts (in thousands):

 
| **Fiscal year** | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions  Charged to  Income** | ** ** | **Write-offs,  Net of  Recoveries** | ** ** | **Deductions  Credited to  Income** | ** ** | **Balance  at End  of Year** | ** ** |
|----------------------|------------|----------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
|                 |       |                                         |       |                                   |       |                                     |       |                                     |       |                                   |       |
| 2008                 |       | $                                            | 374        |                                   | $          | 127                                      |       | $                                        | 105        |                                   | $          | — |   | $ | 396 |   |
| 2007                 |       | 436                                          |       | 368                                    |       | 430                                      |       | —                                   |       | 374                                    |       |
| 2006                 |       | 298                                          |       | 159                                    |       | 21                                       |       | —                                   |       | 436                                    |       |
|                      |            |                                              |            |                                        |            |                                          |            |                                          |            |                                        |            |  |  |  |  |  |

 

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**NOTE 6– INTANGIBLE ASSETS**

 

Intangibleassets consist of the following (in thousands):

 
| ** **                              | ** ** | **June 30,** | ** ** |
|-----------------------------------------|------------|-------------------|------------|
| ** **                              | ** ** | **2008**          | ** ** | **2007** | ** ** |
|                                    |       |              |       |   |   |
| Acquired technology                     |       | $                 | 20,594     |   | $ | 20,594 |   |
| Impairment of Zetta acquired technology |       | (8,411            | )          | (8,411 | ) |
| Intangibles of Snap Server              |       |              |       |   |   |
| Acquired technology                     |       | 1,731             |       | — |   |
| Customer contracts and trade names      |       | 3,752             |       | — |   |
| Adjusted cost basis                     |       | 17,666            |       | 12,183 |   |
| Accumulated amortization                |       | (12,183           | )          | (10,452 | ) |
|                                    |       | $                 | 5,483      |   | $ | 1,731 |   |

 

Intangibleassets as of June 30, 2008 consist solely of the intangible assets acquired inthe June 2008 acquisition of Snap Server. The identifiable intangible assetsacquired in the Snap Server acquisition consist of existing and core technology(acquired technology), which has been assigned an estimated useful life of fouryears, and customer contracts and trade names, which have been assigned anestimated useful life of six years. The intangible assets will be amortized ona straight-line basis over the estimated useful lives of the assets. Estimatedamortization expense for intangible assets will be approximately $1.0 million,$1.0 million, $1.0 million, $1.1 million, $0.6 million and $0.7 million infiscal 2009, 2010, 2011, 2012, 2013 and thereafter, respectively.

 

Amortizationexpense of intangible assets was $1.7 million, $2.5 million and $4.5 millionduring fiscal 2008, 2007 and 2006, respectively. The technology acquired fromOkapi Software, Inc. in June 2003, was being amortized over five years and wasfully amortized at June 30, 2008. The technology acquired from Zetta was beingamortized over four years before its impairment in the first quarter of fiscal2007.

 

**NOTE 7– PROMISSORY NOTE ISSUED IN SNAP SERVER ACQUISITION**

 

Inconnection with the Snap Server acquisition in June 2008, the Company issued a$1.4 million promissory note in favor of Adaptec, Inc. which accrues interestat the rate of 4.0% per annum and is secured by inventory. Principal andinterest are due in one installment on June 27, 2009. At June 30, 2008, thenote had a principal balance of $1.4 million outstanding.

 

**NOTE 8– INCOME TAXES**

 

*FIN No. 48 Implementation*

 

In July 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in Income Taxes —An Interpretation of FASB Statement No. 109* (FIN No. 48).FIN No. 48 clarifies the accounting for uncertainty in income taxesrecognized in an entity’s financial statements in accordance with FASBStatement No. 109, *Accounting for IncomeTaxes*, and prescribes a recognition threshold and measurementattributes for financial statement disclosure of tax positions taken orexpected to be taken on a tax return. Under FIN No. 48, the impact of anuncertain income tax position must be recognized at the largest amount that is “morelikely than not” to be sustained upon audit by the relevant taxing authority.An uncertain income tax position will not be recognized if it has less than a50% likelihood of being sustained. Additionally, FIN No. 48 providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition.

 

The Company adopted the provisions of FINNo. 48 in fiscal 2008. The total unrecognized tax benefit as of the dateof adoption was $734,000, of which (i) $140,000 was recorded as a reduction ofincome taxes receivable, in other current assets, (ii) $262,000 was recorded inother long-term liabilities and (iii) $332,000 was recorded against thedeferred tax asset for which there is a full valuation allowance. As a resultof the implementation of FIN No. 48, the Company recognized an increase inthe liability for unrecognized tax benefits in the amount of $82,000, with acorresponding increase in its accumulated deficit. In addition, the Companyreduced its gross deferred tax assets by $80,000 for unrecognized tax benefits,which was offset by a reduction in its valuation allowance by the same amount.

 

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The following is a reconciliation of the cumulativeunrecognized tax benefits (in thousands):

 

| ** **                                                                                             | ** ** | **2008** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------|------------|
|                                                                                                   |       |     |       |
| Unrecognized tax benefits as of July 2,  2007 (including the cumulative effect increase)               |       | $        | 734        |   |
| Increase (decrease) in unrecognized tax  benefits for years prior to July 2, 2007                      |       | —   |       |
| Increase (decrease) in unrecognized tax  benefits for fiscal 2008                                      |       | —   |       |
| Decrease in unrecognized tax benefits  relating to settlements with tax authorities during fiscal 2008 |       | —   |       |
| Decrease in unrecognized tax benefit for  lapse of statute of limitations.                             |       | (225     | )          |
| Unrecognized tax benefits as of June 30,  2008                                                         |       | $        | 509        |   |

 

Included in the balance of unrecognized tax benefitsat June 30, 2008, are $509,000 of tax benefits that may affect theeffective tax rate, if recognized. Of this amount, $161,000 of tax benefit mayalso be impacted by an increase in the valuation allowance with no net affecton the effective tax rate, depending upon the Company’s financial condition atthe time the benefits are recognized.

 

The Company believes that it is reasonably possiblethat, in the next twelve months, the amount of unrecognized tax benefits may bereduced by up to $195,000. The reduction in unrecognized tax benefits wouldrelate to the settlement of pending claims for refund and the expiration ofstatute of limitations for certain years.

 

The Company recognizes interest and penaltiesrelated to unrecognized tax benefits in its provision for income taxes. Uponadoption of FIN No. 48 and through June 30, 2008, the Company did notrecord any material amounts of interest or penalties.

 

The Company is subject to taxation in the UnitedStates (state and federal) and also in certain foreign tax jurisdictions.Generally, the Company’s tax returns for fiscal 2004 and forward are subject toexamination by the U. S. federal tax authorities and fiscal 2003 and forwardare subject to examination by state tax authorities.

 

During fiscal 2008, the Company’s liability forunrecognized tax benefits decreased by $225,000 due to the expiration ofstatute of limitations for certain years. Of this amount, $171,000 was offsetby an increase in the valuation allowance, with no net affect on the effectivetax rate.

 

*Potential 382 Limitation*

 

Utilization of our net operating loss (NOL) and research anddevelopment (R&D) credit carryforwards may be subject to a substantialannual limitation due to ownership change limitations that may have occurred orthat could occur in the future, as required by Section 382 of the InternalRevenue Code of 1986, as amended (the Code), as well as similar stateprovisions. These ownership changes may limit the amount of NOL and R&Dcredit carryforwards that can be utilized annually to offset future taxableincome and tax, respectively. In general, an “ownership change” as defined bySection 382 of the Code results from a transaction or series oftransactions over a three-year period resulting in an ownership change of morethan 50 percentage points of the outstanding stock of a company by certainstockholders or public groups.

 

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TheCompany has not completed a study to assess whether an ownership change hasoccurred or whether there have been multiple ownership changes since theCompany became a “loss corporation” under the definition of Section 382.If the Company has experienced an ownership change, utilization of the NOL orR&D credit carryforwards would be subject to an annual limitation underSection 382 of the Code, which is determined by first multiplying thevalue of the Company’s stock at the time of the ownership change by theapplicable long-term, tax-exempt rate, and then could be subject to additionaladjustments, as required. Any limitation may result in expiration of a portionof the NOL or R&D credit carryforwards before utilization. Further, until astudy is completed and any limitation known, no amounts are being considered asan uncertain tax position or disclosed as an unrecognized tax benefit under FINNo. 48. Any carryforwards that expire prior to utilization as a result ofsuch limitations will be removed from deferred tax assets with a correspondingreduction of the valuation allowance. Due to the existence of the valuationallowance, it is not expected that any possible limitation will have an impacton the results of operations of the Company.

 

The components of (loss) income before income taxeswere as follows (in thousands):

 

| ** ** | ** ** | **Fiscal Year** | ** ** |
|------------|------------|----------------------|------------|
| ** ** | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|       |       |                 |       |   |   |   |   |
| Domestic   |       | $                    | (32,799    | ) | $ | (44,806 | ) | $ | (24,417 | ) |
| Foreign    |       | 1,172                |       | 970 |   | 1,106 |   |
|       |       | $                    | (31,627    | ) | $ | (43,836 | ) | $ | (23,311 | ) |

 

The provision for (benefit from) income taxes includesthe following (in thousands):

 

| ** **                                       | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|
| ** **                                       | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Current:                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | $                    | (87        | ) | $ | 132 |   | $ | (2,718 | ) |
| State                                            |       | 76                   |       | (55 | ) | (143 | ) |
| Foreign                                          |       | 409                  |       | 345 |   | 224 |   |
| Total current                                    |       | 398                  |       | 422 |   | (2,637 | ) |
|                                             |       |                 |       |   |   |   |   |
| Deferred                                         |       |                 |       |   |   |   |   |
| Federal                                          |       | —               |       | (134 | ) | (961 | ) |
| State                                            |       | —               |       | (13 | ) | (227 | ) |
| Foreign                                          |       | —               |       | — |   | — |   |
| Total deferred                                   |       | —               |       | (147 | ) | (1,188 | ) |
| Total provision for (benefit from) income  taxes |       | $                    | 398        |   | $ | 275 |   | $ | (3,825 | ) |

 

A reconciliation of income taxes computed by applyingthe federal statutory income tax rate of 34.0%****to(loss) income before income taxes to the total income tax provision (benefit)reported in the consolidated statements of operations is as follows (inthousands):

 

| ** **                                        | ** ** | **Fiscal Year** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                              |       |                 |       |   |   |   |   |
| U.S. federal income tax at statutory rate         |       | $                    | (10,753    | ) | $ | (14,904 | ) | $ | (7,926 | ) |
| State income taxes, net of federal benefit        |       | (1,069               | )          | (1,902 | ) | (1,231 | ) |
| Increase in valuation allowance                   |       | 11,668               |       | 17,214 |   | 5,114 |   |
| In-process research and development               |       | —               |       | — |   | 381 |   |
| Share-based compensation expense                  |       | 252                  |       | (30 | ) | 120 |   |
| Extraterritorial income exclusion benefit         |       | —               |       | — |   | (238 | ) |
| Tax exempt interest                               |       | —               |       | — |   | (65 | ) |
| Favorable IRS settlement and statute  expirations |       | (54                  | )          | (82 | ) | (51 | ) |
| Federal R&D tax credit                        |       | (27                  | )          | (178 | ) | (111 | ) |
| Permanent differences                             |       | 234                  |       | 72 |   | 92 |   |
| Other, net                                        |       | 147                  |       | 85 |   | 90 |   |
| Total provision for (benefit from) income  taxes  |       | $                    | 398        |   | $ | 275 |   | $ | (3,825 | ) |

 

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Deferred income taxes comprised (in thousands):

 

| ** **                                  | ** ** | **June 30,** | ** ** |
|---------------------------------------------|------------|-------------------|------------|
| ** **                                  | ** ** | **2008**          | ** ** | **2007** | ** ** |
| Deferred tax assets:                        |       |              |       |   |   |
| Net operating loss carryforward             |       | $                 | 21,781     |   | $ | 14,396 |   |
| Warranty                                    |       | 3,410             |       | 3,120 |   |
| Property and equipment                      |       | 2,242             |       | — |   |
| Tax credits                                 |       | 1,933             |       | 2,292 |   |
| Inventory                                   |       | 1,672             |       | 1,936 |   |
| Share-based compensation                    |       | 715               |       | 622 |   |
| Intangible assets                           |       | 714               |       | 139 |   |
| Vacation and deferred compensation          |       | 580               |       | 414 |   |
| Allowance for doubtful accounts             |       | 148               |       | 140 |   |
| Restructuring accrual                       |       | —            |       | 158 |   |
| Other                                       |       | 800               |       | 54 |   |
| Gross deferred tax asset                    |       | 33,995            |       | 23,271 |   |
|                                        |       |              |       |   |   |
| Deferred tax liabilities:                   |       |              |       |   |   |
| Property and equipment depreciation         |       | —            |       | (297 | ) |
| Purchased intangible assets                 |       | —            |       | (647 | ) |
| Gross deferred tax liability                |       | —            |       | (944 | ) |
| Valuation allowance for deferred tax assets |       | (33,995           | )          | (22,327 | ) |
| Net deferred tax asset                      |       | $                 | —     |   | $ | — |   |

 

The ultimate realization of the net deferred tax asset is dependentupon the generation of future taxable income during the periods in which thosetemporary differences become deductible. SFAS No. 109, *Accountingfor Income Taxes*, considers recent losses to be significant negativeevidence that is difficult to overcome by forecasts of future taxable income tosupport the realization of deferred tax assets. The Company is required torecord a valuation allowance to reduce its net deferred tax asset to the amountthat management believes is more likely than not to be realized. As of June 30,2006, the Company performed an assessment of its deferred tax assets anddetermined that it was appropriate to establish a full-valuation allowanceagainst its net deferred tax asset. The Company continues to maintain a fullvaluation allowance at June 30, 2008 against its net deferred tax asset.

 

At June 30, 2008, the Company has federal and state net operating losscarryforwards of approximately $58.7 million and $38.8 million, respectively.These amounts include share-based compensation deductions of approximately$950,000 which will be recorded to contributed capital when realized. Theremaining federal net operating loss will begin expiring in 2023, unlesspreviously utilized. State net operating loss carryforwards generally begin toexpire in 2016, unless previously utilized.

 

At June 30, 2008, the Company had federal and California researchand development tax credit carryforwards totaling approximately $600,000 and$1.6 million, respectively. The California research credit may be carriedforward indefinitely. The federal research credit will begin expiring in 2025,unless previously utilized. In addition, the Company has foreign tax creditcarryforwards totaling approximately $308,000, which will begin expiring in2015, unless previously utilized. The Company has federal alternative minimumtax credit carryforwards totaling $187,000 that can be carried forwardindefinitely.

 

**NOTE 9 –COMMON STOCK**

 

***Share repurchase program***

 

InOctober 2005, the Company’s Board of Directors expanded the Company’sshare repurchase program to allow for the purchase of up to 2.5 million sharesof its common stock with no fixed dollar amount. In October 2006, the Company’sBoard of Directors terminated the share repurchase program. There were no sharerepurchases after the first quarter of fiscal 2007. During fiscal 2007, anaggregate of approximately 373,000 shares were repurchased at a cost ofapproximately $2.7 million pursuant to the repurchase program. During fiscal2006, an aggregate of 1.3 million shares were repurchased at a cost ofapproximately $10.8 million pursuant to the repurchase program.

 

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**NOTE 10 –SHARE-BASED COMPENSATION**

 

***Stock Option Plans***

 

The Company has five active stock option plans, eachadministered by a Committee of the Board of Directors, which provide for theissuance of options to employees, officers, directors and consultants. As ofJune 30, 2008, the Company had reserved an aggregate of 7.7 million shares ofcommon stock for issuance under the 1995 Stock Option Plan, 1997 ExecutiveStock Option Plan, 2000 Stock Option Plan, 2001 Supplemental Stock Option Plan(2001 Plan) and the 2003 Equity Incentive Plan (2003 Plan) (collectively, theOption Plans). The Option Plans provide for the granting of stock options. Inaddition, the 2003 Plan provides for the granting of restricted stock and stockappreciation rights (collectively, stock awards). The Option Plans have beenapproved by shareholders with the exception of the 2001 Plan. Currently, theCompany may grant new awards only from the 2003 Plan. The Company’s 2003 Planprovides for an automatic annual grant to non-employee directors ofnon-statutory options to purchase 18,000 shares of common stock.

 

Certain options issued under selected plans allow for100% vesting of outstanding options upon a change of control of the Company (ifreplacement options are not issued) or upon death or disability of theoptionee. Options granted generally vest over a three-year period. Optionsgenerally expire after a period not to exceed ten years, except in the event oftermination, whereupon vested shares must be exercised generally within threemonths under the 2003 Plan and within 30 days under the other Option Plans, orupon death or disability, where an extended six- or twelve-month exerciseperiod is specified. As of June 30, 2008, approximately 2.6 million shares werereserved for issuance upon exercise of outstanding options and approximately1.6 million shares were available for grant under the Option Plans.

 

Thefair value of each option award is estimated on the date of grant using theBlack-Scholes option pricing model which uses the weighted-average assumptionsnoted in the following table. Separate groups of employees that have similarhistorical exercise behavior are being considered separately in determiningcertain valuation assumptions. Expected volatilities are based on thehistorical volatility (using daily pricing) of the Company’s stock. Uponadoption of SFAS No. 123(R), the Company now applies a forfeiture rate,based upon historical pre-vesting option cancellations. The expected term ofoptions granted is estimated based on a number of factors, including but notlimited to the vesting term of the award, historical employee exercise behavior(for both options that have run their course and outstanding options), theexpected volatility of the Company’s stock and an employee’s average length ofservice. The risk-free interest rate is determined based upon a U.S. constantrate Treasury Security with a contractual life which approximates the expectedterm of the option award. Weighted-average ranges below result from certaingroups of employees exhibiting different behavior:

 

| ** **               | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                     |       |                 |       |   |   |   |   |
| Expected volatility      |       | 52.1-53.1            | %          | 63.6-65.9 | % | 72.2-74.1 | % |
| Risk-free interest rate  |       | 4.1-4.2              | %          | 4.6-4.8 | % | 4.3-4.4 | % |
| Dividend yield           |       | —               |       | — |   | — |   |
| Expected term (in years) |       | 3.1-3.4              |       | 5.5-6.4 |   | 5.6-5.9 |   |

 

Thestock option activity is summarized below (shares and aggregate intrinsic valuein thousands):

 

| ** **                                | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------|------------|------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
|                                      |       |       |       |                                    |       |                                                              |       |                            |       |
| Options outstanding at June 30, 2007 |       | 1,786      |       | $                                       | 10.63      |                                                              |       |                            |       |   |
| Granted                                   |       | 1,918      |       | 1.57                                    |       |                                                              |       |                            |       |
| Exercised                                 |       | —     |       | —                                  |       |                                                              |       |                            |       |
| Canceled/forfeited                        |       | (1,067     | )          | 10.55                                   |       |                                                              |       |                            |       |
| Options outstanding at June 30, 2008      |       | 2,637      |       | $                                       | 4.08       |                                                              | 3.20       |                            | $          | — |   |
| Exercisable outstanding at June 30, 2008  |       | 2,118      |       | $                                       | 4.69       |                                                              | 3.25       |                            | $          | — |   |

 

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During fiscal 2008, 2007 and 2006, the Companyrecorded share-based compensation associated with outstanding stock optiongrants of approximately $1.0 million, $285,000 and $1.4 million, respectively.As of June 30, 2008, there was $120,000 of total unrecognized compensationexpense related to non-vested stock options granted under the Option Plans.This expense is expected to be recognized over a weighted-average period of0.82 years. The following table summarizes information about stock options forfiscal 2008, 2007 and 2006 (in thousands, except per share amounts):

 

| ** **                                                                                 | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                 | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                       |       |                 |       |   |   |   |   |
| Weighted-average grant date fair value per  share of options granted with exercise prices: |       |                 |       |   |   |   |   |
| Less than fair value                                                                       |       | $                    | —     |   | $ | — |   | $ | — |   |
| Equal to fair value                                                                        |       | 0.63                 |       | 3.07 |   | 5.49 |   |
| Greater than fair value                                                                    |       | —               |       | 3.90 |   | — |   |
| Intrinsic value of options exercised                                                       |       | —               |       | 6 |   | 502 |   |
| Cash received upon exercise of stock  options                                              |       | —               |       | 16 |   | 1,918 |   |
| Actual tax benefit realized for the tax  deductions from option exercise                   |       | —               |       | — |   | — |   |
| Total income tax benefit recognized in the  statement of operations                        |       | —               |       | — |   | — |   |
|                                                                                            |            |                      |            |  |  |  |  |  |  |  |

 

InNovember 2005, the Company’s Board of Directors extended the term of 97,000fully vested options held by a former director. As a result of thatmodification, the Company recognized additional compensation expense ofapproximately $47,000 during the second quarter of fiscal 2006.

 

***Restricted Stock Awards***

 

InApril 2005, the Company issued two restricted stock awards for 50,000shares each to its former CEO. At June 30, 2007, 16,667 shares were vested,83,333 shares were canceled and no shares were subject to repurchase. Theawards are described separately below.

 

Thefirst award (the Service Award) vested as follows: 16,667 shares, 16,667 sharesand 16,666 shares on January 1, 2006, 2007 and 2008, respectively. Inaccordance with APB No. 25, the Service Award was a fixed award and, assuch, compensation expense was recorded for the fair value of the Company’scommon stock less any amounts paid by the employee. The fair value of theService Award was $10.86 per share (the market value of the stock on the dateof issuance) or $543,000, which was recorded as deferred compensation under APBNo. 25. In November 2006, in connection with the termination of the CEO, theunvested shares reverted to the Company and the Company reversed $170,000 ofshare-based compensation expense previously recognized associated with sharescanceled prior to vesting. Compensation expense recorded during fiscal 2006(under SFAS No. 123(R)) totaled approximately $300,000. See Note 1, *Change in Accounting Principle and Accounting for Share-BasedCompensation*.

 

Thesecond award (the Market Award) vested as follows: 12,500 shares, 12,500 sharesand 25,000 shares, if the volume weighted daily average stock price of theCompany for ten consecutive trading days were to reach $20.00, $25.00 and$30.00 (collectively, the target stock price), respectively, on or beforeJanuary 1, 2008. Based upon the market values of the Company’s commonstock through June 30, 2005, satisfaction of the vesting conditions was notconsidered probable by management and therefore no compensation expense wasrecorded under APB No. 25. Upon adoption of SFAS No. 123(R), the Companybegan recognizing compensation expense associated with this award. Theweighted-average grant date fair value of this restricted stock award wasestimated at $5.73, using a trinomial option pricing model based on thefollowing assumptions: expected volatility of 54.2%, risk-free interest rate of3.8%, dividend yield of 0.0% and an expected term of 978 days. Commencing withthe adoption of SFAS No. 123(R), expense was recognized in theaccompanying consolidated statement of operations with offsetting credits tocommon stock. In November 2006, in connection with the termination of the CEO,the unvested shares reverted to the Company and the Company reversed allpreviously recorded share-based compensation expense of $77,000 as all sharescomprising the Market award canceled prior to vesting. Compensation expenserecorded during fiscal 2006 totaled approximately $77,000.

 

InAugust 2005, the Company issued an aggregate of 64,625 restricted sharesof common stock to new hires, 15,000 shares of which vested annually over aperiod of three years in equal increments and 49,625 shares of which vestedannually over a period of five years in equal increments, in each case subjectto continuing service by the recipient of the restricted 

 

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stock. The fair value of the restricted stockwas $7.84 per share (the market value of the stock on the date of issuance) or$506,660 and was to be recorded to compensation expense, net of relatedforfeitures, over the requisite service periods of the awards. In fiscal 2007,$113,000 of share-based compensation expense previously recorded was reverseddue to the cancellation of shares prior to vesting in excess of the amountpreviously estimated. Compensation expense recorded during fiscal 2006 wasapproximately $183,000. At June 30, 2007, 9,075 shares were vested, 55,550shares were canceled and no shares were subject to repurchase.

 

Duringfiscal 2008, there was no activity related to restricted stock awards and as ofJune 30, 2008, the Company had no restricted stock awards outstanding

 

The following table summarizes information aboutrestricted stock awards vested during fiscal 2008, 2007 and 2006 (inthousands):

 

| ** **                                    | ** ** | **Fiscal Year** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                          |       |                 |       |   |   |   |   |
| Fair value of vested restricted stock  awards |       | $                    | —     |   | $ | 62 |   | $ | 134 |   |
|                                               |            |                      |            |  |  |  |  |  |  |  |

 

***1996 and 2006 Employee Stock Purchase Plans***

 

In February 1997, the Company adopted the 1996Employee Stock Purchase Plan (1996 ESPP), which expired January 31, 2007. The2006 Employee Stock Purchase Plan (2006 ESPP) replaced the 1996 ESPP effectiveFebruary 1, 2007. A total of 500,000 shares of common stock have been reservedunder the 2006 ESPP for issuance and purchase by employees of the Company toassist them in acquiring a stock ownership interest in the Company and toencourage them to remain employees of the Company. The 2006 ESPP is qualifiedunder Section 423 of the Internal Revenue Code and permits eligibleemployees to purchase common stock at a discount through payroll deductions duringspecified six-month offering periods. No employee may purchase more than$25,000 worth of stock in any calendar year or 1,500 shares in any one offeringperiod.

 

Effective with the offering period beginning inAugust 2005, the purchase price of common stock under the 1996 ESPP wasdetermined as either (i) a percentage not less than 85.0% (the DesignatedPercentage), subject to the Compensation Committee’s discretion of the fairmarket value of the common stock on the last day of the offering period or (ii) thelower of (a) the Designated Percentage of the fair market value of thecommon stock on the first day of the offering period or (b) the DesignatedPercentage of the fair market value of the common stock on the last day of theoffering period. In August 2005, the Compensation Committee of the Boardof Directors determined the purchase price to be 95.0% of the fair market valueof the common stock on the last day of each offering period, beginning with theAugust 2005 offering. As a result, commencing with the August 2005offering period, the 1996 ESPP will no longer be compensatory under SFAS No.123(R). Expense prior to this date was not significant. The 2006 ESPP uses thesame designated percentage as the 1996 ESPP.

 

During fiscal 2008, 2007 and 2006, approximately16,000, 23,000 and 54,000 shares, respectively, were issued under the 1996 ESPPand the 2006 ESPP for combined proceeds of approximately $26,000, $127,000 and$338,000, respectively. As of June 30, 2008, approximately 484,000 shares were availableunder the 2006 ESPP.

 

#### **NOTE 11 – 401(k) PLAN**

####  

The Company maintains an employee savings andretirement plan (the 401(k) Plan) covering all of the Company’s employees. The401(k) Plan permits but does not require matching contributions by the Companyon behalf of participants. The Company matches employee contributions at 75%,up to 6% of an employee’s pretax income. The totals of these employercontributions were $558,000, $714,000 and $777,000 in fiscal 2008, 2007 and2006, respectively.

 

**NOTE 12– COMMITMENTS AND CONTINGENCIES**

 

**Leases**

 

TheCompany leases its office, production and sales facilities under non-cancelableoperating leases, which expire in various years through fiscal year 2018. Theleases provide for biennial or annual rent escalations intended to approximateincreases in cost of living indices, and certain of the leases provide for rentabatement. The Company has a one five-year 

 

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option to renew its lease on its San Diegoheadquarters facility. Future minimum lease payments under these arrangementsare as follows (in thousands):

 

| ** **  | ** ** | **Minimum  Lease  Payments** | ** ** |
|-------------|------------|------------------------------|------------|
|        |       |                         |       |
| Fiscal 2009 |       | $                            | 4,211      |   |
| Fiscal 2010 |       | 3,974                        |       |
| Fiscal 2011 |       | 3,544                        |       |
| Fiscal 2012 |       | 3,573                        |       |
| Fiscal 2013 |       | 3,679                        |       |
| Thereafter  |       | 3,732                        |       |
|        |       | $                            | 22,713     |   |

 

Rentalexpense is recognized on a straight-line basis over the respective lease termsand approximated $4.0 million, $4.1 million and $4.0 million in fiscal 2008,2007 and 2006, respectively.

 

**Litigation**

 

Fromtime to time, the Company may be involved in various lawsuits, legalproceedings or claims that arise in the ordinary course of business. Managementdoes not believe any legal proceedings or claims pending at June 30, 2008 willhave, individually or in the aggregate, a material adverse effect on itsbusiness, liquidity, financial position or results of operations. Litigation,however, is subject to inherent uncertainties, and an adverse result in theseor other matters may arise from time to time that may harm the Company’s business.

 

**NOTE 13– SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

Thefollowing tables present selected quarterly financial information (inthousands, except per share data) for the periods indicated. This informationhas been derived from the Company’s unaudited quarterly consolidated condensedfinancial statements, which in the opinion of management include alladjustments (consisting only of normal recurring adjustments) necessary for afair statement of such information. The quarterly per share amounts presentedbelow were calculated separately and may not sum to the annual figurespresented in the accompanying consolidated statement of operations. Theseoperating results are also not necessarily indicative of results for any futureperiod.

 

 

| ** **               | ** ** | **Fiscal 2008** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **Q1**               | ** ** | **Q2** | ** ** | **Q3** | ** ** | **Q4** | ** ** | **Total** | ** ** |
| ** **               | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue              |       | $                    | 32,901     |   | $ | 34,060 |   | $ | 31,794 |   | $ | 28,945 |   | $ | 127,700 |   |
| Gross profit             |       | 6,472                |       | 7,782 |   | 7,697 |   | 6,105 |   | 28,056 |   |
| Loss from operations     |       | (4,654               | )          | (6,091 | ) | (4,672 | ) | (15,041 | ) | (30,458 | ) |
| Loss before income taxes |       | (4,466               | )          | (6,349 | ) | (4,864 | ) | (15,948 | ) | (31,627 | ) |
| Net loss                 |       | (4,521               | )          | (6,504 | ) | (4,935 | ) | (16,065 | ) | (32,025 | ) |
|                     |       |                 |       |   |   |   |   |   |   |   |   |
| Net loss per share:      |       |                 |       |   |   |   |   |   |   |   |   |
| Basic and diluted        |       | $                    | (0.35      | ) | $ | (0.51 | ) | $ | (0.39 | ) | $ | (1.26 | ) | $ | (2.51 | ) |

 

| ** **               | ** ** | **Fiscal 2007** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **Q1**               | ** ** | **Q2** | ** ** | **Q3** | ** ** | **Q4** | ** ** | **Total** | ** ** |
| ** **               | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue              |       | $                    | 41,827     |   | $ | 46,760 |   | $ | 37,798 |   | $ | 34,058 |   | $ | 160,443 |   |
| Gross profit             |       | 5,298                |       | 7,859 |   | 5,032 |   | 6,154 |   | 24,343 |   |
| Loss from operations     |       | (20,587              | )          | (9,215 | ) | (9,203 | ) | (5,840 | ) | (44,845 | ) |
| Loss before income taxes |       | (19,985              | )          | (8,960 | ) | (9,066 | ) | (5,825 | ) | (43,836 | ) |
| Net loss                 |       | (19,997              | )          | (8,889 | ) | (9,203 | ) | (6,022 | ) | (44,111 | ) |
|                     |       |                 |       |   |   |   |   |   |   |   |   |
| Net loss per share:      |       |                 |       |   |   |   |   |   |   |   |   |
| Basic and diluted        |       | $                    | (1.54      | ) | $ | (0.70 | ) | $ | (0.72 | ) | $ | (0.47 | ) | $ | (3.45 | ) |

 

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**NOTE 14– SUBSEQUENT EVENTS**

 

*Downgrade of Auction Rate Securities Rating*

 

InJuly 2008, the two ARS instruments held by the Company were downgraded by FitchRatings from AAA to A+ and A, respectively. As a result, the coupon rate on thesecurities has increased and is expected to continue to increase. The impact onthe fair value of the Company’s auction rate securities were evaluated as ofJune 30, 2008 as the conditions that gave rise to the downgrade existed at June30, 2008 and were considered to have a material impact on the value of the ARSinstruments. Accordingly, the loss has been reported in the Company’sconsolidated financial statements as if the downgrades had occurred prior toJune 30, 2008. See Note 4 for discussion of the fair value of the ARSinstruments.

 

*401(k)Plan*

 

EffectiveOctober 20, 2008, the Company will discontinue making bi-weekly matchingcontributions under its 401(k) Plan. The Company continues to be able to makediscretionary contributions as considered appropriate.

 

*Restructuring*

 

In August2008, the Company reduced the employee workforce by 13% worldwide, or by 53employees, in accordance with the Company’s initiatives to reduce costs andrestructure its workforce. Severance costs, including COBRA, related to theterminated employees are estimated to be $340,000 and will be recorded and paidin the Company’s first and second quarters of fiscal 2009.

 

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