**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

FORM 10-K

**Annual report pursuant to section 13 or 15(d) oftheSecurities Exchange Act of 1934**

**Forthe fiscal year ended December 31, 2003**

**Commissionfile number 000-26887**

----

Silicon Image, Inc.

(Exact name of registrant as specified in its charter)

 
| **Delaware**              | **77-0396307**                        |
|---------------------------|---------------------------------------|
| (State of  incorporation) | (IRS employer  identification number) |

 

**1060 East Arques AvenueSunnyvale, CA 94085**

(Address of principalexecutive offices and zip code)

**(408) 616-4000**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant to section 12(g) ofthe Act:

**CommonStock, $0.001 par value**

----

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

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K o

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 under the SecuritiesExchange Act of 1934). Yes xNo o

The aggregate market value of voting and non-votingcommon equity held by non-affiliates at June 30, 2003 was approximately$359,084,000, based on the last reported sale price of our common shares on theNASDAQ Stock Market on that date of $5.50 per share. We had 65,288,000 commonshares outstanding at June 30, 2003.

Part IIIincorporates by reference information from our proxy statement for our annualmeeting of stockholders’ to be held on May 25, 2004.

 

----

**TABLE OF CONTENTS**

** **
| **Part I**                                           |   |                                                                                            |   |   |
|-----------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------|--------|--------|
| Item 1                                                    |   | Business                                                                                        |   | 1      |
| Item 2                                                    |   | Properties                                                                                      |   | 18     |
| Item 3                                                    |   | Legal Proceedings                                                                               |   | 18     |
| Item  4                                                   |   | Submission of Matters to a Vote of Securities  Holders                                          |   | 21     |
| **Part II**                                          |   |                                                                                            |   |   |
| Item  5                                                   |   | Market  for the Registrant’s Common Stock and Related Stockholder Matters                  |   | 22     |
| Item 6                                                    |   | Selected Financial Data                                                                         |   | 23     |
| Item  7                                                   |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations     |   | 24     |
| Item  7A                                                  |   | Quantitative and Qualitative Disclosure of Market  Risk                                         |   | 68     |
| Item  8                                                   |   | Financial Statements and Supplementary Data                                                     |   | 68     |
| Item  9                                                   |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure           |   | 68     |
| Item 9A                                                   |   | Controls and Procedures                                                                         |   | 68     |
| **Part III**                                         |   |                                                                                            |   |   |
| Item  10                                                  |   | Directors and Executive Officers of the Registrant                                              |   | 70     |
| Item 11                                                   |   | Executive Compensation                                                                          |   | 70     |
| Item  12                                                  |   | Security Ownership of Certain Beneficial Owners  and Management and Related Stockholder Matters |   | 70     |
| Item  13                                                  |   | Certain Relationships and Related Transactions                                                  |   | 70     |
| Item 14                                                   |   | Principal Accountant Fees and Services                                                          |   | 70     |
| **Part IV**                                          |   |                                                                                            |   |   |
| Item  15                                                  |   | Exhibits, Financial Statement Schedules, and  Reports on Form 8-K                          |   | 70     |
| Signatures                                                |   | 107                                                                                             |
| Index to Exhibits  Filed Together with this Annual Report |   | 108                                                                                             |

 

----

*This reportcontains forward-looking statements within the meaning of Section 21E ofthe Securities and Exchange Act of 1934 and Section 27A of the SecuritiesAct of 1933. These forward-looking statements involve a number of risks anduncertainties, including those identified in the section of this Form 10-Kentitled “Factors Affecting Future Results,” that may cause actual results todiffer materially from those discussed in, or implied by, such forward-lookingstatements. Forward-looking statements within this Form 10-K areidentified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,”“will” and other similar expressions. However, these words are not the onlymeans of identifying such statements. In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances are forward-looking statements. We undertake no obligation topublicly release the results of any revisions to these forward-lookingstatements that may be made to reflect events or circumstances occurringsubsequent to the filing of this Form 10-K with the SEC. Our actualresults could differ materially from those anticipated in, or implied by,forward-looking statements as a result of various factors, including the risksoutlined elsewhere in this report. Readers are urged to carefully review andconsider the various disclosures made by Silicon Image, Inc. in thisreport and in our other reports filed with the SEC that attempt to adviseinterested parties of the risks and factors that may affect our business.*

**PART I**

**Item1. Business**

Silicon Image is a leader in multi-gigabitsemiconductor solutions for the secure transmission, storage and display ofrich digital media. The company’s mission is to be the leader in defining thearchitectures, intellectual property (IP) and semiconductor technology requiredto build secure digital content delivery systems. To ensure that rich digitalcontent is always available on any device, consumer electronics (“CE”), personalcomputers (“PC”) and storage devices must be architected for contentcompatibility and interoperability*.*

Silicon Image’s strategy entails establishingindustry-standard, high-speed digital interfaces and building market momentumand leadership through its first-to-market, standards-based IC products. Furtherleveraging its strong IP portfolio, the company broadens market adoption of theDigital Visual Interface (DVI), High-Definition Multimedia Interface (HDMI) andSerial ATA (SATA) interfaces by licensing its proven IP cores to companiesproviding advanced system-on-a-chip solutions incorporating these interfaces. Licensing,in addition to creating revenue and return on engineering investment in marketsegments we choose not to address, creates products complementary to our ownthat expand the markets for our products and help to improve industry wideinteroperability.

Silicon Image is a leader in the global PC/displayarena with its innovative PanelLink® digital interconnecttechnology, which enables an all-digital connection between PC host systems anddigital displays such as LCD monitors, plasma displays and projectors. PanelLinktechnology is the basis for the DVI industry standard the company pioneered andremains the most popular DVI implementation with more than 40 million unitsshipped to date.

In 2000, in order to decrease our absolute dependenceon the PC business, we embarked upon a plan to diversify into the CE andstorage markets. Products sold into the PC market have been declining as apercentage of our total revenues and generated 32% of our revenue in 2003, 58%of our revenue in 2002, and 70% of our revenue in 2001.

Leveraging our core technology and standards-settingexpertise, Silicon Image is driving HDMI, the new digital interface standardfor the consumer electronics market. Introduced by founders Hitachi, Matsushita(Panasonic), Philips, Silicon Image, Sony, Thomson and Toshiba, HDMI enablesthe distribution of uncompressed, high-definition video and multi-channel audioin a single, all-digital interface that dramatically simplifies cabling. SiliconImage’s HDMI technology is marketed under the PanelLink CinemaTM brand andincludes High-bandwidth Digital Content Protection (HDCP), which is supportedby certain Hollywood studios as the technology of choice for the securedistribution of premium 

1

----

content. The PanelLinkCinema chip and the first HDMI-compliant silicon are on the market and arefeatured in the world’s first consumer electronics products with HDMI functionality.

Products sold into the CE market have been increasingas a percentage of our total revenues and generated 25% of our revenue in 2003,11% of our revenue in 2002, and 8% of our revenue in 2001. Our CE productsoffer a securable interface for transmission of digital video and audio toconsumer devices, such as digital TVs and DVD players. Demand for theseproducts will be driven primarily by the adoption rate of new technologies,such as HDMIand HDCP.

In the storage market, Silicon Image has assumed aleadership role in SATA, the new high-bandwidth, point-to-point interface thatis replacing Parallel ATA in desktop storage and making inroads in theenterprise arena due to its price/performance. Silicon Image is a leadingsupplier of discrete SATA devices with hundreds of motherboard and add-in-carddesign wins. Silicon Image’s SATALinkTM-branded solutions are fully SATA-compliantand offer advanced features and capabilities such as Native Command Queuing,port multiplier capability and ATAPI support. Silicon Image also supplieshigh-performance, low-power Fibre Channel Serializer/Deserializer (SerDes) toleading switch manufacturers.

Semiconductor products sold into the storage markethave been increasing as a percentage of our total revenues and generated 27% ofour revenue in 2003, 15% of our revenue in 2002, and 5% of our revenue in 2001.Demand for our storage semiconductor products is dependent upon the rate atwhich interface technology transitions from parallel to serial, and the extentto which SATA and fibre channel functionality are integrated into chip sets andcontrollers offered by other companies, which would make our discrete devicesunnecessary.

Sales of storage subsystems products generated 2% ofour revenue in 2003, 8% of our revenue in 2002, and 17% of our revenue in 2001.We are phasing out our storage subsystems products. In conjunction with ourdecision to phase out our storage subsystems products, we decided to designproducts for and/or license our technology to third parties in this market.

We also derive revenue from licensing our intellectualproperty and related development activities. Our licensing activity iscomplementary to our product sales because we believe this activity can help usmonetize our intellectual property as well as accelerate adoption curvesassociated with our technology. Most of our licenses include a field of userestriction that prevents the licensee from building a chip in directcompetition with those market segments we have chosen to pursue. Revenue fromdevelopment, licensing and royalties (collectively, “licensing”) accounted for14%, 8% and 0% of our revenues and represented 25%, 16% and 0% of our totalgross margin for 2003, 2002, and 2001, respectively. Licensing contracts arecomplex and depend upon many factors including completion of milestones, allocationof values to delivered items, and customer acceptances. Although we attempt tomake these factors predictable, many of these factors require significantjudgments. Licensing revenues have fluctuated significantly from period toperiod and may continue to do so in the future; because of their high margincontent licensing revenues can have a disproportionate impact on gross marginsand profitability.

In October 1999, we raised approximately $48.0million in our initial public offering. We have incurred losses in all but onequarterly period since our inception and, as of December 31, 2003, we hadan accumulated deficit of $172.7 million.

Prior to 2000 we focused most of our efforts on thesale and development of PanelLink transmitters, receivers and controllers forthe PC/Display market. In 2000, we began focusing our resources on entering twonew markets, storage and CE, which we believed would grow significantly and inwhich we believed we could apply our technology and expertise in high-speedserial interfaces. During 2000, we acquired Zillion Technologies (“Zillion”), adeveloper of high-speed transmission technology for data storage applications,and DVDO, a provider of digital video processing systems for the CE market.

2

----

In 2001, we focused on accelerating our entry into theCE and storage markets, leveraging our IP into licensing revenue andrestructuring the company to improve profitability. During 2001, we acquiredCMD Technologies (“CMD”), a provider of storage subsystems and semiconductorsdesigned for storage area networks, and Silicon Communications Lab (“SCL”), aprovider of mixed-signal and high-speed circuit designs.

During 2002, we achieved double-digit sequentialrevenue growth in each fiscal quarter, resulting in record annual revenue of $81.5million, which was a 57% increase from 2001 revenue levels. We also began tosee the benefits of our diversification strategy, which resulted inestablishing a presence in the CE and storage markets, both of which areexpected to experience strong growth rates during the next several years.Additionally, we were able to successfully leverage our IP to generate $6.7million of development, licensing and royalty revenue. We also focused onimproving our profitability and reducing our cash usage rate.

During 2003, we achieved significant growth, resultingin record annual revenue of $103.5 million, representing a 27% increasecompared to 2002. We were also able to continue to take advantage of ourdiversification strategy effectively, which resulted in our being able tofurther expand our presence into the CE and storage markets, both of which weexpect will continue to experience significant growth rates during the nextseveral years. Additionally, we continued to successfully leverage ourintellectual property and generated $14.2 million of development, licensing androyalty revenue.

On April 7, 2003, we issued approximately2,501,000 shares of common stock in exchange for all outstanding shares ofTransWarp Networks (“TWN”)capital stock, and converted all outstanding TWN options into options topurchase approximately 760,000 shares of our common stock. The purchase pricefor this acquisition was approximately $14.5 million. Approximately 392,000shares of our issued common stock will be held in escrow for a period ofeighteen months as collateral for indemnity obligations of the principal TWNstockholders.  We also assumed TWN’s 2002 Stock Option / StockIssuance Plan, under which a reserve of approximately 116,000 shares of ourcommon stock remained available for future issuance. This transaction has beenaccounted for as an asset purchase. We expensed $5.5 million of in-processresearch and development and recorded tangible and intangible assets of $4.2million in connection with this transaction.

On July 15, 2003, theFederal District Court in Richmond, Virginia, upheld our interpretation of apreviously agreed upon Memorandum of Understanding (MOU) with GenesisMicrochip, Inc (“Genesis”). On August 6, 2003, the Court entered a final judgmentbased on its July 15, 2003 ruling. Under the final judgment order, Genesiswas ordered to make a substantial cash payment, and make royalty payments; although Genesis has made and continues tomake cash payments to the Court, it may not have made all the payments that arerequired under the final judgment order. We have filed motions forreimbursement of some of our expenses, including some of our legal fees, andfor modification and/or clarification of certain items of the judgment, and tohold Genesis in contempt of Court for breaching the protective order in thecase by disclosing secret information to at least one of our competitors. On December 19,2003, the Court granted our motions in part and denied them in part: the courtissued an amended judgment, and held Genesis in contempt of Court for breachingthe protective order. On January 16, 2004, Genesis filed a notice ofappeal. To date, we have not received any cash nor have we recognizedany revenue associated with this litigation. Under the settlement agreement,Genesis was granted a royalty-bearing license for the right to use certainnon-necessary patent claims referred to in the DVI Adopters Agreement. Inaddition, upon Genesis’s becoming a signatory to the HDMI Adopters Agreement,Genesis will be granted a royalty-bearing license for the right to use theseclaims as part of their HDMI implementation. Genesis also was granted aroyalty-bearing license to expand use of certain DVI-related patent claims tothe consumer electronics marketplace.

3

----

**Markets and Customers**

We focus our sales and marketing efforts on achievingdesign wins with leading original equipment manufacturers (“OEMs”) of PC, CEand storage products. In most cases, these OEMs outsource manufacturingfunctions to third parties. Therefore, once our product is designed into an OEM’sproduct, we typically work with the OEM’s third party manufacturer to ready thedesign for production. Once the design is complete, we sell our products tothese third party manufacturers either directly or indirectly throughdistributors.

Historically, a relativelysmall number of customers and distributors have generated a significant portionof our revenue. Our top five customers, including distributors, generated 41%,41%, and 51% of our revenue in 2003, 2002 and 2001, respectively. The decreasein 2003 and 2002 from 2001 levels can be attributed to the success of ourmarket diversification strategy. Additionally, the percentage of revenuegenerated through distributors tends to be significant, since many OEMs relyupon third party manufacturers or distributors to provide purchasing andinventory management functions. In 2003, 42% of revenue was generated throughdistributors, compared to 42% in 2002 and 40% in 2001. Our licensing revenue isnot generated through distributors, and to the extent licensing revenueincreases, we would expect a decrease in the percentage of our revenuegenerated through distributors. A substantial portion of our business isconducted outside the United States; as a result we are subject to foreignbusiness, political and economic risks. Nearly all our products aremanufactured in Taiwan or elsewhere in Asia and for the years ended December 31,2003, 2002 and 2001, 74%, 72% and 79% of our revenue, respectively, wasgenerated from customers and distributors located outside the United States,primarily in Asia.

**Products**

Our industry and the markets we serve arecharacterized by rapid technological advancement. We constantly strive forinnovation in our product offerings. We introduce products both to addressmarkets or applications that we previously have not addressed, and to replaceour existing products with products that are based on more advanced technologyand that incorporate new or enhanced features. Silicon Image markets productsto the PC/display, CE and storage markets. We introduced 11 new products in2003, and expect to introduce 12 to 15 new products in 2004. We expect tocontinue integrating more functionality into our existing products in order toenhance their performance and capabilities.

When we introducereplacement products, we notify our customers in advance, work with ourcustomers to qualify and migrate to our newer products and accept final ordersfor replaced products. This allows us to eventually discontinue production andsupport for our older, less advanced products. We may decide to phase outproducts for reasons other than new product introductions. Such reasons couldinclude failure of products to achieve market acceptance, changing marketconditions and changes in business strategy.

**PC/Display**

Pioneered by Silicon Image and introduced by theDigital Display Working Group (DDWG), the Digital Visual Interface (DVI) is thede facto standard for connecting PCs to digital displays. DVI defines a robust,high-speed serial communication link between host systems and displays—enablingsharper, crystal-clear images and lower cost designs. Accommodating bandwidthin excess of 165 MHz, DVI provides UXGA support with a single-link interface.

Silicon Image’s Transition-Minimized DifferentialSignaling (“TMDS”®) technology serves as the basis of DVI. PanelLink®is Silicon Image’s branded implementation of DVI and is a market leader withwell over 40 million units shipped to date.

4

----

*PanelLink**Transmitters.*Our PanelLink transmitter products reside on host systems, such asPC motherboards, graphics add-in boards and notebook PCs. Transmitters take astream of digital data from a graphics source, convert it to DVI-compliantdigital output and transmit that output to a receiver in a display. OurPanelLink transmitter products are:
| **PanelLink Transmitters**            |
|---------------------------------------|
| **Product**                           | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Target Applications** |
| SiI 1172                              |   | QXGA 

(2048 x1536 pixels) |   | 6.8 Gbps |   | Desktop PCs (motherboards and add-in boards),  notebook PCs |
| SiI 1162                              |   | UXGA 

(1600 x 1200 pixels) |   | 5 Gbps |   | Desktop PCs (motherboards and add-in boards),  notebook PCs |
| SiI 178                               |   | QXGA 

(2048 x 1536 pixels) |   | 10 Gbps |   | Desktop PCs that support Dual Link DVI |
| SiI 160, SiI 164, SiI 166 and SiI 168 |   | UXGA 

(1600 x 1200 pixels) |   | 5 Gbps |   | Desktop PCs (motherboards and add-in boards),  notebook PCs. |
| SiI 170B                              |   | UXGA 

(720 / 1080i / 1080p) |   | 5 Gbps |   | Digital set-top boxes, DVD players |

 

*PanelLinkReceivers.*Our PanelLink receiver products reside in displaysystems, such as flat panel displays and projectors. Receivers receiveDVI-compliant digital input and restore the video data format. Our receiversalso contain functionality that simplifies the design of digital displays. OurPanelLink receiver products are:
| **PanelLink Receivers** |
|-------------------------|
| **Product**             | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Target Applications** |
| SiI 1171                |   | QXGA 

(2048 x1536 pixels) |   | 6.8 Gbps |   | LCD monitors, data, video and multimedia projectors,  plasma displays |
| SiI 1161                |   | UXGA 

(1600 x 1200 pixels) |   | 5 Gbps |   | LCD monitors, data, video and multimedia projectors,  plasma displays |
| SiI 1151                |   | SXGA 

(1280 x 1024 pixels) |   | 3.36 Gbps |   | LCD monitors, data, video and multimedia projectors,  plasma displays |
| SiI 163B                |   | QXGA 

(2048 x 1536 pixels) |   | 10 Gbps |   | Desktop monitors that support Dual Link DVI |
| SiI 161B                |   | UXGA 

(1600 x 1200 pixels) |   | 5 Gbps |   | Flat panel displays, plasmas, projectors, embedded/specialty/retail  and industrial LCD panels |
| SiI 153B                |   | SXGA 

(1280 x 1024 pixels) |   | 4.1 Gbps |   | Flat panel displays, plasmas, projectors,  embedded/specialty/retail and industrial LCD panels |
| SiI 151B                |   | SXGA 

(1280 x 1024 pixels) |   | 3.36 Gbps |   | Flat panel displays, plasmas, projectors,  embedded/specialty/retail and industrial LCD panels |
| SiI 143B                |   | High-Refresh XGA 

(1024 x 768 pixels) |   | 2.58 Gbps |   | Flat panel displays, plasmas, projectors,  embedded/specialty/retail and industrial LCD panels |
| SiI 141B                |   | High-refresh XGA 

(1024 x768 pixels) |   | 2.58 Gbps |   | Flat panel displays, projectors,  embedded/specialty/retail and industrial, LCD panels |
| SiI 169                 |   | UXGA 

(1600 x 1200 pixels) |   | 5 Gbps |   | DTVs, plasma displays, LCD TVs |

 

5

----

*PanelLinkControllers.*Our PanelLink controller products are suitablefor display systems such as flat panel displays and digital televisions. OurPanelLink controller products are:
| **PanelLink Controllers** |
|---------------------------|
| **Product**               | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Key Features** | ** ** | **Target Applications** |
| SiI 863                   |   | SXGA+ 

(1400 x 1050 pixels) |   | 3.36 Gbps |   | LVDS Tx, scaling,  on-screen display, power management, gamma correction, dithering |   | Flat panel displays,  plasmas, projectors, embedded/specialty/retail and industrial |
| SiI 861                   |   | SXGA+ 

(1400 x 1050 pixels) |   | 3.36 Gbps |   | HDCP, LVDS Tx, scaling  on-screen display, power management, gamma correction, dithering |   | LCDs and flat panel  displays |
| SiI 859                   |   | SXGA+ 

(1400 x 1050 pixels) |   | 3.36 Gbps |   | HDCP, scaling, on-screen  display, power management, gamma correction, dithering |   | LCD microdisplays |
| SiI 907B                  |   | UXGA 

(1600 x 1200 pixels) |   | 4.95 Gbps |   | Integrated  digital-to-analog converter, HDCP |   | Direct View, DTV,  digital CRTs |

 

*IntelligentPanel Controllers.*Our Intelligent Panel controller productsare programmable controllers with integrated timing controllers that reside onthe LCD display module. These products receive digital input, restore the videodata format and directly interface with the LCD module electronics. OurIntelligent Panel controller products are (*denotes product has been phasedout):
| **Intelligent Panel Controllers** |
|-----------------------------------|
| **Product**                       | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Key Features** | ** ** | **Target Applications** |
| SiI 1257                          |   | WUXGA |   | 165MHz |   | PanelLink receiver TTL  LCD timing controller |   | LCDs for flat panel  displays |
| SiI 263                           |   | UXGA |   | 140 MHz |   | PanelLink receiver RSDS  LCD timing controller |   | LCDs for flat panel  displays |
| SiI 253                           |   | SXGA |   | 140 MHz |   | PanelLink receiver TTL  LCD timing controller |   | LCDs for flat panel  displays |
| SiI 215A                          |   | WXGA 

(1280 x 768 pixels) |   | 85 MHz |   | 1 channel LVDS input  interface, RSDS output |   | LCDs for notebook PCs  and flat panel displays |
| SiI 223A*                         |   | WSXGA 

(1440 x 1050 pixels) |   | 108 MHz |   | 2 channel LVDS input  interface, LCD timing controller |   | LCDs for notebook PCs  and flat panel displays |
| SiI 243A*                         |   | WXGA 

(1152 x 768 pixels) |   | 85 MHz |   | PanelLink receiver LCD  timing controller |   | LCDs for notebook PCs  and flat panel displays |

 

6

----

**ConsumerElectronics**

Developed by Sony, Hitachi, Thomson (RCA), Philips,Matsushita (Panasonic), Toshiba and Silicon Image as the digital interfacestandard for the consumer electronics market, the HDMI specification combineshigh-definition video and multi-channel audio in a single digital interface toprovide crystal-clear digital quality over a single cable.

Based on Silicon Image’s TMDS technology and fullybackward compatible with products incorporating the DVI standard (alsopioneered by Silicon Image) designed for PC applications, HDMI offersadditional consumer enhancements such as automatic format adjustment and anintegrated remote. HDMI offers significant advantages over analog A/Vinterfaces, including the ability to transmit uncompressed digital video andaudio.

PanelLink CinemaTM is Silicon Image’s brandedimplementation of HDMI and has been selected by several CE companiesimplementing some of the world’s first HDMI consumer products.

*PanelLinkCinema Transmitters.*Our PanelLink Cinema transmitterproducts reside on host systems, such as DVD players, DVD recorders, A/Vreceivers, set-top boxes, personal video recorders (“PVRs”) and D-VHS players. PanelLinkCinema transmitters encrypt digital video and audio from a source device,combine it in a single, HDMI-compliant stream and transmit the secure contentto a HDMI receiver in a display. Our PanelLink Cinema transmitter products are:
| **PanelLink Cinema Transmitters** |
|-----------------------------------|
| **Product**                       | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Target Applications** |
| SiI 9030                          |   | 1080p |   | 5 Gbps |   | DVD players, DVD  recorders, A/V receivers, set-top boxes, PVRs, D-VHS players |
| SiI 9190                          |   | 720p/1080i |   | 2.58 Gbps |   | HDTV digital set-top  boxes, DVD and D-VHS players, A/V receivers |

 

*PanelLink Cinema Receivers.*Our PanelLinkCinema receiver products reside in display systems, such as HDTV’s, plasma TVs,LCD TVs, liquid crystal on silicon (“LCOS”) TVs, digital light processing (“DLP”)TVs and projectors, as well as A/V receivers. PanelLink Cinema receivers decodeand decrypt an incoming HDMI stream and deliver YPbPr or analog RGB video alongwith digital audio. Our PanelLink receiver products are:
| **PanelLink Cinema Receivers** |
|--------------------------------|
| **Product**                    | ** ** | ** ** | ** ** | **Maximum Resolution** | ** ** | **Maximum  Bandwidth** | ** ** | **Target Applications** |
| SiI 9031                       |   | 1080p |   | 5 Gbps |   | A/V receivers, plasma TVs, LCD TVs, DTVs |
| SiI 9021                       |   | 1080p |   | 5 Gbps |   | DTVs, plasma TVs, LCD TVs, projectors |
| SiI 9993                       |   | 720p/1080i |   | 2.58 Gbps |   | HDTVs, A/V receivers |

 

7

----

*DigitalVideo Processors.*Our digital video processor products arehigh-quality digital video format converters that convert any standard-definitioninterlaced video signal to a non-interlaced signal, resulting inhigher-definition images. These products are suitable for display on LCD,digital light processing DTVs or progressive scan. Our digital video processorsand processing system products are (* denotes product has been phased out):
| **Digital Video Processors and Processing  Systems** |
|------------------------------------------------------|
| **Product**                                          | ** ** | ** ** | ** ** | **Key Features** | ** ** | **Target Applications** |
| SiI 504                                              |   | Deinterlacer, horizontal  scaler, color lookup, table memory controller, color space converter, LCD/CRT  Controller |   | Progressive scan DVD  players, DTVs, LCD TVs, projectors, set-top boxes |
| iScan Pro*                                           |   | Motion adaptive-video  deinterlacing, source adaptive processing NTSC sources, source transmission  management, auto-dynamic thresholds enabling reliable pulldown, picture  controls |   | HDTVs, multimedia TVs,  data and video projectors (31.5KHz scan rate required), computer monitors |
| iScan Ultra*                                         |   | Accepts standard NTSC,  PAL and SECAM signals, Progressive scan video, Picture controls, DVI digital  video output |   | HDTVs, multimedia TVs,  data and video projectors (31.5KHz scan rate required), PC monitors |

 

**Storage**

Silicon Image’s proven high-speed, Multi-layer serialLink (MSLTM) architecture lends itself to storage market applications, includingSerial ATA. MSL technology is a multi-layer approach to providing robust,cost-effective, multi-gigabit semiconductor solutions on a single chip forhigh-bandwidth applications.

Serial ATA offers a number of benefits over ParallelATA interfaces, including higher bandwidth, scalability, lower voltage andnarrower cabling. As a result, Serial ATA is expected to become the standarddrive interface for desktop and notebook PCs and establish a significantpresence in enterprise storage applications. SATALinkTM is Silicon Image’sbranded implementation of Serial ATA.

8

----

*SerialATA Controllers, PHYs and Bridges.*The products in ourSATALink family include five host controllers, a dual-channel PHY and onebridge IC that are intended to enable customers to begin to incorporate serialATA while they transition from parallel ATA. Our serial ATA controller, PHY andbridge devices are based on the SATA 1.0 specification, which is used totransmit and receive data at a rate of 1.5 Gbps, and certain enhancements to theSATA 1.0 specification published by the SATA II working group that we expectwill become part of the SATA 2.0 specification, and are:
| **Serial ATA Controllers and Bridges** |
|----------------------------------------|
| **Product**                            | ** ** | ** ** | ** ** | **Key Features** | ** ** | **Target Applications** |
| SiI 3124-2                             |   | Single chip, quad channel,  PCI-X-to-SATA II host controller, SATARAIDTM software, 1st Party  DMA, hot plug, ATAPI support, port multiplier support with FIS-based  switching, variable output strengths for backplane support Supports up to  3Gb/s per channel. |   | Server motherboards,  server add-in-cards, host bus adapters, RAID subsystems, embedded  applications |
| SiI 3124-1                             |   | Single-chip,  quad-channel, PCI-X-to-SATA host controller, SATARAIDTM software, 1st  Party DMA, hot plug, ATAPI support, port multiplier support with FIS-based  switching, variable output strengths for backplane support Supports up to  1.5Gb/s per channel. |   | Server motherboards,  server add-in-cards, host bus adapters, RAID subsystems, embedded  applications |
| SiI 3114                               |   | Single-chip,  quad-channel, PCI-to-SATA host controller, SATARAIDTM software, hot plug,  ATAPI support, variable output strengths for backplane support |   | PC motherboards, PC  add-in-cards, server motherboards, host bus adapters, RAID subsystems,  embedded applications |
| SiI 3512                               |   | Single-chip,  dual-channel, low pin-count PCI-to-SATA host controller, SATARAIDTM software,  hot plug, ATAPI support |   | PC motherboards, PC  add-in-cards, server motherboards, host bus adapters, RAID subsystems,  embedded applications |
| SiI 3112                               |   | Single chip,  dual-channel, PCI-to-SATA host controller, SATARAIDTM software, hot plug,  ATAPI support |   | PC motherboards, RAID or  non-RAID disk controller add-in cards, storage and embedded systems |
| SiI 3611                               |   | Serial ATA-to-Parallel  ATA disk bridge, ATAPI support |   | Optical and hard disk  drives, storage systems |
| SiI 3012                               |   | Single-chip,  dual-channel, SATA PHY |   | PC motherboards, storage  and embedded systems |

 

9

----

*ParallelATA and USB Controllers.*Our parallel ATA and USB controllersserve products incorporating parallel ATA and USB interfaces such asmotherboards, add-in cards and embedded systems. Our parallel ATA and USBcontroller products are (* denotes product has been phased out):
| **Parallel ATA and USB Controllers** |
|--------------------------------------|
| **Product**                          | ** ** | ** ** | ** ** | **Key Features** |
| SiI 0680                             |   | Ultra ATA / 133  PCI-to-ATA host controller |
| SiI 0649                             |   | Ultra ATA / 100 PCI-to-ATA  host controller |
| SiI 0648                             |   | Ultra ATA / 66  PCI-to-ATA host controller |
| SiI 0673*                            |   | USB host chip for 3V  applications for a wide range of embedded designs |
| SiI 0670*                            |   | USB host chip for 5V  applications ranging from PCs to set-top boxes to auto PCs |
| PCI 646 U2*                          |   | Ultra 33 5V 100-pin PQFP  chip for embedded 5V designs |
| PCI-643*                             |   | IDE 3.3V 100-pin chip  for quick and low-lost connectivity |

 

*FibreChannel SerDes.*Our Fibre Channel serializer/deserializer (“SerDes”)products are a low-power, high-quality (low-jitter), cost-effective solutionfor applications such as host bus adapters (“HBAs”) and switches that connectPCs and servers to large storage banks. Our fibre channel products are:
| **Fibre Channel SerDes** |
|--------------------------|
| **Product**              | ** ** | ** ** | ** ** | **Key Features** | ** ** | **Target Applications** |
| SiI 2024                 |   | 2.125G Quad channel, fibre channel SerDes, 1.8V core |   | HBAs, switches, routers |
| SiI 2022                 |   | 2.125G Single channel, fibre channel SerDes, 3.3V  core |   | HBAs, switches, routers |
| SiI 2020A                |   | 2.125G Single channel, fibre channel SerDes, 2.5V  core |   | HBAs, switches, routers |

 

**Promotion of Industry Standards**

As technology innovators,a key element of our business strategy is the development and promotion ofindustry standards in our target markets. Current standards efforts include:

*Digital VisualInterface (DVI)*

We, together withIntel, Compaq, IBM, Hewlett-Packard, NEC and Fujitsu, announced the formationof the Digital Display Working Group (“DDWG”) in 1998. Subsequently, theseparties entered into a Promoter’s Agreement in which they agreed to:

·       define,establish and support the DVI specification, an industry specification forsending video data between a computer and a digital display;

·       encouragebroad industry adoption of the DVI specification, in part by creating animplementer’s forum that others may join in order to receive information and byproviding support for the DVI specification; and

·       invitethird parties to enter into a Participant’s Agreement in order to consult onthe content, feasibility and other aspects of the DVI specification.

In 1999, the DDWG published the DVI 1.0 specification,which defines a high-speed serial data communication link between computers anddigital displays. Today, over 100 companies, including systems manufacturers,graphics semiconductor companies and monitor manufacturers have participated inDDWG activities, and many are developing hardware and software productsdesigned to be compliant with the DVI specification.

In October 2003, theFederal Communications Commission (“FCC”) published its proposed rules forthe compatibility between cable systems and consumer electronics devices(Second Report and Order and Second Further Notice of Proposed Rulemaking datedOctober 9, 2003, “Plug & Play Order”). In the 

10

----

Plug &Play Order the FCC in setting forth the proposed rules governing the U.S.transition to digital television, proposed that by July 1, 2005 allhigh-definition set top boxes distributed by cable operators must includeeither a DVI or HDMI interface. Further, the FCC proposed that for a consumerelectronics product to be marketed or labeled “digital cable ready” it mustinclude either a DVI or HDMI interface.

*Joint Developmentof High Definition Content Protection (HDCP)*

In 2000, the High-bandwidth Digital Content Protection(“HDCP”) specification HDCP 1.0 was published by Intel, with contributions bySilicon Image acknowledged in the specification. The specification wasdeveloped to provide a content protected link from host devices, such as PC’s,set-top boxes and DVD and D-VHS players, to displays such as computer monitors,HDTVs and digital TVs. This technology has support from the members of theMotion Picture Industry Association and aims to prevent high-definition moviecontent from being copied when transmitted over a digital link. In 2003, theHDCP specification was modified and made available for use over HDMIinterfaces.

In November 2003, the FCC published its proposed rules forthe protection of digital broadcast content (Report and Order and FurtherNotice of Proposed Rulemaking dated November 4, 2003, “Broadcast FlagOrder”). In the Broadcast Flag Order setting forth the proposed rules that,among other things, would govern the means to protect high-definitiontelevision broadcast as this content is transferred between consumerelectronics devices, HDCP is listed as one of the authorized digital outputprotection technologies.

*High DefinitionMultimedia Interface (HDMI)*

We, together with Sony, Matsushita (Panasonic),Philips, Thomson (RCA), Hitachi and Toshiba, entered into a Founder’s Agreementand formed a working group to develop a specification for a next-generationdigital interface for consumer electronics. In December 2002, the finalspecification for High Definition Multimedia Interface (“HDMI”) 1.0 wasreleased. The HDMI 1.0 specification is based on our transition minimizeddifferential signaling (TMDSTM) technology, the underlying technology for DVI1.0, and has received strong support from Fox and Universal studios, DirecTVand Echostar.

The FoundersAgreement provides that the signatories:

·       define,establish and support the HDMI specification, an industry specification for anext-generation digital interface for consumer electronics that enables thedistribution of uncompressed high-definition video and multi-channel audio in asingle cable;

·       encouragebroad industry adoption of the HDMI specification, by charging identical annualfees and running royalties to all adopters, and to appoint a licensing agent,HDMI Licensing LLC (a wholly owned subsidiary of Silicon Image), to sign HDMIAdopters’ Agreements and provide necessary patent licenses to adopters;

·       encouragecompatibility of HDMI enabled products by mandating compatibility testing priorto the first use of HDMI;

·       encourageconsumer recognition of the compatibility and presence of the HDMI technologyby branding the HDMI name and logo; and

·       haveHDMI Licensing LLC oversee the collection of annual fees and running royalties.

11

----

As of December 31,2003, sixty companies have signed HDMI Adopters Agreements, under whichadopters are granted a standard license to the HDMI specification and necessarypatents. We expect HDMI to become a standard digital interface for consumerelectronics products that carry digital audio and video signals. As notedabove, the FCC in the Plug & Play Order has proposed that by July 1,2005 all high-definition set top boxes distributed by cable operators mustinclude either a DVI or HDMI interface. Further, the FCC proposed that for aconsumer electronics product to be marketed or labeled “digital cable ready” itmust include either a DVI or HDMI interface.

*Serial ATA WorkingGroup*

During 2000, we acquiredZillion Technologies, a developer of high-speed transmission technology fordata storage applications. Zillion contributed in drafting the preliminaryserial ATA specification (SATA 1.0), which was published in 2001 and is beingpromoted as a successor to parallel bus technology. We are a contributor to theSATA working group, which includes, Dell, Intel, Maxtor, Seagate, and Vitesseamong its promoters. In February 2002, we joined the SATA II Working Groupas a contributor. The SATA II working group released “Extensions to Serial ATA1.0 Specifications” in October 2002 and “Extensions to Serial ATA 1.0arev. 1.1” in November of 2003 to enhance the existing SATA 1.0specification for the server and network storage markets. The SATA II workinggroup has also released specifications for SATA port multipliers and SATA portselectors. In addition, the SATA II working group is developing a specificationfor the next-generation SATA speed of 3 Gbps and external cabling for SATA. TheSATA II working group includes many of the same members as the SATA workinggroup.

*Incits T-13Committee*

In 2003, Silicon Imagejoined the Incits T-13 technical committee (the “T-13 Committee”)as a contributor. The T-13 Committee is responsible for publishing theATA specification and is currently working to make improvements to the ATAspecification, including the incorporation of the Serial ATA 1.0aspecification into their next revision of the ATA specification, ATA-7. Membersof the T-13 Committee include Hitachi, Intel, Seagate, PhoenixTechnologies, Maxtor, Microsoft, Fujitsu and nVidia among others.

**Silicon Image Technology**

*Multi-LayeredSystems Approach to Solving High-Speed Interconnect Problems*

We invented technology upon which the DVI and HDMIspecifications are based and have substantial experience in the design,manufacture and deployment of semiconductor products incorporating thishigh-speed data communications technology. The advanced nature of ourhigh-speed digital design allows us to integrate significant functionality withmultiple high-speed communication channels using industry-standard, low-costcomplementary metal oxide semiconductor (“CMOS”) manufacturing processes. Atthe core of our innovation is a multi-layered approach to providingmulti-gigabit semiconductor solutions.

The three layers of our Multi-layer Serial Link (MSL)architecture include the physical, coding and protocol layers. Serial linktechnology is the basis for the physical layer, which performs electricalsignaling in several data communication protocols, including DVI 1.0, HDMI 1.0,Serial ATA and fibre channel. This technology converts parallel data into aserial stream that is transmitted sequentially at a constant rate and thenreconstituted into its original form. Our high-speed serial link technologyincludes a number of proprietary elements designed to address the significantchallenge of ensuring that data sent to a display or a storage device can beaccurately recovered after it has been separated and transmitted in serialstreams over multiple channels. In order to enable a display or a storagedevice to recognize data at the proper time and rate, our digital serial linktechnology uses a digital phase-locked loop combined with a unique phasedetecting and tracking method to monitor the timing of the data.

12

----

At the coding layer, wehave developed substantial intellectual property in data coding technology forhigh-speed serial communication. Our coding technology simplifies the protocolfor high-speed serial communication and allows tradeoffs to be made in physicalimplementation of the link, which in turn reduces the cost of bandwidth andsimplifies the overall system design. In addition, we have ensured directcurrent balanced transmission and the ability to use TMDS to keepelectromagnetic emissions low and to enable connection to fiber optic interconnectswithout use of additional components.

*PanelLink Cinema*

Our PanelLink Cinematechnology sends high-fidelity digital audio and can protect video across theHDMI link for use in the consumer electronics market. Combining digital videoand digital audio transmissions in a single interconnect system simplifies andreduces the cost of the connection between consumer electronics devices, whilemaintaining high quality and protection. PanelLink Cinema technology is fullycompliant with the HDMI 1.0 specification.

**Research and Development**

We have assembled a team of engineers andtechnologists with extensive experience in the areas of high-speed interconnectarchitecture, circuit design, digital imaging processor architecture, LCDpanels and storage interconnect, software and systems. Our engineering teamincludes a group of consultants in Asia that focuses primarily on advancedtechnology development. The majority of these consultants are students at auniversity that we utilize for research and design services.

From our inception until 1998, our internal researchand development efforts focused primarily on the development of our corePanelLink technology, our initial transmitter and receiver products, and ourfirst intelligent panel controller product. In 1999, we improved our PanelLinktechnology and developed new transmitter and receiver products, focusing onproviding both higher speeds and improved ease of use. We also begandevelopment of our PanelLink architecture for digital displays. In 2000, wefocused our internal research and development efforts on integrating ourPanelLink receiver technology with additional functionality, such as PanelLinkA/V and HDCP, for flat panel displays, digital CRTs and the consumerelectronics industry. In 2001, we diversified our research and developmentefforts by increasing our investment in storage semiconductor development andby adding storage system architecture and software development expertisethrough our acquisition of CMD Technology. In 2002 and 2003, our research anddevelopment efforts focused primarily on technology and applications for theconsumer electronics and storage markets, including the development of HDMItechnology.

Our research and development efforts continue to focuson developing higher bandwidth links with and links with expanded functionalityfor use in various PC, CE and storage applications. By utilizing our patenteddata coding technology and different clocking methodologies, we believe ourhigh-speed link can scale with advances in semiconductor manufacturing processtechnology, simplify system design, and be combined with other functionality toprovide new innovative solutions for our customers.

We have invested, andexpect that we will continue to invest, significant funds for research anddevelopment activities. Our research and development expenses wereapproximately $43.4 million in 2003, $40.2 million in 2002, and $34.8 millionin 2001. Excluding non-cash stock compensation expense, our research anddevelopment expenses were approximately $36.5 million in 2003, $32.8 million in2002 and $25.5 million in 2001.

**Salesand Marketing**

We sell our products to distributors and OEMsthroughout the world using a direct sales force with field offices located inNorth America, Taiwan, Europe, Japan and Korea, and indirectly through a 

13

----

network of distributorsand manufacturer’s representatives located throughout North America, Asia andEurope.

Our sales strategy for allproducts is to achieve design wins with key industry leaders in order to growthe markets in which we participate and to promote and accelerate the adoptionrate for industry standards we support or are developing, such as DVI, HDMI andSerial ATA. Our sales personnel and applications engineers provide a high-levelof technical support to our customers. Our marketing efforts focus primarily onpromoting adoption of the DVI, HDMI and Serial ATA standards, participating inindustry trade shows and forums, entering into branding relationships such asPanelLink for DVI, PanelLink Cinema for HDMI, and SATALink for Serial ATA tobuild awareness of our brands, and bringing new solutions to market.

**Manufacturing**

*Wafer Fabrication*

Our semiconductor productsare fabricated using standard CMOS processes, which permit us to engageindependent wafer foundries to fabricate our semiconductors. By outsourcing ourmanufacturing requirements, we are able to avoid the high cost of owning andoperating a semiconductor wafer fabrication facility, take advantage of thesesuppliers’ high-volume economies of scale and also gives us direct and timelyaccess to advancing process technology. This allows us to focus our resourceson the design and quality of our products. Our devices are currently fabricatedusing 0.5 micron, 0.35 micron, 0.25 micron and 0.18 micron processes. Wecontinuously evaluate the benefits, primarily improved performance, andfeasibility of migrating our products to smaller geometry process technologies.We rely almost entirely on Taiwan Semiconductor Manufacturing Company (“TSMC”),an outside foundry, to produce all of our PC, CE and fibre channel and serialATA storage products. We also rely on other outside foundries, such as Kawasakiand Atmel, to produce our parallel ATA and USB storage semiconductor products.We do not have long-term supply agreements with any of these foundries andtherefore cannot be assured of sufficient capacity availability or futureprices. Because of the cyclical nature of the semiconductor industry, capacityavailability can change quickly and significantly. We attempt to optimize waferavailability by continuing to use less advanced wafer geometries, such as 0.5micron, 0.35 micron and 0.25 micron, which generally have more availablecapacity.

*Assembly and Test*

After wafer fabrication, die (semiconductor devices)are assembled into packages and the finished products are tested. Our productsare designed to use low-cost standard packages and to be tested with widelyavailable semiconductor test equipment. We outsource all of our packaging andthe majority of our test requirements to Amkor Technology in Korea, AdvancedSemiconductor Engineering in Taiwan, Malaysia and the United States, andFujitsu and Kawasaki in Japan. This enables us to take advantage of thesesubcontractors’ high-volume economies of scale and supply flexibility, andgives us direct and timely access to advancing packaging technology. We test asmall portion of our products in-house.

The high-speed nature ofour products makes it difficult to test our products in a cost-effective mannerprior to assembly. Since the fabrication yields of our products havehistorically been high and the costs of our packaging have historically beenlow, we test our products after they are assembled. Our operations personnelclosely review the process control monitor information provided to us by ourfoundries. To ensure quality, we have established firm guidelines for rejectingwafers that we consider unacceptable. To date, not testing our products priorto assembly has not caused us to experience higher final test failures or loweryields. However, lack of testing prior to assembly could have adverse effectsif there are significant problems with wafer processing. Additionally, fornewer products and products for 

14

----

whichyield rates have not stabilized, we may conduct bench testing using ourpersonnel and equipment, which is more expensive than fully automated testing.

*Quality Assurance*

We focus on productquality through all stages of the design and manufacturing process. Our designsare subjected to in-depth circuit simulation at temperature, voltage andprocessing extremes before being fabricated. We pre-qualify each of oursubcontractors through an audit and analysis of the subcontractor’s qualitysystem and manufacturing capability. We also participate in quality andreliability monitoring through each stage of the production cycle by reviewingdata from our wafer foundries and assembly subcontractors. We closely monitorwafer foundry production to ensure consistent overall quality, reliability andyields. Our independent foundries and assembly and test subcontractors haveachieved ISO 9000 certification.

**Intellectual Property**

Our success and future revenue growth will depend, inpart, on our ability to protect our intellectual property. We rely on acombination of patent, copyright, trademark and trade secret laws, as well asnondisclosure agreements and other methods, to protect our proprietarytechnologies. As of December 31, 2003, we have been issued over 40 UnitedStates patents and have in excess of 140 United States patent applicationspending. Our issued patents expire in 2016 or later, subject to our payment ofperiodic maintenance fees. We cannot assure you that any valid patent will beissued as a result of any applications or, if issued, that any claims allowedwill be sufficiently broad to protect our technology, or that any patent willbe upheld in the event of a dispute. In addition, we do not file patentapplications on a worldwide basis, meaning we do not have patent protection insome jurisdictions. We also generally control access to and distribution of ourdocumentation and other proprietary information. Despite our precautions, itmay be possible for a third party to copy or otherwise obtain and use ourproducts or technology without authorization, develop similar technologyindependently or design around our patents. It is also possible that some ofour existing or new licensing relationships will enable other parties to useour intellectual property to compete against us. Legal actions to enforce intellectualproperty rights tend to be lengthy and expensive, and the outcome often is notpredictable, and the relief available may not compensate for the harm caused.

Our participation in the DDWG requires that we grantothers the right to use specific elements of our intellectual property inimplementing the DVI specification in their products, at no cost, in exchangefor an identical right to use specific elements of their intellectual propertyfor this purpose. We agreed to grant rights to the DDWG members and otheradopters of the DVI specification in order to promote the adoption of ourtechnology as an industry standard. We thereby limited our ability to rely onintellectual property law to prevent the adopters of the DVI specification fromusing certain specific elements of our intellectual property for certainpurposes for free. This reciprocal free license covers the connection between acomputer and digital display. It does not, however, extend to the internalmethods by which such performance is created. Although the DVI specification isan open industry standard, we have developed proprietary methods ofimplementing the DVI specification. The intellectual property that we haveagreed to license defines the logical structure of the interface, such as thenumber of signal wires, the signaling types, and the data encoding method forserial communication. Our implementation of this logical structure inintegrated circuits remains proprietary, and includes our techniques to convertdata to and from a serial stream, our signal recovery algorithms and ourcircuits to reduce electromagnetic interference (EMI). Third parties maydevelop proprietary intellectual property relating to DVI implementations thatwould prevent us from developing or enhancing our DVI implementation inconflict with those rights. Third parties may also develop equivalent orsuperior implementations of the DVI specification and we cannot guarantee thatwe will succeed in protecting our intellectual property rights in ourproprietary 

15

----

implementation. Thirdparties may have infringed or be infringing our intellectual property rights,or may do so in the future, and we may not discover that fact in a timely orcost-effective manner. Moreover, the cost of pursuing an intellectual propertyinfringement may be greater than any benefit we would realize.

Our participation as a founder of the HDMIspecification requires that we grant others the right to use specific elementsof our intellectual property in implementing the HDMI specification in theirproducts, in exchange for a license. This license bears an annual fee androyalties that are payable to HDMI Licensing, L.L.C., a wholly owned subsidiaryof ours. There can be no assurance that such license fees and royalties willadequately compensate us for having to license our intellectual property. Thelicense, with restrictions, generally covers the patent claims necessary toimplement the specification of an interface for CE devices, and does not extendto the internal methods by which such performance is created. Although the HDMIspecification is a proposed industry standard, we have developed proprietarymethods of implementing the HDMI specification. The intellectual property thatwe have agreed to license defines the logical structure of the interface, suchas the number of signal wires, the signaling types, and the data encodingmethod for serial communication. Our implementation of this logical structurein integrated circuits remains proprietary, and includes our techniques toconvert data to and from a serial stream, our signal recovery algorithms, ourimplementation of audio and visual data processing, and our circuits to reduceEMI. Third parties may also develop intellectual property relating to HDMIimplementations that would prevent us from developing or enhancing our HDMIspecification in conflict with those rights. Third parties may also developequivalent or superior implementations of the HDMI specification and we cannotguarantee that we will succeed in protecting our intellectual property rightsin our proprietary implementation. Third parties may have infringed or beinfringing our intellectual property rights, or may do so in the future, and wemay not discover that fact in a timely or cost-effective manner. Moreover, thecost of pursuing an intellectual property infringement may be greater than anybenefit we would realize. In addition, third parties may not pay the prescribedlicense fees and royalties, in which case we may become involved ininfringement or collection actions, or we may determine that the cost ofpursuing such matters may be greater than any benefit we would realize. Weagreed to grant rights to the founders and adopters of the HDMI specificationin order to promote the adoption of our technology as an industry standard. Wethereby limited our ability to rely on intellectual property law to prevent thefounders and adopters of the HDMI specification from using certain specificelements of our intellectual property for certain purposes for the specifiedroyalties.

We entered into a patent cross-license agreement withIntel in which each of us granted the other a license to use certain of thegrantor’s existing and future patents, including certain future patents, withspecific exclusions related to the grantor’s current and anticipated futureproducts and network devices. Products excluded include our digital receivers,discrete digital transmitters and discrete display controllers, and Intel’sprocessors, chipsets, graphics controllers and flash memory products. Thiscross-license does not require delivery of any masks, designs, software or anyother item evidencing or embodying such patent rights, thus making “cloned”products no easier to create. The cross-license agreement expires when the lastlicensed patent expires, anticipated to be no earlier than 2016, subject to theright of either party to terminate the agreement earlier upon material breachby the other party, or a bankruptcy, insolvency or change of control of theother party. We have forfeited, however, our ability to rely on intellectualproperty law to prevent Intel from using our patents within the scope of thislicense. To date, we are not aware of any use by Intel of our patent rightsthat negatively impacts our business.

The semiconductor industry is characterized byvigorous protection and pursuit of intellectual property rights or positions,which can result in significant, protracted litigation. We have brought apatent infringement suit against Genesis, which is described in further detailbelow in the section entitled “Legal Proceedings.”

16

----

**Competition**

The markets in which we compete are intenselycompetitive and are characterized by rapid technological change, evolvingstandards, short product life cycles and decreasing prices. We believe thatsome of the key factors affecting competition in our markets are levels ofproduct integration, compliance with industry standards, time-to-market, cost,product capabilities, system design costs, intellectual property, customersupport, quality and reputation.

In the PC market,our products face competition from a number of sources including analogsolutions, DVI-compliant solutions, dual-interface solutions and other digitalinterface solutions.

·       *Analog Solutions.* Display systems still predominantly employan analog interface. Improvements to analog interface display solutions mayslow the adoption of all-digital display systems. We compete with analogsolution vendors such as Analog Devices, Genesis Microchip, MRT and a number ofTaiwan-based companies.

·       *DVI-Compliant Solutions.* We believe that over time, the DVIspecification will become widely adopted in the digital display industry andattract additional market entrants. We believe the following companies havedeveloped or announced intentions to develop DVI-compliant solutions: AnalogDevices, ATI Technologies, Broadcom, Chrontel, Connexant, Genesis Microchip,MRT, National Semiconductor, nVidia, Pixelworks, SIS, Smart ASIC, STMicroelectronics, Texas Instruments and Thine.

·       *Dual-Interface Solutions.* The following companies havedeveloped, or announced intentions to develop, products that connect to bothanalog and digital host systems, also known as a dual-interface solution:Genesis Microchip, Macronix, MRT, Philips Semiconductor, Pixelworks and anumber of Taiwan-based companies.

·       *Other Digital Interface Solutions.* Texas Instruments, Thine,and National Semiconductor offer proprietary digital interface solutions basedon LVDS, or low voltage differential signaling technology. LVDS technology hasgained broad market acceptance in notebook PCs, and has gained some adoptionwith PC and display manufacturers for use outside of the notebook PC market.

The market for our intelligent panel controllerproducts is also very competitive. Some of our intelligent panel controllerproducts are designed to be functionally interchangeable with similar productssold by National Semiconductor, Texas Instruments, Samsung Semiconductor,Novatek and Thine.

In the consumer electronics market, our digitalinterface products are used to connect new cable set-top boxes, satelliteset-top boxes and DVD players to digital televisions. These products incorporateDVI and HDCP, or HDMI with or without HDCP support. Companies that haveannounced or are shipping competing DVI-HDCP solutions include Analog Devices,Texas Instruments, Thine, Broadcom, and Genesis Microchip. In addition, ourvideo processor products face competition from products sold by AV Science,Broadcom, Focus Enhancements, Genesis Microchip, Mediamatics, MicronasSemiconductor, Oplus, Philips Semiconductor, Pixelworks, and Trident. We alsocompete in some instances against in-house processing solutions designed bylarge consumer electronics OEMs. We expect competition for HDMI productsfrom the other HDMI founders and adopters, including Hitachi, Matsushita,Philips, Sony, Thomson and Toshiba.

In the storage market, our fibre channel products facecompetition from companies selling similar discrete products, includingAgilent, Mindspeed, PMC-Sierra, Serverworks and Vitesse, from other fibrechannel SerDes providers who license their core technology, such as LSI Logic,and from companies that sell HBA controllers with integrated SerDes, such asQLogic and Agilent.

17

----

Our serial ATA products compete with similar productsfrom Marvell, VIA, SIS and Promise. In addition, other companies, such as APT,Intel, LSI Logic, ServerWorks and Vitesse, have developed or announcedintentions to develop serial ATA products. We also are likely to competeagainst Intel and other motherboard chip-set makers that have announcedintentions to integrate serial ATA functionality into their chipsets.

Many of our competitorshave longer operating histories and greater presence in key markets, greatername recognition, access to larger customer bases and significantly greaterfinancial, sales and marketing, manufacturing, distribution, technical andother resources than we do. As a result, they may be able to adapt more quicklyto new or emerging technologies and customer requirements, or devote greaterresources to the promotion and sale of their products. In particular,well-established semiconductor companies, such as Analog Devices, Intel,National Semiconductor and Texas Instruments, and consumer electronicsmanufacturers, such as Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba,may compete against us in the future. We cannot assure you that we can competesuccessfully against current or potential competitors, or that competition willnot seriously harm our business.

**Employees**

As of December 31,2003, we had a total of 250 employees, including 9 located outside of theUnited States. None of our employees are represented by a collective bargainingagreement, nor have we experienced any work stoppages. We consider ourrelations with our employees to be good. We depend on the continued service ofour key technical, sales and senior management personnel, and our ability toattract and retain additional qualified personnel. If we are unable to hire andretain qualified personnel, our business will be seriously harmed.

**Available Information**

Our Internet websiteaddress is *http://www.siliconimage.com*. We makeavailable free of charge through our Internet website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-Kand amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after we electronically file such material with, or furnish it to,the Securities and Exchange Commission.

**Item2. Properties**

Our principal operatingfacility, consisting of approximately 80,000 square feet of space in Sunnyvale,California, is leased through August 1, 2010 and should be adequate tomeet our requirements through at least 2004. We also have approximately 91,000square feet of space in Irvine, California, which is leased through November 2005,and approximately 8,000 square feet of space in Milpitas, California, which wecurrently do not occupy and which is leased through April 2006. Wecurrently sublease to third parties, under three separate arrangements,approximately 38,000 square feet of our space in Irvine, California, onconventional terms, and are attempting to sublease additional space at thisfacility and at our Milpitas facility. We leased a facility in Taiwan for anoffice space of approximately 1,800 square feet. This lease expired on December 31,2003. We did not renew this lease on termination, but effective January 1,2004, we leased another facility consisting of approximately 6,500 square feetfor a period of three years. We also entered into a lease in December 2003for office space in Japan, and under the terms of this agreement, leaseapproximately 1,700 square feet in Tokyo. This lease extends through December 2005.

**Item 3. Legal Proceedings**

On April 24, 2001, we filed suit in the U.S.District Court for the Eastern District of Virginia against Genesis MicrochipCorp. and Genesis Microchip, Inc. (collectively, “Genesis”) forinfringement of our 

18

----

U.S. patent number5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R)(the “Federal Suit”). On April 24, 2001, we also filed a complaint againstGenesis with the International Trade Commission of the United States government(“ITC”) for unlawful trade practices related to the importation of articlesinfringing our patent (the “ITC investigation”). The actions sought injunctionsto halt the importation, sale, manufacture and use of Genesis DVI receiverchips that infringe our patent, and monetary damages. We voluntarily moved todismiss the ITC investigation, with notice that we would proceed directly inthe Federal Suit. Our motion to dismiss was granted on February 7, 2002.We filed an amended complaint in the Federal Suit as of February 28, 2002,adding a claim for infringement of our U.S. patent number 5,974,464. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. Also in April 2002, we filed a motion to dismiss certain ofGenesis’s counterclaims. In addition, we filed a motion to bifurcate trial ofthe counterclaims to the extent the court does not dismiss them. In May 2002,the Court granted our motion to dismiss certain of the counterclaims, withleave to amend. Genesis re-filed counterclaims against us for fraud and patentmisuse. We filed another motion to dismiss these counterclaims. In December 2002,the parties entered into a memorandum of understanding (MOU) to settle thecase. In January, the parties presented different interpretations of the MOU tothe Court. On July 15, 2003, the Court granted our motion to interpret theMOU in the manner we requested, and ruled that Genesis had engaged in effortsto avoid its obligations under the MOU. On August 6, 2003, the Courtentered a final judgment based on its July 15, 2003 ruling. Under thefinal judgment order, Genesis was ordered to make a substantial cash payment,and to make royalty payments; although Genesis has made a cash payment to theCourt, it has not made all the payments that are required under the finaljudgment order. We have filed motions for reimbursement of some of ourexpenses, including some of our legal fees, and for modification and/orclarification of certain items of the judgment, and to hold Genesis in contemptof Court for breaching the protective order in the case by disclosing secretinformation to at least one of our competitors. On December 19, 2003, theCourt granted our motions in part and denied them in part: the court issued anamended judgment, and held Genesis in contempt of Court for breaching theprotective order. Underthe amended judgment, Genesis was ordered to make a substantial cash payment,royalty payments, and interest; although Genesis has made and continues to makecash payments to the Court, it may not have made all the payments that arerequired under the amended judgment. The Court has not ruled on pending motionsregarding the disposition of the money held by the Court. On January 16,2004, Genesis filed a notice of appeal. To date, we have not received any cashnor have we recognized any revenue associated with this litigation. Due to thecontinuing and contentious nature of this litigation, we will not record anyincome or revenue related to this matter until the litigation is complete andall other income and revenue recognition criteria have been satisfied. Managementintends to prosecute our position vigorously until this matter is resolved.Through December 31, 2003, we have spent approximately $10.4 million onthis matter and expect to continue to incur significant costs through at leastthe fourth quarter of 2004.

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01CV 10903 (SDNY 2001) pending in Federal District Court for the SouthernDistrict of New York. The lawsuit alleges that all defendants were part of ascheme to manipulate the price of Silicon Image’s stock in the aftermarketfollowing Silicon Image’s initial public offering in October 1999.Response to the complaint and discovery in this action on behalf of SiliconImage and individual defendants has been stayed by order of the court. Thelawsuit is proceeding as part of a coordinated action of over 300 such casesbrought by plaintiffs in the Southern District of New York. Pursuant to atolling agreement, individual defendants have been dropped from the suit forthe time being. In February 2003, the Court denied the underwriters’motion to dismiss and ordered that the case may proceed against issuers includingagainst Silicon Image. A proposed settlement has been negotiated that has yetto be reviewed and approved by the Court. In the event that the settlement isapproved, we do not expect it to have a material effect on our results of 

19

----

operations or financialposition. In the event that the settlement is not approved, we could notaccurately predict the outcome the litigation, but we intend to defend thismatter vigorously.

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al.,No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court forthe Southern District of Florida. Plaintiff filed an action on behalf of aputative class of shareholders who purchased stock from some or all ofapproximately 50 issuers whose public offerings were underwritten by CreditSuisse First Boston. The lawsuit alleges that Silicon Image and certainofficers were part of a scheme by Credit Suisse First Boston to artificiallyinflate the price of Silicon Image’s stock through the dissemination ofallegedly false analysts’ reports. Silicon Image has not been served with acopy of the complaint. The plaintiff in this matter has filed an amendedcomplaint in which Silicon Image, and the named officers, were dropped asdefendants. We believe that the proposed settlement described above, ifapproved, would encompass the claims in this case. We believe that these claimswere without merit and, if revived, and not subject to the settlement, we woulddefend this matter vigorously.

Certain officers and directors of Silicon Image havebeen named as defendants in consolidated shareholder derivative litigation,captioned “In re Silicon Image, Inc. Derivative Litigation, No. 1:03CV010302”,commenced on December 4, 2003 and pending in the Superior Court ofCalifornia, County of Santa Clara. Plaintiffs purport to sue the individualdefendants on behalf of Silicon Image. The lawsuit alleges that as a result ofthe recently completed examination conducted by the Audit Committee of SiliconImage’s Board of Directors, Silicon Image will be required to restate itsfinancial results for 2002 and 2003. The lawsuit further alleges that such arestatement would be due to breaches by the individual defendants of theirfiduciary duties to Silicon Image; that certain of the individual defendantsare liable to Silicon Image for insider trading under California law; and thatthe individual defendants are liable to Silicon Image for mismanagement, abuseof control, and waste. Before filing suit, plaintiffs did not make a demandupon the board of directors to pursue any such claims directly on behalf ofSilicon Image. With the announcement by the Audit Committee of Silicon Image’sBoard of Directors that it has completed its examination and that it hasconcluded that no changes to Silicon Image’s previously announced financialresults are required, the lawsuit may be moot in whole or in part, althoughplaintiffs may amend the complaint once as a matter of right. The individualdefendants believe the lawsuit is without merit, and they intend to defend theaction vigorously if plaintiffs do not amend it. We cannot predict what claimsplaintiffs might assert in an amended complaint.

Silicon Image and certain of its officers have beennamed as defendants in consolidated securities class action litigationcaptioned “In re Silicon Image, Inc. Securities Litigation, No. C-03-5579JW PVT”, commenced on December 11, 2003 and pending in the United StatesDistrict Court for the Northern District of California. Plaintiffs filed theaction on behalf of a putative class of shareholders who purchased SiliconImage stock between April 15, 2002 and November 15, 2003. The lawsuitalleges that Silicon Image had materially overstated its licensing revenue, netincome and financial results during this time period, and that Silicon Imagewas being forced to restate its financial results. With the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the lawsuit may be moot inwhole or in part, although plaintiffs may amend the complaint once as a matterof right. We believe the lawsuit is without merit, and intend to defend theaction vigorously if plaintiffs do not amend it. We cannot predict what claimsplaintiffs might assert in an amended complaint.

On August 7, 2002, we filed a demand forarbitration with the American Arbitration Association, file #74 Y 117 01399 02GAP, against the principal shareholders of CMD Technology (CMD) relating toshares held in escrow in connection with our acquisition of CMD. Pursuant toagreements by which we acquired CMD, a portion of the Silicon Image commonstock issued to the principal shareholders of CMD was held in two separateescrow pools as collateral for the indemnification obligations of these 

20

----

shareholders. Wepreviously made indemnification claims against these escrow pools for therelease of escrow shares with a value of approximately $5.4 million, whichclaims were contested by the principal shareholders of CMD. On February 28,2003, we and the principal shareholders of CMD entered into a settlementagreement and mutual release, pursuant to which our indemnification claims wereresolved. As a result of the settlement, we received 949,780 of the escrowedshares, valued at approximately $4.7 million, and recorded a net non-operating gainof $4.6 million in the first quarter of 2003.

In addition, we are involved in a number of judicialand administrative proceedings incidental to our business. We intend toprosecute or defend, as appropriate, such matters vigorously, and althoughadverse decisions or settlements may occur in one or more of such cases, thefinal resolution of these matters, individually or in the aggregate, is notexpected to have a material adverse effect on our results of operations orfinancial position.

The amount of legal feeswe incur with respect to the litigation matters described above will depend onthe duration of our litigation matters, as well as the nature and extent of thelitigation activities. We are not able to accurately estimate the amount oflegal fees we will incur in 2004 with respect to the litigation mattersdescribed above, however, we do expect to incur substantial amounts through2004.

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

None

21

----

**PART II**

**Item 5.** Market for the Registrant’s Common Stock andRelated Stockholder Matters 

Ourcommon shares have been traded on the NASDAQ Stock Market since our initialpublic offering on October 6, 1999. Our common shares traded under thesymbol “SIMG”. Our shares are not listed on any other markets or exchanges. Thefollowing table shows the high and low closing prices for our common shares asreported by the NASDAQ Stock Market:
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2003**       |       |     |       |    |       |
| Fourth Quarter |       | $        | 9.05       |    | $          | 4.28 |   |
| Third Quarter  |       | 6.65     |       | 4.50    |       |
| Second Quarter |       | 6.18     |       | 4.17    |       |
| First Quarter  |       | 7.65     |       | 3.98    |       |
| **2002**       |       |     |       |    |       |
| Fourth Quarter |       | 7.42     |       | 2.34    |       |
| Third Quarter  |       | 6.87     |       | 3.34    |       |
| Second Quarter |       | 10.67    |       | 4.41    |       |
| First Quarter  |       | 9.14     |       | 4.06    |       |
|                |            |          |            |         |            |  |  |

 

As of January 31, 2004, we had approximately 184holders of record of our common shares and a substantially greater number ofbeneficial owners.

We filed a Registration Statement on Form S-1(File No. 333-83665) that was declared effective by the SEC on October 5,1999. On October 6, 1999, Silicon Image shares commenced trading, and on October 12,1999, we completed the sale of all 8,970,000 registered shares at a price of$6.00 per share.

We received net proceeds of $48.0 million, afterdeducting underwriting discounts and commissions of approximately $3.8 millionand estimated offering expenses of approximately $1.7 million. None of theseoffering expenses were paid directly or indirectly to any of our directors orofficers, any person owning 10% or more of any class of our equity securities,or any of our affiliates. We intend to use the proceeds from this offering forgeneral corporate purposes, including working capital and capital expenditures.

We have never declared or paid cash dividends onshares of our capital stock. We intend to retain any future earnings to financegrowth and do not anticipate paying cash dividends in the future.

In connection with ouracquisition of Zillion Technologies, LLC, we are obligated under an exchangeagreement to periodically issue to the two founders of Zillion shares of ourcommon stock as consideration for their membership interests in Zillion whichwe acquired and services provided pursuant to their employment agreements withus. The Zillion founders were granted registration rights with respect to theshares to be issued under this exchange agreement. These issuances of shareswere made in reliance on an exemption from registration under Section 4(2) ofthe Securities Act. On December 31, 2003, we issued 18,750 shares of ourcommon stock to the Zillion founders pursuant to the exchange agreement. Theissuances of shares were made without general solicitation or advertising andwere only made to two individuals.

22

----

**Item 6. Selected Financial Data**

Thefollowing selected financial data should be read in connection with our consolidatedfinancial statements and notes thereto and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included elsewherein this Form 10-K. Historical results of operations are not necessarilyindicative of future results.
| ** **                                         | ** ** | **Year Ended December 31,**                                                                 | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2003**                                                                                                   | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
| ** **                                         | ** ** | **(in thousands, except footnotes, employees and per share data)** | ** ** |
| **Statements of Operations Data:**                 |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Total revenue                                      |       | $                                                                                                          | 103,525    |   | $ | 81,539 |   | $ | 51,966 |   | $ | 50,035 |   | $ | 21,244 |   |
| Cost of revenue:                                   |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Absolute dollars(1)                                |       | $                                                                                                          | 46,609     |   | $ | 38,110 |   | $ | 25,063 |   | $ | 18,798 |   | $ | 7,985 |   |
| % of revenue                                       |       | 45.0                                                                                                       | %          | 46.7 | % | 48.2 | % | 37.6 | % | 37.6 | % |
| Research and  development:                         |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Absolute dollars(2)                                |       | $                                                                                                          | 36,523     |   | $ | 32,809 |   | $ | 25,473 |   | $ | 12,811 |   | $ | 7,168 |   |
| % of revenue                                       |       | 35.3                                                                                                       | %          | 40.2 | % | 49.0 | % | 25.6 | % | 33.7 | % |
| Selling, general and  administrative:              |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Absolute dollars(3)                                |       | $                                                                                                          | 18,401     |   | $ | 17,454 |   | $ | 18,773 |   | $ | 18,902 |   | $ | 8,110 |   |
| % of revenue                                       |       | 17.8                                                                                                       | %          | 21.4 | % | 36.1 | % | 37.8 | % | 38.2 | % |
| Loss from  operations                              |       | $                                                                                                          | (17,719    | ) | $ | (40,850 | ) | $ | (78,530 | ) | $ | (26,858 | ) | $ | (8,697 | ) |
| Net loss                                           |       | $                                                                                                          | (12,810    | ) | $ | (40,092 | ) | $ | (76,108 | ) | $ | (23,243 | ) | $ | (7,621 | ) |
| Net loss per share:                                |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Basic and diluted                                  |       | $                                                                                                          | (0.18      | ) | $ | (0.62 | ) | $ | (1.32 | ) | $ | (0.47 | ) | $ | (0.38 | ) |
| Weighted average shares                            |       | 69,412                                                                                                     |       | 64,283 |   | 57,790 |   | 49,720 |   | 20,192 |   |
| **Balance Sheet and Other Data as  of Year End:**  |       |                                                                                                       |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |       | $                                                                                                          | 37,254     |   | $ | 35,833 |   | $ | 41,218 |   | $ | 60,189 |   | $ | 58,147 |   |
| Working capital                                    |       | $                                                                                                          | 37,674     |   | $ | 27,787 |   | $ | 36,179 |   | $ | 56,713 |   | $ | 55,380 |   |
| Total assets                                       |       | $                                                                                                          | 87,742     |   | $ | 77,616 |   | $ | 90,162 |   | $ | 99,499 |   | $ | 67,501 |   |
| Tangible assets                                    |       | $                                                                                                          | 71,693     |   | $ | 64,595 |   | $ | 68,534 |   | $ | 78,146 |   | $ | 67,501 |   |
| Long-term debt  obligations                        |       | $                                                                                                          | —     |   | $ | — |   | $ | 819 |   | $ | 1,030 |   | $ | 528 |   |
| Total  stockholders’ equity                   |       | $                                                                                                          | 62,393     |   | $ | 48,170 |   | $ | 67,324 |   | $ | 83,197 |   | $ | 57,564 |   |
| Tangible net book  value                           |       | $                                                                                                          | 46,344     |   | $ | 35,149 |   | $ | 45,696 |   | $ | 61,844 |   | $ | 57,564 |   |
| Regular full-time  employees                       |       | 250                                                                                                        |       | 249 |   | 266 |   | 150 |   | 85 |   |

----

(1)          Excludesnon-cash stock compensation and warrant expense of $583,000, $1.2 million,$279,000, $593,000, and $609,000, for the years ended December 31, 2003,2002, 2001, 2000 and 1999, respectively.

(2)          Excludes non-cash stockcompensation and warrant expense of $6.9 million, $7.4 million, $9.3 million,$10.2 million, and $2.5 million for the years ended December 31, 2003,2002, 2001, 2000, and 1999, respectively.

(3)          Excludesnon-cash stock compensation and warrant expense of $2.5 million, $2.5 million,$2.8 million, $2.8 million and $3.5 million for the years ended December 31,2003, 2002, 2001, 2000 and 1999, respectively.

23

----

**Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**Audit Committee Examination**

In November 2003, the Company announced that itwould delay the filing of its quarterly report on Form 10-Q because an examination had been commenced byits Audit Committee. The Company’s Audit Committee, with the assistance of independent outsidecounsel and independent outside consultants, was examining certain matters, principallythe Company’s recognition of revenue associated with its licensing transactionsin 2002 and 2003.

In February 2004, the Company’s Audit Committeecompleted its examination. During the course of the examination, the AuditCommittee and its outside advisors conducted a thorough review of the Company’slicensing transactions in 2002 and 2003, as well as a review of certain othermatters. As a result of its examination, the Audit Committee concluded that nochanges were required to the results previously announced for the quarter endedSeptember 30, 2003, or any prior reporting period. In its review, theAudit Committee concluded that there were no accounting irregularities and thatno member of the Company’s management engaged in misconduct in connection withthe matters under examination.

During the course of its examination, the AuditCommittee identified certain areas in which the Company’s control environmentshould be improved. As a result, the Company, under the direction of the AuditCommittee and the Board of Directors, is taking steps to strengthen the Company’scontrols. In connection with these steps, the Company is adopting a policyrequiring additional documentation of items necessary for licensing revenuerecognition decisions; increasing the standardization of licensing deliverablesand post-contract customer support for revenue recognition purposes; andformalizing its licensing deal review process. The Company only began to reportrevenues from licensing transactions in 2002. These enhancements to the Company’scontrols are in part designed to help the Company adapt to the growingcomplexity and importance of this additional component of its businessstrategy.

The Company is also in theprocess of adopting and implementing internal measures designed to enhance theCompany’s overall internal control environment and to increase the level ofcommunication within the management team and between the management team andthe Board of Directors, including the Audit Committee. These measures include restructuring some reportingrelationships among management and evaluating and redefining management rolesand responsibilities. The Company may receive and consider additionalrecommendations designed to enhance its overall internal control environment. TheCompany believes that the steps it has taken and its continued monitoring andimprovement of its internal controls are and will remain sufficient to ensurecontinued compliance with law.

**Overview**

Silicon Image is a leader in multi-gigabitsemiconductor solutions for the secure transmission, storage and display ofrich digital media. The company’s mission is to be the leader in defining thearchitectures, intellectual property (IP) and semiconductor technology requiredto build secure digital content delivery systems. To ensure that rich digitalcontent is always available on any device, consumer electronics, PC and storagedevices must be architected for content compatibility and interoperability*.*

Silicon Image’s strategy entails establishingindustry-standard, high-speed digital interfaces and building market momentumand leadership through its first-to-market, standards-based IC products. Furtherleveraging its strong IP portfolio, the company broadens market adoption of theDigital Visual Interface (DVI), High-Definition Multimedia Interface (HDMI) andSerial ATA (SATA) interfaces by licensing its proven IP cores to companiesproviding advanced system-on-a-chip solutions incorporating these interfaces. Licensing,in addition to creating revenue and return on engineering investment in market 

24

----

segments we choose not toaddress, creates products complementary to our own that expand the markets forour products and help to improve industry wide interoperability.

Silicon Image is a leader in the global PC/displayarena with its innovative PanelLink® digital interconnecttechnology, which enables an all-digital connection between PC host systems anddigital displays such as LCD monitors, plasma displays and projectors. PanelLinktechnology is the basis for the DVI industry standard the company pioneered andremains the most popular DVI implementation with more than 40 million unitsshipped to date.

In 2000, in order to decrease our absolute dependenceon the PC business, we embarked upon a plan to diversify into the CE andstorage markets. Products sold into the PC market have been declining as apercentage of our total revenues and generated 32% of our revenue in 2003, 58%of our revenue in 2002, and 70% of our revenue in 2001.

Leveraging our core technology and standards-settingexpertise, Silicon Image is driving HDMI (High Definition MultimediaInterface), the new digital interface standard for the consumer electronicsmarket. Introduced by founders Hitachi, Matsushita (Panasonic), Philips,Silicon Image, Sony, Thomson and Toshiba, HDMI enables the distribution ofuncompressed, high-definition video and multi-channel audio in a single,all-digital interface that dramatically simplifies cabling. Silicon Image’sHDMI technology is marketed under the PanelLink CinemaTM brand and includesHigh-bandwidth Digital Content Protection (HDCP), which is supported by certainHollywood studios as the technology of choice for the secure distribution ofpremium content. The PanelLink Cinema chip and the first HDMI-compliant siliconare on the market and are featured in the world’s first consumer electronicsproducts with HDMI functionality.

Products sold into the CE market have been increasingas a percentage of our total revenues and generated 25% of our revenue in 2003,11% of our revenue in 2002, and 8% of our revenue in 2001. Our CE productsoffer a securable interface for transmission of digital video and audio toconsumer devices, such as digital TVs and DVD players. Demand for theseproducts will be driven primarily by the adoption rate of new technologies,such as High-Definition Multimedia Interface (“HDMI”) and High-Bandwidth Digital ContentProtection (“HDCP”).

In the storage market, Silicon Image has assumed aleadership role in Serial ATA (“SATA”), the new high-bandwidth, point-to-pointinterface that is replacing Parallel ATA in desktop storage and making inroadsin the enterprise arena due to its price/performance. Silicon Image is aleading supplier of discrete SATA devices with hundreds of motherboard andadd-in-card design wins. Silicon Image’s SATALinkTM-branded solutions are fullySATA-compliant and offer advanced features and capabilities such as NativeCommand Queuing, port multiplier capability and ATAPI support. Silicon Imagealso supplies high-performance, low-power Fibre Channel Serializer/Deserializer(SerDes) to leading switch manufacturers.

Semiconductor products sold into the storage markethave been increasing as a percentage of our total revenues and generated 27% ofour revenue in 2003, 15% of our revenue in 2002, and 5% of our revenue in 2001.Demand for our storage semiconductor products is dependent upon the rate atwhich interface technology transitions from parallel to serial, and the extentto which SATA and fibre channel functionality are integrated into chip sets andcontrollers offered by other companies, which would make our discrete devicesunnecessary.

Sales of storage subsystems products generated 2% ofour revenue in 2003, 8% of our revenue in 2002, and 17% of our revenue in 2001.We are phasing out our storage subsystems products. In conjunction with ourdecision to phase out our storage subsystems products, we decided to designproducts for and/or license our technology to third parties in this market.

License revenue is recognized when an agreement with alicensee exists, the price is fixed or determinable, delivery or performancehas occurred, and collection is reasonably assured. Generally, we expect tomeet these criteria and recognize revenue at the time we deliver the agreed-uponitems. 

25

----

However, we may deferrecognition of revenue until cash is received if collection is not reasonablyassured at the time of delivery. A number of our license agreements requirecustomer acceptance of deliverables, in which case we would defer recognitionof revenue until the licensee has accepted the deliverables and either paymenthas been received or is expected within 90 days of acceptance. Certainlicensing agreements provide for royalty payments based on agreed upon royaltyrates. Such rates can be fixed or variable depending on the terms of theagreement. The amount of revenue we recognize is determined based on a timeperiod or on the agreed-upon royalty rate, extended by the number of unitsshipped by the customer. To determine the number of units shipped, we rely uponactual royalty reports from our customers when available and rely uponestimates in lieu of actual royalty reports when we have a sufficient historybase of receiving royalties from a specific customer for us to make an estimatebased on available information from the licensee such as quantities held,manufactured and other information. These estimates for royalties necessarilyinvolve the application of management judgment. As a result of our use ofestimates, period-to-period numbers are “trued-up” in the following period toreflect actual units shipped. To date, such “true-up” adjustments have not beensignificant. In cases where royalty reports and other information are notavailable to allow us to estimate royalty revenue, we recognize revenue onlywhen royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure.

Our licensing activity is complementary to our productsales because we believe this activity can help us monetize our intellectualproperty as well as accelerate adoption curves associated with our technology.Most of our licenses include a field of use restriction that prevents thelicensee from building a chip in direct competition with those market segmentswe have chosen to pursue. Revenue from development, licensing and royaltiesaccounted for 14%, 8% and 0% of our revenues, and represented 25%, 16% and 0%of our total gross margin, for 2003, 2002 and 2001, respectively. Licensingcontracts are complex and depend upon many factors including completion ofmilestones, allocation of values to delivered items, and customer acceptances. Althoughwe attempt to make these factors predictable, many of these factors requiresignificant judgments. Licensing revenues have fluctuated significantly fromperiod to period and may continue to do so in the future; because of their highmargin content they can have a disproportionate impact on gross margins andprofitability.

In October 1999, we raised approximately $48million in our initial public offering. We have incurred losses in all but onequarterly period since our inception and, as of December 31, 2003, we hadan accumulated deficit of $172.7 million.

Prior to 2000 we focused most of our efforts on thesale and development of PanelLink transmitters, receivers and controllers forthe PC/Display market. In 2000, we began focusing our resources on entering twonew markets, storage and CE, which we believed would grow significantly and inwhich we believed we could apply our technology and expertise in high-speedserial interfaces. During 2000, we acquired Zillion, a developer of high-speedtransmission technology for data storage applications, and DVDO, a provider ofdigital video processing systems for the CE market.

In 2001, we focused on accelerating our entry into theCE and storage markets, leveraging our IP into licensing revenue, andrestructuring the company to improve profitability. During 2001, we acquiredCMD, a provider of storage subsystems and semiconductors designed for storagearea networks, and SCL, a provider of mixed-signal and high-speed circuitdesigns.

During 2002, we achieveddouble-digit sequential revenue growth in each fiscal quarter, resulting inrecord annual revenue of $81.5 million, which was a 57% increase from 2001revenue levels. We also began to see the benefits of our diversificationstrategy, which resulted in establishing a presence in the CE and storagemarkets, both of which are expected to experience strong growth rates duringthe next several 

26

----

years.Additionally, we were able to successfully leverage our intellectual propertyto generate $6.7 million of development, licensing and royalty revenue. We alsofocused on improving our profitability and reducing our cash usage.

**Year2003**

During 2003, we achieved significant growth, resultingin record annual revenue of $103.5 million, representing a 27% increasecompared to 2002. We were also able to continue to take advantage of ourdiversification strategy effectively, which resulted in our being able toexpand our presence in the CE and storage markets, both of which we expect willexperience significant growth rates during the next several years.Additionally, we were able to successfully leverage our intellectual propertyto generate $14.2 million of development, licensing and royalty revenue.

In 2003 we introduced our first HDMI products for theCE market. HDMI is a new standard for digital video and audio transmission forconsumer devices. This standard was created by Silicon Image, together withSony, Matsushita (Panasonic), Philips, Thomson (RCA), Hitachi and Toshiba, andwith strong support from Fox and Universal studios, DirecTV and Echostar. Webelieve that a majority of digital TVs, DVDs and set-top boxes will include adigital interconnect, whether it is DVI or HDMI, within the next five years. Wealso believe that a majority of these digital interfaces will be secured,whether DVI or HDMI, with high definition content protection (HDCP). There hasbeen initial market acceptance of our HDMI products and major CE manufacturershave already incorporated our products into several of their designs. Duringthe year we also opened an HDMI authorized testing center for testing ofproducts for compliance with the HDMI specifications.

In the storage market, we had a number of new andadvanced product offerings. We were able to achieve numerous design wins withour SATALink products. In particular, there was widespread market acceptance ofthe PCI to four-port serial ATA solutions for the PC and server markets and anumber of major manufacturers incorporated our products into theirmotherboards. We believe we are well positioned to continue to be in theforefront and benefit from an increasingly rapid rate of transition to serialATA technology. Furthermore we expect to leverage our storage expertise in therapidly growing area of storage for CE storage devices. Additionally, our 2GBfibre channel solutions experienced strong growth as our major OEM’s haveexperienced increased strength in their businesses. Demand declined throughoutthe year for our parallel ATA and USB 1.0 products as the market began totransition to serial ATA. We expect demand for these legacy products tocontinue to decrease significantly throughout 2004.

In the PC market, we introduced a number of newtransmitter and receiver chips and in particular our next generation ofPanelLink DVI receiver chips was well received and incorporated by several PCmanufacturers. These DVI solutions are also finding their way into CE devices.In fact, according to DisplaySearch, an independent research firm, DVI is wellpositioned to enjoy rapid growth due to significant increases expected in itstwo largest target markets—LCD monitor market and the LCD TV market—the LCDmonitor market is expected to grow from 49 million units in 2003 to 139 millionunits in 2007 and the LCD TV market is expected to grow from 4.2 million unitsin 2003 to 31 million units in 2007. Consistent with the overall growth in theDVI CE market, we expect the DVI adoption rate to increase for the PC marketduring the next two years as quality, cost and content will make an all-digitalconnection more attractive than an analog solution. We also expect the pricesof digital displays to continue to decrease, which we expect will increasedemand for digital displays. Our transmitter products continued to experiencecompetitive pressure, primarily from integration by the graphic chip supplierssuch as ATI and nVidia. Thine and Texas Instruments also remain competitors.Because of this increased competition we saw lower average selling prices forthese products. We expect graphic card manufacturers to continue to integrate atransmitter into their graphics chip, thus eliminating the need for a discretetransmitter device in many host products. We believe that integration in thenext two-to-three years will be limited to lower resolution technology, andthat higher resolutions will continue to require a discrete transmitter toachieve 

27

----

high-resolution quality.We continued to lose market share in the receiver market during 2003, as OEMscontinued to use dual-interface solutions in flat panels to accommodate bothdigital and analog signals. In addition, we generated licensing revenue bylicensing certain technology to companies for use in making products for thedual-interface market. During the year we also opened a DVI Compliance TestCenter.

On April 7, 2003, we issued approximately2,501,000 shares of common stock in exchange for all outstanding shares of TransWarpNetworks (“TWN”)capital stock, and converted all outstanding TWN options into options topurchase approximately 760,000 shares of our common stock. The purchase pricefor this acquisition was approximately $14.5 million. Approximately 392,000 sharesof our issued common stock will be held in escrow for a period of eighteenmonths as collateral for indemnity obligations of the principal TWNstockholders. We also assumed TWN’s 2002 Stock Option / Stock IssuancePlan, under which a reserve of approximately 116,000 shares of our common stockremained available for future issuance. This transaction has been accounted foras an asset purchase. We expensed $5.5 million of in-process research anddevelopment and recorded tangible and intangible assets of $4.2 million inconnection with this transaction.

On July 15, 2003, the Federal District Court inRichmond, Virginia, upheld our interpretation of a previously agreed uponMemorandum of Understanding (MOU) with Genesis. On August 6, 2003, theCourt entered a final judgment based on its July 15, 2003 ruling. Underthe final judgment order, Genesis was ordered to make a substantial cashpayment, and make royalty payments; although Genesis has made and continues to make cash payments to theCourt, it may not have made all the payments that are required under the finaljudgment order. We filed motions for reimbursement of some of our expenses,including some of our legal fees, and for modification and/or clarification ofcertain items of the judgment, and to hold Genesis in contempt of Court forbreaching the protective order in the case by disclosing secret information toat least one of our competitors. On December 19, 2003, the Court grantedour motions in part and denied them in part: the court issued an amendedjudgment, and held Genesis in contempt of Court for breaching the protectiveorder. On January 16, 2004, Genesis filed a notice of appeal. Todate we have not received any cash payments nor have we recognized any revenueassociated with the matter. Under the settlement agreement, Genesis was granteda royalty-bearing license for the right to use certain non-necessary patentclaims referred to in the DVI Adopters Agreement. In addition, upon Genesis’sbecoming a signatory to the HDMI Adopters Agreement, Genesis will be granted aroyalty-bearing license for the right to use these claims as part of their HDMIimplementation. Genesis also was granted a royalty-bearing license to expanduse of certain DVI-related patent claims to the consumer electronicsmarketplace.

During 2003, we alsofocused on improving the company’s profitability and reducing our cash usagerate. Our cash and short-term investments increased by $1.4 million in 2003,versus a decline of $5.4 million in 2002.

**Outlook**

We expect 2004 revenue to increase from the levelachieved in 2003, and believe our revenue in the first quarter of 2004 willgrow sequentially from the fourth quarter of 2003.

We believe our expected revenue growth during 2004will be driven by several factors. First, DVI adoption rates are expected toincrease as demand for notebook computers and graphics cards containing ourproducts increase during the year. Second, in the CE market we have had anumber of important design wins, some which begin mass production in early 2004and we expect the production of other designs already in mass production toincrease during the year. As the CE industry continues to transition to anall-digital solution, we expect the marketplace for our products to grow significantly.Third, Serial ATA adoption rates are expected to increase. Lastly, we expectour licensing market to continue to be attractive and as our licensing basegrows, we also expect to see an increase in royalty revenues.

28

----

Among the factors that maycause our actual results to differ materially from those anticipated by ourassumptions include the rate at which the PC market adopts DVI, acceptance ofall digital solutions in the PC market, CE market acceptance of our DVI withHDCP and HDMI products, the rate at which the storage market transitions to 2Gb fibre channel switches and serial ATA technology, consumer demand in the PCand CE markets, the availability of serial ATA-enabled hard drives and otherperipherals, whether and how quickly OEMs are able to integrate transmitters intheir graphics chips and serial ATA functionality into their chip sets, ourability to leverage our intellectual property into licensing revenue and theability of our semiconductor foundry vendors to manufacture our products incommercial volumes at an acceptable cost and in a timely manner. In addition,our revenue remains subject to competition and general economic and marketconditions, none of which can be accurately predicted.

We expect our gross marginpercentage to increase slightly from 2003 levels as a result of higherlicensing and royalty revenue, for which there is no associated cost of sales,manufacturing cost reductions on certain of our higher volume products, higherunit volume and shifts in product mix whereby higher margin CE products willgrow faster than our PC or storage product lines that have lower gross margins.These positive effects will be offset by declining average selling prices (“ASPs”),especially for products in the PC market, and higher manufacturing overheadspending to support increased production levels for products in all three ofour markets.

Excluding non-cash chargesfor stock compensation expense, we expect the dollar amount of our R&Dexpense to increase approximately 10 - 20% in 2004. R&D expense will beincurred for enhancements to existing products and for further development oftechnology related to consumer electronics and storage applications. Excludingnon-cash charges for stock compensation expense, we expect the dollar amount ofour SG&A expense to increase approximately 10 - 20% in 2004, primarily as aresult of increased headcount levels necessary to support our revenue growth.We cannot predict the R&D or SG&A expenses including the non-cashcharges for stock compensation expense, which will fluctuate with changes inour stock price and volatility.

We expect to incursubstantial non-cash stock compensation expense in 2004 and future periods as aresult of previous stock option repricings, stock options assumed in connectionwith our prior acquisitions, the issuance of stock options to consultants, andmodifications to stock options. We may also incur non-cash stock compensationexpense in connection with future acquisitions. The amount of stockcompensation expense in each period will fluctuate with changes in our stockprice and volatility.

During 2004 and futureperiods, we may also incur non-cash expenses for the impairment or amortizationof intangible assets.

We will also incur legalfees in 2004 in conjunction with our patent infringement lawsuit againstGenesis, the recently completed Audit Committee examination, and otheroutstanding litigation. The amount of legal fees incurred will depend on theduration of the litigation, as well as the nature and extent of the litigationactivities. We are not able to accurately estimate the amount of legal fees wewill incur with respect to this matter; however, we do expect to incursubstantial amounts through at least the fourth quarter of 2004. We estimatethe costs associated with the conduct of the Audit Committee examination to beapproximately $0.8 million during the first quarter of 2004. Pending litigationcosts associated with the examination cannot be accurately projected for thefollowing quarters and could be significant.

**Commitments,Contingencies and Concentrations**

Historically, a relativelysmall number of customers and distributors have generated a significant portionof our revenue. For instance, our top five customers, including distributors,generated 41%, 41%, and 51% of our revenue in 2003, 2002 and 2001,respectively. The decrease in 2003 and 2002 from 2001 levels can be attributedto our market diversification. Additionally, the percentage of revenuegenerated through distributors tends to be significant, since many OEM’s relyupon third party manufacturers or distributors to provide purchasing andinventory management functions. In 2003, 42% of revenue was 

29

----

generatedthrough distributors, compared to 42% in 2002 and 40% in 2001. Our licensingrevenue is not generated through distributors, and to the extent licensingrevenue increases, we would expect a decrease in the percentage of our revenuegenerated through distributors.

A significant portion ofour revenue is generated from products sold overseas. Sales (includinglicensing) to customers in Asia, including distributors, generated 69%, 64%,and 64% of our revenue in 2003, 2002, and 2001, respectively. The reason forour geographical concentration in Asia is that most of our products are part offlat panel displays, graphic cards and motherboards, the majority of which aremanufactured in Asia. The percentage of our revenue derived from any country isdependent upon where our end customers choose to manufacture their products.Accordingly, variability in our geographic revenue is not necessarilyindicative of any geographic trends, but rather is the combined effect of newdesign wins and changes in customer manufacturing locations. All revenue todate has been denominated in U.S. dollars.

In September 1998, weentered into an agreement with Intel to develop and promote the adoption of adigital display interface specification. In connection with this agreement, wegranted Intel a warrant to purchase 285,714 shares of our common stock at $1.75per share. Under the same agreement, we granted Intel a warrant to purchase285,714 shares of our common stock at $0.18 per share upon achievement of aspecified milestone that was reached during the first quarter of 1999. Both ofthese warrants were exercised in May 2001. Additionally, if a secondspecified milestone is achieved, which we do not believe is likely, we would berequired to grant Intel a third warrant to purchase 285,714 shares of ourcommon stock at $0.18 per share. The estimated fair value of the warrant at December 31,2003 was $2.0 million. This warrant expires in September 2008.

**Critical AccountingPolicies**

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectamounts reported in our consolidated financial statements and accompanyingnotes. We base our estimates on historical experience and all known facts andcircumstances that we believe are relevant. Actual results may differmaterially from our estimates. We believe the following accounting policies tobe most critical to an understanding of our financial condition and results ofoperations because they require us to make estimates, assumptions and judgmentsabout matters that are inherently uncertain.

*Revenue recognition*

For products sold directlyto end-users, or to distributors that do not receive price concessions and donot have rights of return, we recognize revenue upon shipment and titletransfer if we believe collection is reasonably assured. Reserves for salesreturns and allowances are estimated based primarily on historical experienceand are provided at the time of shipment. The amount of sales returns andallowances has not been, and is not expected to be, material.

The majority of ourproducts are sold to distributors with agreements allowing for priceconcessions and product returns. We recognize revenue based on our bestestimate of when the distributor sold the product to its end customer based onpoint of sales reports received from our distributors. Due to the timing ofreceipt of these reports, we recognize distributor sell-through usinginformation that lags quarter end by one month. Revenue is not recognized uponshipment since, due to various forms of price concessions, the sales price isnot substantially fixed or determinable at that time. Price concessions arerecorded when incurred, which is generally at the time the distributor sellsthe product to an end-user. Additionally, these distributors have contractualrights to return products, up to a specified amount for a given period of time.Revenue is earned when the distributor sells the product to an end-user, atwhich time our sales price to the distributor becomes fixed. Our revenue ishighly dependent on receiving pertinent and accurate data from our distributorsin a timely fashion. Distributors provide us periodic data 

30

----

regardingthe product, price, quantity, and end customer on their shipments as well asthe quantities of our products they still have in stock. In determining theappropriate amount of revenue to recognize, we use this data and apply judgmentin reconciling differences between their reported inventories and activities.If distributors incorrectly report their inventories or activities, or if ourjudgment is in error, it could lead to inaccurate reporting of our revenues andincome.

License revenue isrecognized when an agreement with a licensee exists, the price is fixed ordeterminable, delivery or performance has occurred, and collection isreasonably assured. Generally, we expect to meet these criteria and recognizerevenue at the time we deliver the agreed-upon items. However, we may deferrecognition of revenue until cash is received if collection is not reasonablyassured at the time of delivery. A number of our license agreements requirecustomer acceptance of deliverables, in which case we would defer recognitionof revenue until the licensee has accepted the deliverables and either paymenthas been received or is expected within 90 days of acceptance. Certainlicensing agreements provide for royalty payments based on agreed upon royaltyrates. Such rates can be fixed or variable depending on the terms of theagreement. The amount of revenue we recognize is determined based on a timeperiod or on the agreed-upon royalty rate, extended by the number of unitsshipped by the customer. To determine the number of units shipped, we rely uponactual royalty reports from our customers when available, and rely uponestimates in lieu of actual royalty reports when we have a sufficient historybase of receiving royalties from a specific customer for us to make an estimatebased on available information from the licensee such as quantities held,manufactured and other information. These estimates for royalties necessarilyinvolve the application of management judgment. As a result of our use ofestimates, period-to-period numbers are “trued-up” in the following period toreflect actual units shipped. To date, such “true-up” adjustments have not beensignificant. In cases where royalty reports and other information are notavailable to allow us to estimate royalty revenue, we recognize revenue onlywhen royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement, and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure. Ourlicense revenue recognition depends upon many factors including completion ofmilestones, allocation of values to delivered items and customer acceptances.Many of these factors require significant judgments, and if our judgment is inerror it could lead to inaccurate reporting of our revenues and income.

*Allowance for Doubtful Accounts*

We review collectibilityof accounts receivable on an on-going basis and provide an allowance foramounts we estimate will not be collectible. During our review, we consider ourhistorical experience, the age of the receivable balance, the credit-worthinessof the customer, and the reason for the delinquency. Write-offs to date havenot been material. At December 31, 2003, we had $13.4 million of grossaccounts receivable and an allowance for doubtful accounts of $670,000. Whilewe endeavor to accurately estimate the allowance, we may record unanticipatedwrite-offs in the future.

*Inventories*

We record inventories atthe lower of standard cost, determined on a first-in first-out basis, ormarket. Standard cost approximates actual cost. Provisions are recorded forexcess and obsolete inventory, and are estimated based on a comparison of thequantity and cost of inventory on hand to management’s forecast of customer demand.Customer demand is dependent on many factors and requires us to use significantjudgment in our forecasting process. We must also make assumptions regardingthe rate at which new products will be accepted in the marketplace and at whichcustomers will transition from older products to newer products. Generally,inventories in excess of six months demand are written down to zero and therelated provision is recorded as a cost of revenue. While we endeavor toaccurately predict demand and 

31

----

stockcommensurate inventory levels, we may record unanticipated material inventorywrite-downs in the future.

*Long-Lived Assets*

Consideration paid inconnection with acquisitions is required to be allocated to the assets,including identifiable intangible assets, and liabilities acquired. Acquiredassets and liabilities are recorded based on our estimate of fair value, whichrequires significant judgment with respect to future cash flows and discountrates.

For certain long-livedassets, primarily fixed assets and intangible assets, we are required toestimate the useful life of the asset and recognize its cost as an expense overthe useful life. We use the straight-line method to depreciate long-livedassets. We regularly compare the carrying value of long-lived assets to ourprojection of future undiscounted cash flows attributable to such assets and inthe event that the carrying value exceeds the future undiscounted cash flows,we record an impairment charge against income equal to the excess of thecarrying value over the asset’s fair value. Predicting future cash flowsattributable to a particular asset is difficult, and requires the use ofsignificant judgment.

*Goodwill*

We adopted the Statementof Financial Accounting Standard No.142 (SFAS 142), “Goodwill and OtherIntangible Assets” on January 1, 2002. This standard requires thatgoodwill no longer be amortized, and instead, be tested for impairment on aperiodic basis. The process of evaluating the potential impairment of goodwillis highly subjective and requires significant judgment at many points duringthe analysis. In estimating the fair value of the business, we make estimatesand judgments about the future cash flows. Although our cash flow forecasts arebased on assumptions that are consistent with the plans and estimates we areusing to manage our business, there is significant judgment in determining suchfuture cash flows. We also consider market capitalization (adjusted forunallocated monetary assets such as cash, marketable debt securities and debt)on the date we perform the analysis. Based on our annual impairment testperformed for 2003, we concluded that there was no impairment of goodwill infiscal 2003. However, there can be no assurance that we will not incur chargesfor impairment of goodwill in the future, which could adversely affect ourearnings.

*Deferred Tax Assets*

We account for incometaxes using an asset and liability approach, which requires recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been recognized in our financial statements, but have not beenreflected in our taxable income. A valuation allowance is established to reducedeferred tax assets to their estimated realizable value. Therefore, we providea valuation allowance to the extent we do not believe it is more likely thannot that we will generate sufficient taxable income in future periods torealize the benefit of our deferred tax assets. To date, as a result of ourrecurring losses we have provided a 100% valuation allowance against all of ourdeferred tax assets. Predicting future taxable income is difficult, andrequires the use of significant judgment. 

*Accrued Liabilities*

Certain of our accruedliabilities are based largely on estimates. For instance, we record a liabilityon our balance sheet each period for the estimated cost of goods and servicesrendered to us, for which we have not received an invoice. Additionally, acomponent of our restructuring accrual related to a loss we expect to incur forexcess leased facility space is based on numerous assumptions and estimates,such as the market value of the space and the time it will take to sublease thespace. Our estimates are based on historical experience, input from sourcesoutside the company, and other relevant facts and circumstances. Actual amountscould differ materially from these estimates.

32

----

Certain of our licensingagreements indemnify our customers for expenses or liabilities resulting fromclaimed infringements of patent, trademark or copyright by third partiesrelated to intellectual property content of our products. Certain of these indemnificationprovisions are perpetual from execution of the agreement and, in someinstances, the maximum amount of potential future indemnification is notlimited. To date, we have not paid any such claims or been required to defendany lawsuits with respect to a claim.

*Stock-BasedCompensation Expense*

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

*Legal Matters*

We are subject to variouslegal proceedings and claims, either asserted or unasserted. We evaluate, amongother factors, the degree of probability of an unfavorable outcome andreasonably estimate the amount of the loss. Significant judgment is required inboth the determination of the probability and as to whether an exposure can bereasonably estimated. When we determine that it is probable that a loss hasbeen incurred, the effect is recorded promptly in the consolidated financialstatements. Although the outcome of these claims cannot be predicted withcertainty, we do not believe that any of the existing legal matters will have amaterial adverse effect on our financial condition and results of operations.However, significant changes in legal proceedings and claims or the factorsconsidered in the evaluation of those matters could have a material adverseeffect on our business, financial condition and results of operations. 

**Recent Accounting Pronouncements**

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued Interpretation Number (“FIN”)46, “Consolidation of Variable Interest Entities.” In general, a variableinterest entity is a corporation, partnership, trust, or any other legalstructure used for business purposes that either (a) does not have equityinvestors with voting rights or (b) has equity investors that do notprovide sufficient financial resources for the entity to support itsactivities. FIN 46 requires certain variable interest entities to beconsolidated by the primary beneficiary of the entity if the investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. The consolidationrequirements of FIN 46 apply immediately to variable interest entities createdafter January 31, 2003. The consolidation requirements apply to olderentities as early as the first fiscal quarter of 2004. Certain of thedisclosure requirements apply to all financial statements issued after January 31,2003, regardless of when the variable interest entity was established. Theeffective dates of certain elements of FIN 46 have been deferred. We do notbelieve that the adoption of this standard will have a material impact on ourconsolidated financial statements.

33

----

**Annual Results of Operations**

**REVENUE**
| ** **                            | ** ** | **2003**                             | ** ** | **Change** | ** ** | **2002** | ** ** | **Change** | ** ** | **2001** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                            | ** ** | **(dollars in thousands)** | ** ** |
| Personal  Computers                   |       | $                                    | 33,163     |       | (30.0      | )%       | $          | 47,405     |       | 29.8     | %          | $ | 36,535 |   |
| Consumer  Electronics                 |       | 25,762                               |       | 186.5      | %          | 8,993    |       | 120.3      | %          | 4,082    |       |
| Storage IC  products                  |       | 28,070                               |       | 128.4      | %          | 12,291   |       | 393.8      | %          | 2,489    |       |
| Storage Systems                       |       | 2,340                                |       | (62.2      | )%         | 6,195    |       | (30.1      | )%         | 8,860    |       |
| Product revenue                       |       | $                                    | 89,335     |       | 19.3       | %        | $          | 74,884     |       | 44.1     | %          | $ | 51,966 |   |
| Percentage of total revenue           |       | 86.3                                 | %          | (5.5       | ) pts | 91.8     | %          | (8.2       | ) pts | 100.0    | %          |
| Development,  licensing and royalties |       | $                                    | 14,190     |       | 113.2      | %        | $          | 6,655      |       | 100.0    | %          | $ | — |   |
| Percentage of total revenue           |       | 13.7                                 | %          | 5.5        |  pts  | 8.2      | %          | 8.2        |  pts  | 0        | %          |
| Total revenue                         |       | $                                    | 103,525    |       | 27.0       | %        | $          | 81,539     |       | 56.9     | %          | $ | 51,966 |   |

 

The increase in revenue during 2003 is primarily dueto increased sales of CE products, which contributed an additional $16.8million of revenue, increased sales of storage IC products, which contributedan additional $15.8 million in revenue, and increased licensing activity, whichcontributed an additional $7.5 million of revenue, partially offset bydecreased sales of PC products and storage systems products. The increases in the CE and storage ICproducts are primarily attributable to our new product offerings, as well asthe overall growth in these markets, resulting in increased volumes. Thedecrease in demand for our PC products, is attributable to loss of market sharedue primarily to integration and an overall weakness in the PC market, and thedecreased revenue from our storage systems products, resulting from ourdecision to phase out this product line. We license our technology in each ofour areas of business, but usually limit the scope of the license to marketareas that are complementary to our products sales and that do not directlycompete with our direct product offerings. The growth in development, licensingand royalty revenues as a component of total revenues was primarily due to ourability to successfully leverage and create a market for our intellectualproperty and enter into new licensing agreements and as a result of an increasein our royalty stream, primarily due to a larger licensing base. 

The principal reasons forthe increase in revenue during 2002 relative to 2001 were the growth in our PCand CE businesses driven by the increased adoption rates of DVI, a full year’sworth of revenue on either new product offerings or products acquired inconnection with acquisitions, particularly with respect to fibre channelproducts and parellel ATA and USB controllers, and licensing revenue. Theseincreases were partially offset by the effect of our strategic restructuringprogram to de-emphasize our storage subsystems board business in 2002, and theeffect of declining average selling prices (“ASPs”) during 2002. 

34

----

**COST OF REVENUE ANDGROSS MARGIN**
| ** **                                                                         | ** ** | **2003**                             | ** ** | **Change** | ** ** | **2002**   | ** ** | **Change** | ** ** | **2001** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|------------|------------|----------|------------|
| ** **                                                                         | ** ** | **(dollars in thousands)** | ** ** |
| Product gross margin  (excluding licensing revenue)                                |       | $                                    | 42,143     |       |       |       |       |       | $          | 35,584   |       |   |   | $ | 26,624 |   |
| Percentage of product  revenue                                                     |       | 47.2                                 | %          |       | (0.3       | ) pts |       | 47.5       | %          | (3.7     | ) pts | 51.2 | % |
| Gross margin                                                                       |       | $                                    | 56,333     |       |       |       |       |       | $          | 42,239   |       |   |   | $ | 26,624 |   |
| Percentage of total  revenue                                                       |       | 54.4                                 | %          |       | 2.6        |  pts  |       | 51.8       | %          | 0.6      |  pts  | 51.2 | % |
| Stock compensation  expense                                                        |       | $                                    | 583        |       |       | (51.4      | )%         |       | $          | 1,190    |       | 330.1 | % | $ | 279 |   |
| Product gross margin  (excluding stock compensation expense and licensing revenue) |       | $                                    | 42,726     |       |       |       |       |       | $          | 36,774   |       |   |   | $ | 26,903 |   |
| Percentage of product  revenue                                                     |       | 47.8                                 | %          |       | (1.3       | ) pts |       | 49.1       | %          | (2.7     | ) pts | 51.8 | % |
| Gross margin (excluding  stock compensation expense)                               |       | $                                    | 56,916     |       |       |       |       |       | $          | 43,429   |       |   |   | $ | 26,903 |   |
| Percentage of total  revenue                                                       |       | 55.0                                 | %          |       | 1.7        |  pts  |       | 53.3       | %          | 1.5      |  pts  | 51.8 | % |

 

Cost of revenue consistsprimarily of costs incurred to manufacture, assemble and test our products, aswell as related overhead costs. Gross margin (revenue minus cost of revenue, asa percentage of revenue was 54.4%, 51.8% and 51.2% for 2003, 2002 and 2001,respectively), and excluding non-cash stock compensation expense, was 55% for2003, 53.3% for 2002 and 51.8% for 2001. The increase in gross margin from 2002to 2003 and from 2001 to 2002 is attributable primarily to increased licensingrevenue, which has no associated cost of sales, and, to a lesser extent,reduced sales of storage subsystems products which are lower margin productsthan our IC related products. These factors were offset by declines in ASPs’,yield and quality issues related to certain new products during the first halfof 2003, and increased sales of storage IC products, which have lower marginsrelative to our other volume products. Non-cash stock compensationexpense associated with cost of revenue was $583,000, $1.2 million and $279,000for 2003, 2002 and 2001 respectively.

35

----

**OPERATING EXPENSES**
| ** **                                         | ** ** | **2003**                             | ** ** | **Change** | ** ** | **2002** | ** ** | **Change** | ** ** | **2001** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                                         | ** ** | **(dollars in thousands)** | ** ** |
| Research and  development(1)                       |       | $                                    | 36,523     |       | 11.3       | %        | $          | 32,809     |       | 28.8     | %          | $ | 25,473 |   |
| Percentage of total revenue                        |       | 35.3                                 | %          | (4.9       | ) pts | 40.2     | %          | (8.8       | ) pts | 49.0     | %          |
| Selling, general  and administrative(2)            |       | $                                    | 18,401     |       | 5.4        | %        | $          | 17,454     |       | (7.0     | )%         | $ | 18,773 |   |
| Percentage of total revenue                        |       | 17.8                                 | %          | (3.6       | ) pts | 21.4     | %          | (14.7      | ) pts | 36.1     | %          |
| Stock  compensation expense                        |       | $                                    | 9,988      |       | (10.1      | )%       | $          | 11,107     |       | (10.4    | )%         | $ | 12,390 |   |
| Percentage of total revenue                        |       | 9.6                                  | %          | (4.0       | ) pts | 13.6     | %          | (10.2      | ) pts | 23.8     | %          |
| Amortization of  goodwill and intangible assets    |       | $                                    | 1,103      |       | (68.3      | )%       | $          | 3,482      |       | (75.3    | )%         | $ | 14,124 |   |
| Percentage of total revenue                        |       | 1.1                                  | %          | (3.2       | ) pts | 4.3      | %          | (22.9      | ) pts | 27.2     | %          |
| In-process  research and development               |       | $                                    | 5,482      |       | N/M        |     | $          | —     |       | (100.0   | )%         | $ | 1,500 |   |
| Impairment of  goodwill and intangible assets      |       | $                                    | —     |       | (100.0     | )%       | $          | 5,200      |       | (82.6    | )%         | $ | 29,880 |   |
| Restructuring                                      |       | $                                    | 986        |       | (86.3      | )%       | $          | 7,193      |       | 395.4    | %          | $ | 1,452 |   |
| Patent defense  and acquisition integration  costs |       | $                                    | 2,152      |       | (69.4      | )%       | $          | 7,034      |       | 282.1    | %          | $ | 1,841 |   |
| Interest income                                    |       | $                                    | 498        |       | (50.1      | )%       | $          | 998        |       | (63.5    | )%         | $ | 2,731 |   |
| Interest expense  and other, net                   |       | $                                    | 207        |       | (13.8      | )%       | $          | 240        |       | (22.3    | )%         | $ | 309 |   |
| Gain on escrow  settlement, net                    |       | $                                    | 4,618      |       | N/M        |     | $          | —     |       | N/M      |       | $ | — |   |

(1)          Excludes non-cash stockcompensation expense of $6.9 million, $7.4 million and $9.3 million for 2003,2002 and 2001, respectively

(2)          Excludes non-cash stockcompensation expense of $2.5 million, $2.5 million and $2.8 million for 2003,2002 and 2001, respectively

N/M—Not Meaningful 

*Researchand Development.**  *R&Dexpense consists primarily of compensation and related costs for employees,fees for independent contractors, the cost of software tools used for designingand testing our products, and costs associated with prototype materials.R&D expense, excluding non-cash stock compensation expense, was $36.5million, or 35.3% of revenue, for 2003, compared to $32.8 million, or 40.2% ofrevenue, for 2002, and $25.5 million, or 49.0% of revenue, for 2001. Theincrease in absolute dollars for 2003 was primarily due to an increase in thenumber of R&D projects to support the multiple markets in which we operate,as well as additional personnel, including personnel from TransWarp Networks.Although we introduced 11 new products in 2003, many of these new productsinvolved a higher degree of complexity. The increase in absolute dollars for2002 can be attributed primarily to our acquisition of CMD in June 2001,which increased spending by $4.7 million in 2002 due to the inclusion of 12months of CMD related expense in 2002, versus only 7 months of expense in 2001.Additionally, we increased our product development efforts in 2002 in order toaccelerate our entrance into the storage and CE markets. We introduced 16 newproducts in 2002, versus 12 in 2001. These increases were partially offset byan additional one-week shutdown in 2002. R&D excludes non-cash stockcompensation expense of $6.9 million, $7.4 million and $9.3 million for 2003,2002 and 2001, respectively. Including stock compensation expense, R&D expensewould have been $43.4 million, $40.2 million and $34.8 million, or 41.9%, 49.3%and 66.9% of revenue for 2003, 2002 and 2001, respectively.

*Selling,General and Administrative.**  *SG&Aexpense consists primarily of employee compensation and benefits, salescommissions, and marketing and promotional expenses. Excluding non-cash stockcompensation expense, SG&A expense was $18.4 million, or 17.8% of revenuefor 2003, $17.5 million, or 21.4% of revenue for 2002, and $18.8 million, or36.1% of revenue for 2001. The increase in spending for 2003 can be attributedto the increased headcount in the second half of 2003 to support the increasedrate of growth of the Company, and approximately $1.1 million incurred duringthe fourth quarter of 2003 

36

----

relating to the costsassociated with the Audit Committee examination. The decrease in spending for2002 relative to 2001 can be attributed primarily to a reduction in SG&Aheadcount from 88 at December 31, 2001 to 69 at December 31, 2002.Additionally, as part of our expense management efforts in 2002, we implementedan additional one-week shutdown in 2002 and reduced spending on discretionaryitems such as advertising, travel and professional fees. Lastly, we were ableto reduce spending in 2002 by consolidating space in our facilities. SG&Aexcludes non-cash stock compensation expense of $2.5 million for 2003 and 2002and $2.8 million for 2001. Including stock compensation expense, SG&A expensewould have been $20.9 million, $20.0 million and $21.6 million, or 20.2%, 24.5%and 41.5% of revenue for 2003, 2002 and 2001, respectively.

*Stock Compensation.**  *Stock compensation expense was $10.0 million or 9.6%of revenue for 2003, $11.1 million or 13.6% of revenue, for 2002, and $12.4million or 23.8% of revenue, for 2001. The decrease in total stock compensationexpense from 2002 to 2003, can be attributed primarily to a decrease in theexpense associated with the options granted to employees and assumed inconnection with acquisitions, offset by an increase in expense relating torepriced options. Lower average stock price during 2003, and a decline in thenumber of options subject to variable accounting, as certain older optionsbecome fully expensed, contributed to a decrease, which was offset by anincrease in our repricing expense as a result of an increase in our stock pricein the fourth quarter of 2003. The decrease from 2001 to 2002 can be attributedto use of the accelerated method for recognizing expense for stock optionsgranted to employees and for stock options assumed in connection withacquisitions, which results in a higher proportion of the expense beingrecognized in earlier periods. These decreases are partially offset by expenserecognized in 2002 for options repriced in 2001 and 2000, as our average stockprice in 2002 exceeded the strike price of the repriced options. We did notrecognize expense in 2001 in conjunction with our stock option repricings sinceour average stock price was less than the exercise price of the repricedoptions. The following table summarizes the components of our stockcompensation expense for 2003, 2002 and 2001 (in thousands).
| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Options granted  to employees                    |       | $                                          | 353        |   | $ | 1,943 |   | $ | 2,643 |   |
| Options granted  to non-employees                |       | 1,977                                      |       | 2,304 |   | 2,322 |   |
| Option repricings                                |       | 4,704                                      |       | 2,935 |   | — |   |
| Options assumed  in connection with acquisitions |       | 2,954                                      |       | 3,925 |   | 7,425 |   |
|                                             |       | $                                          | 9,988      |   | $ | 11,107 |   | $ | 12,390 |   |

 

We will incur substantial non-cash stock compensationexpense in future periods as a result of (1) the issuance of, ormodifications to, restricted stock awards and stock option grants to employeesand consultants, (2) the stock option repricing programs we implemented in2000 and 2001, and (3) amortization of our existing unearned compensationbalance. Since the expense associated with our stock option repricings andstock options issued to consultants is dependent on our stock price andvolatility, stock compensation expense may fluctuate significantly from periodto period. To date we have recognized over $7.6 million of expense inconnection with our stock option repricings, and this may become an even moresignificant component of our stock compensation expense in future periods if ourweighted average stock price exceeds $5.63, the exercise price of theserepriced stock options. Approximately 3.3 million stock options wereoutstanding as of December 31, 2003 that were repriced in 2000 and 2001.Basically, the Company will incur a non-cash charge of $3.3 million for everydollar increase in the average stock price until these options are exercised.

*Amortizationof Goodwill and Intangible Assets.  *During 2003,we recorded $1.1 million of amortization of intangible assets, compared to $3.5million and $14.1 million of expense for the amortization of goodwill andintangible assets, for 2002 and 2001, respectively. The decrease from 2002 to2003 is attributable to the lower balance of amortizable intangibles during2003. The decrease from 2001 to 

37

----

2002 can be attributed toadoption of a new accounting standard that required companies to no longeramortize goodwill to expense beginning January 1, 2002, and to theimpairment charges recorded against intangible assets in 2001 and 2002 thatreduced the carrying value of the assets subject to amortization. 

*In-process Research andDevelopment.  *In-process research and developmentrepresents technology that has not reached technological feasibility and thathas no alternative future use as of the acquisition date. A discussion of ourrecent acquisitions and in-process research and development expense is asfollows:

*TWN*

During the quarter ended June 30,2003, we completed the acquisition of the assets of TWN and recorded a one-timeexpense of $5.5 million for in-process research and development. As of theacquisition date, there was one identified development project that met thenecessary criteria—“Polaris”. The value of this project was determined byestimating the future cash flows from the time it was expected to becommercially feasible, discounting the net cash flows to present value, and applyinga percentage of completion to the calculated values. The net cash flows fromthe identified project were based on estimates of revenue, cost of revenue,research and development expenses, selling, general and administrative expenses, and applicable incometaxes. Revenue for Polaris is expected to commence in 2004 and extend through2007. We based our revenue projections on estimates of market size and growth,expected trends in technology and the expected timing of new productintroductions by our competitors and us. The discount rate used for thisproject was 30%, which we believe is appropriate based on the risk associatedwith technology that is not yet commercially feasible. The percentage ofcompletion for this project was based on research and development expensesincurred immediately prior to the acquisition as a percentage of the totalestimated research and development expenses required to bring this project totechnological feasibility. As of the date of the acquisition, we estimated thatPolaris was 17% complete, with total projected costs of approximately$3,250,000. The project was not completed as of December 31, 2003.

*CMD*

During the quarter ended June 30, 2001, werecorded a one-time operating expense of $1.5 million for in-process researchand development incurred in connection with the acquisition of CMD. As of theacquisition date, there were four identified development projects that met thenecessary criteria—Titan 2U, Titan.next, SANBox and IDE Ultra-680. The value ofthese projects was determined by estimating their future cash flows from thetime they were expected to become commercially feasible, discounting the netcash flows to their present value, and applying a percentage of completion tothe calculated values. The net cash flows from the identified projects werebased on estimates of revenue, cost of revenue, research and developmentexpenses, selling general and administrative expenses, and applicable incometaxes. These estimates did not take into account any potential synergies thatcould be realized as a result of the acquisition, and were in line withindustry averages and growth estimates for the storage and semiconductorindustries.

Revenue for Titan 2U was expected to commence in thefourth quarter of 2001 and to extend through 2003. Revenue for IDE Ultra-680was expected to commence in the fourth quarter of 2001 and extend through 2004,and revenue for both Titan.next and SANBox was expected to commence in 2002 andextend through 2005. We based our revenue projections on estimates of marketsize and growth, expected trends in technology and the expected timing of newproduct introductions by our competitors and us. The discount rate used for allprojects was 25%, a rate that is consistent with the estimated rates of returnon our intangible assets. This rate is higher than the industry weightedaverage cost of capital because of the risks associated with the inherentuncertainties of the successful development of the in-process research anddevelopment, market acceptance of the technology, the useful life of thetechnology, the profitability level of such technology and the uncertainty oftechnological advances.

38

----

The percentage of completion for each project wasdetermined based on research and development expenses incurred immediatelyprior to the acquisition as a percentage of total estimated research anddevelopment expenses to bring each project to technological feasibility. As of June 30,2001, we estimated that Titan 2U was 25% complete with total projected costs of$164,000, that Titan.next was 15% complete with total projected costs of$200,000, that SANBox was 10% complete with total projected costs of $150,000and that IDE Ultra-680 was 85% complete with total projected costs of $500,000.Consistent with our projections, revenue related to Titan 2U and IDE Ultra-680commenced in the fourth of quarter of 2001. Development of Titan.next andSANBox was not completed.

We expect to make future acquisitions if advisable andmay record additional expenses for in-process research and development inconnection with those acquisitions.

Given the uncertainties of the commercializationprocess, we cannot assure you that deviations from our estimates will notoccur. We believe there is a reasonable chance of realizing the economic returnexpected from the acquired in-process technology. However, there is a riskassociated with the realization of benefits related to commercialization of anin-process project due to rapidly changing customer needs, complexity oftechnology and growing competitive pressures. Therefore, we cannot assure youthat any project will achieve commercial success. Failure to successfullycommercialize an in-process project would result in the loss of the expectedeconomic return inherent in the fair value allocation.

*Impairmentof Goodwill and Intangible Assets.  *In 2002, werecorded $5.2 million of expense for the impairment of goodwill and intangibleassets recorded in connection with the acquisition of CMD in 2001. These assetsbecame impaired as a result of our decision in the second quarter of 2002 totransition to a licensing model for our storage subsystem board products,whereby instead of developing, manufacturing and selling board products, wewill develop and license board designs in exchange for license fees androyalties. For 2001, we recorded $29.9 million of expense for the impairment ofgoodwill and intangible assets recorded in connection with the acquisitions ofDVDO and CMD. DVDO goodwill and intangible assets became impaired primarily asa result of our decision to phase out or de-emphasize certain existing digitalvideo processing products and to cease funding of certain digital videoprocessing development projects. Additionally, prevailing economic and industryconditions and the departure of certain key DVDO employees during the quarterended September 30, 2001 also contributed to the impairment expense of$13.9 million. We recorded impairment expense of $16.0 million in the fourthquarter of 2001 related to goodwill and intangible assets recorded inconnection with our CMD acquisition. This impairment resulted from a decreasein our initial estimate of future revenue from CMD’s products. There can be noassurance that future goodwill impairment tests will not result in a charge toearnings.

Based on our annual impairment test performed for 2003,in accordance with SFAS No.142, we concluded that there was no impairment ofour goodwill and intangible assets in fiscal 2003. The impairment analysis wasbased on our estimates of forecasted discounted cash flows as well as ourmarket capitalization at that time.

*Restructuring.**  *Duringthe third quarter of 2001, we began a program to focus our business on productsand technology, including those obtained through acquisitions, in which wehave, or believe we can achieve, a market leadership position. As part of thisprogram, we decided to cancel numerous products under development, to removecertain projects from our development plan, to phase out or de-emphasizecertain existing products and to integrate the operations of two acquiredcompanies—CMD Technology (“CMD”) and Silicon Communication Lab (“SCL”).

In connection with this program, we reduced ourworkforce in the fourth quarter of 2001 by approximately 60 people, or 20%.This workforce reduction was the initial step in eliminating duplicate positionsthat resulted from our acquisitions, and also represented the elimination ofother positions based on our new product and technology focus. Positions wereeliminated from all functional areas—operations, R&D and SG&A. Becauseof this workforce reduction, we recorded a restructuring expense of $1.5million 

39

----

in the fourth quarter of2001, consisting of cash severance-related costs of $599,000, non-cashseverance-related costs of $303,000 representing the intrinsic value ofmodified stock options, an expected loss on leased facilities of $500,000 andfixed asset write-downs of $50,000. In addition, we reversed $286,000 ofunearned compensation, a component of stockholders’ equity, for unvested stockoptions that were cancelled in connection with employee terminations.

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

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

In connection with our decision to stop selling boardproducts and to transition to a licensing model, we assessed recoverability ofour intangible assets subject to amortization in accordance with SFAS No. 144.During the quarter ended September 30, 2002, an impairment expense of$749,000 was recognized for acquired technology and $60,000 was recognized forpatent and other intangible assets, based upon our projection of significantlyreduced future cash flows. Additionally, we reduced our estimate of the usefullives of the remaining intangible assets subject to amortization such thatthese assets were fully amortized by the end of 2002. We also tested thecarrying value of goodwill for impairment in accordance with SFAS No. 142.As a result of our impairment test, a goodwill impairment expense of $4.4million was recognized during the second quarter of 2002. To determine theamount of the impairment, we estimated the fair value of our storage systemsbusiness based primarily on expected future cash flows. We then reduced thisamount by the fair value of identifiable tangible and intangible assets otherthan goodwill (also based primarily on expected future cash flows), andcompared the unallocated fair value of the business to the carrying value ofgoodwill. To the extent goodwill exceeded the unallocated fair value of thebusiness, an impairment expense was recognized.

In December 2002, we revised our estimate of theloss we expect to incur on subleased facilities and recorded a restructuringexpense of $1.5 million. Real estate market conditions deteriorated in thefourth quarter of 2002, causing us to reassess the length of time it would taketo find tenants and the fair value lease rate of our available space. As of December 31,2003, our expected loss on subleased facilities was based on estimated subleaseincome of approximately $1.0 million over the remaining lease terms. To theextent we are unable to generate $1.0 million of sublease income, our futureresults of operations and financial condition will be negatively affected.

40

----

In March 2003, we reorganized parts of themarketing and product engineering activities of the company into lines ofbusiness for PC, CE and storage products to enable us to better manage ourlong-term growth potential The central engineering, sales, manufacturing, andgeneral and administrative activities were not organized into the line ofbusiness structure. In connection with this reorganization, we reduced ourworkforce by 27 people, or approximately 10%. These reductions were primarilyin engineering and operations functions. Because of this workforce reduction,we recorded restructuring expense of $1.0 million in the first quarter of 2003,consisting of cash severance-related costs of $340,000 and non-cashseverance-related costs of $646,000, representing the intrinsic value ofmodified stock options. 

Severance related costs were determined based on theamount of pay people received that was not for services performed and bymeasuring the intrinsic value of stock options that were modified to thebenefit of terminated employees. For those employees terminated in the three monthperiod ending March 31, 2003, the remaining service period from thecommunication date did not exceed 60 days. The expected loss on leasedfacilities resulted from our plan to consolidate our remaining workforce to theextent practicable and sublease any excess space. To determine the expectedloss, we compared our lease and operating costs for the space to our estimateof the net amount we would be able to recover by subleasing the space. Thisestimate was based on a number of assumptions, including the length of time itwill take to secure a tenant, the sublease rate per square foot, the cost ofnecessary improvements or modifications and real estate broker commissions. Thefixed asset write-downs in 2001 and 2002 were determined based on the estimatedfair value of assets, primarily computer hardware and software that would nolonger be utilized after the employees’ termination dates.

Severanceand benefits payments are substantially complete. Lease payments will be madein the form of cash through the end of the related lease term of November 2005.The following table presents restructuring activity for 2001 through December 31,2003 (in thousands):
| ** **                            | ** ** | **Severance  and Benefits** | ** ** | **Leased  Facilities** | ** ** | **Fixed Assets** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|------------------------|------------|-----------------------|------------|-----------|------------|
| 2001 provision                        |       |                             | $          | 902                    |       |                  | $          | 500       |       |   | $ | 50 |   |   | $ | 1,452 |   |
| Cash payments                         |       |                             | (191       | )                      |       | —                |       |      | —     |   |   | (191 | ) |
| Non-cash activity                     |       |                             | (303       | )                      |       | (115                  | )          |      | —     |   |   | (418 | ) |
| Balance as of  December 31, 2001 |       |                             | 408        |                   |       | 385                   |       |      | 50         |   |   | 843 |   |
| 2002 provision                        |       |                             | 2,547      |                   |       | 2,633                 |       |      | 2,013      |   |   | 7,193 |   |
| Cash payments                         |       |                             | (865       | )                      |       | (420                  | )          |      | —     |   |   | (1,285 | ) |
| Non-cash activity                     |       |                             | (1,952     | )                      |       | —                |       |      | (2,063     | ) |   | (4,015 | ) |
| Balance as of  December 31, 2002 |       |                             | 138        |                   |       | 2,598                 |       |      | —     |   |   | 2,736 |   |
| 2003 provision                        |       |                             | 986        |                   |       | —                |       |      | —     |   |   | 986 |   |
| Cash payments                         |       |                             | (441       | )                      |       | (760                  | )          |      | —     |   |   | (1,201 | ) |
| Non-cash activity                     |       |                             | (646       | )                      |       | —                |       |      | —     |   |   | (646 | ) |
| Balance as of  December 31, 2003 |       |                             | $          | 37                     |       |                  | $          | 1,838     |       |   | $ | — |   |   | $ | 1,875 |   |

 

*Patentdefense and acquisition integration costs.**  *Patent defense and acquisition integration costs were$2.2 million for 2003, $7.0 million for 2002 and $1.8 million for 2001. Patentdefense costs are related to the lawsuit we filed against Genesis in April 2001,and acquisition integration costs represent costs incurred to integrate CMD andSCL. The increase in 2002 can be attributed to discovery, motions, depositionsand other activities in preparation for trial in connection with the Genesislitigation. We expect to incur significant patent defense costs through atleast the fourth quarter of 2004. The amount of legal fees incurred in 2004will depend on the duration of the litigation, as well as the nature and extentof the litigation activities. We are not able to accurately estimate the amountof legal fees we will incur.

41

----

*InterestIncome.**  *Interestincome was $498,000 for 2003, $1.0 million for 2002, and $2.7 million for 2001.The declines in 2003 and 2002 can be attributed primarily to declining interestrates and decreasing average cash and investment balances.

*InterestExpense and Other Net.**  *Netinterest expense and other was $207,000 for 2003, $240,000 for 2002 and$309,000 for 2001. The decrease in 2003 and 2002 can be attributed todecreasing average outstanding debt balances during 2003 and 2002.

*Provisionfor Income Taxes.**  *Due toour losses in 2003, 2002 and 2001, no provision for income taxes was recordedin any of those years. At December 31, 2003, we had a net operating losscarryforward for federal income tax purposes of approximately $75.1 millionthat expires in various years through 2023. These future tax benefits have notbeen recognized as an asset on our balance sheet due to uncertaintiessurrounding our ability to generate sufficient taxable income in future periodsto realize these tax benefits. Under the Tax Reform Act of 1986, the amountsof, and benefits from, net operating loss carryforwards may be restricted orlimited in certain circumstances. We do not expect to be subject to theserestrictions or limitations.

*Gainon escrow settlement, net.**  *During the quarter ended March 31, 2003, werecognized a net gain of $4.6 million associated with the settlement of anescrow claim against the selling shareholders of CMD.

42

----

**Liquidity andCapital Resources**
| ** **                                               | ** ** | **2003**                             | ** ** | **Change** | ** ** | **2002** | ** ** | **Change** | ** ** | **2001** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|----------|------------|------------|------------|----------|------------|
| ** **                                               | ** ** | **(dollars in thousands)** | ** ** |
| Cash and cash  equivalents                               |       | $                                    | 24,059     |       | $          | (2,204   | )          | $          | 26,263     |     | $          | 7,317 |   | $ | 18,946 |   |
| Short term  investments                                  |       | 13,195                               |       | 3,625      |       | 9,570    |       | (12,702    | )          | 22,272   |       |
| Total cash, cash equivalents and short term  investments |       | $                                    | 37,254     |       |       |     | $          | 35,833     |       |     |       | $ | 41,218 |   |
| Percentage of total assets                               |       | 42.5                                 | %          | (3.7       | ) pts | 46.2     | %          | 0.5        |  pts  | 45.7     | %          |
| Total current  assets                                    |       | $                                    | 63,023     |       | $          | 5,790    |       | $          | 57,233     |     | $          | (965 | ) | $ | 58,198 |   |
| Total current  liabilities                               |       | (25,349                              | )          | 4,097      |       | (29,446  | )          | (7,427     | )          | (22,019  | )          |
| Working capital                                          |       | $                                    | 37,674     |       | 9,887      |     | $          | 27,787     |       | (8,392   | )          | $ | 36,179 |   |
| Cash (used in)  operating activities                     |       | (2,893                               | )          | 5,985      |       | (8,878   | )          | 5,272      |       | (14,150  | )          |
| Cash provided by  (used in) investing activities         |       | (8,572                               | )          | (17,571    | )          | 8,999    |       | (3,613     | )          | 12,612   |       |
| Cash provided by  (used in) financing activities         |       | 9,261                                |       | 2,065      |       | 7,196    |       | 9,936      |       | (2,740   | )          |
| Net increase (decrease)  in cash and cash equivalents    |       | (2,204                               | )          | (9,521     | )          | 7,317    |       | 11,595     |       | (4,278   | )          |

 

Since our inception, wehave financed our operations through a combination of private sales ofconvertible preferred stock, our initial public offering, lines of credit andcapital lease financing. At December 31, 2003, we had $37.7 million ofworking capital and $37.3 million of cash, cash equivalents and short-terminvestments. If we are not able to generate cash from operating activities, wewill liquidate short-term investments or, to the extent available, utilizecredit arrangements to meet our cash needs.

*Operatingactivities*

Operating activities used $2.9 million of cash during2003. For 2003, our net income excluding depreciation, stock compensationexpense, amortization of goodwill and intangible assets, in-process researchand development, non-cash restructuring charges and non-cash gain on escrowsettlement was $4.5 million. Increases in accounts receivable, inventories,prepaid expenses and other assets, and decreases in accounts payable andaccrued liabilities used $10.6 million in cash, offset by an increase indeferred margin on sales to distributors of $3.1 million. 

Net accounts receivable increased to $12.8 million at December 31,2003 from $11.6 million at December 31, 2002. The increase is primarilydue to increased sales volume, offset by the effect of the timing of thereceivables, as revenues levels were higher in the earlier half of the fourthquarter of 2003 and the effect of improved collections. Net accounts receivableincreased by $4.1 million at December 31, 2002 compared to December 31,2001. The increase is attributable primarily to the increase in businessvolume. The days of sales outstanding (“DSO”) was 38 days at December 31,2003, compared to 44 days at the end of December 31, 2002. The decrease inthe DSO days is primarily due to improved linearity of revenue shipments,improved collections and a reduction in the December versus September 2003distributor shipments. 

Inventories increased to $10.3 million at December 31,2003 from $7.3 million at December 31, 2002. The increase is attributableprimarily to increased business volume during the year 2003 and to supportfuture projected revenue activity. Inventories increased by $765,000 at December 31,2002 compared to December 31, 2001. Our inventory turn rate decreased to5.1 as at December 31, 2003 from 5.9 as at December 31, 2002.Inventory turns are computed on an annualized basis, using the fourth quarterresults, and are a measure of the number of times inventory is replenishedduring the year. Our inventory turns 

43

----

decreased primarily due tohigher inventory balances as at December 31, 2003. We expect this measureto remain basically flat during the first quarter of 2004. 

Accounts payable and accrued liabilities decreased to$6.4 million and $9.9 million, respectively, at December 31, 2003 from$10.3 million and $11.2 million, respectively, at December 31, 2002. Thedecrease in accounts payable was due to our stronger cash flow position and thetiming of when payables became due, and the decrease in accrued liabilities isprimarily due to a decrease in restructuring accruals. 

Deferred margin on salesto distributors increased to $7.3 million at December 31, 2003 from $4.1million at December 31, 2002. The increase is principally due to theeffect of increased distributor related shipments at December 31, 2003compared to December 31, 2002. There was no significant movement in thebalance at December 31, 2002 compared to December 31, 2001.

*Investing andfinancing activities*

We used $8.6 million of cash in our investingactivities in 2003. We used $5.1 million towards the purchase of property andequipment (including the purchase of a new enterprise resource planning system)and used $3.6 million towards the net purchases of short-term investments. Wegenerated $9.0 million of cash from investing activities in 2002 and generated$12.6 million of cash from investing activities in 2001. Net proceeds fromsales and purchases of short-term investments generated $12.7 million of cashin 2002. During 2002, we used $3.7 million for purchases of property andequipment, primarily software tools for use in R&D activities. During 2001,we received net proceeds from sales and purchases of short-term investments of$17.4 million, and used $3.0 million of cash for acquisition costs and $1.8million of cash for purchases of property and equipment. 

We generated $9.3 millionfrom financing activities in 2003. This primarily included $11.5 million inproceeds received from issuances of common stock, offset by $2.5 millionrepresenting repayment of debt. We generated $7.2 million of cash fromfinancing activities in 2002 and used $2.7 million of cash for financingactivities in 2001. During 2002, we received $7.8 million of proceeds fromissuances of common stock through our stock option and stock purchase plans,and our net borrowing activities, including releases of security deposits anddebt repayments, used $0.7 million of cash during 2002. Cash used by financingactivities in 2001 was from security deposits on lease financing and debtpayments, partially offset by cash provided by issuances of common stock forstock option exercises and stock purchase plan sales. 

**Debt and Lease Obligations**

In October 2002, we entered into a $3.6 millionterm loan to refinance $3.1 million of debt acquired in connection with ouracquisition of CMD and $500,000 of other bank debt. This loan bears interest atprime (4.0% at December 31, 2003) plus 0.25% and requires monthly paymentsthrough its maturity of October 1, 2004. During the three months ended March 31,2003, we borrowed $383,000 to finance certain capital equipment. This term loanbears interest at 5% and requires monthly payments through its maturity in February 2005.As of December 31, 2003, $1,732,000 was outstanding under these termloans. Our debt facilities contain certain quarterly and annual financialcovenants with which we must comply. In the fourth fiscal quarter of 2003, wefell out of compliance with the lending institution’s quarterly covenantsregarding providing periodic financial statements. We were granted a waiverfrom the lending institution and were not in default of the loan agreement. Dueto the nature of the underlying covenants, we have classified all amountsoutstanding as current liabilities as of December 31, 2003. Subsequent to December 31,2003, we entered into an agreement to extend this debt facility by way of arevolving line of credit with an availability of up to $10.0 million, and anequipment line of credit of up to $3.0 million. Borrowings under the revolvingline are limited to the lesser of $10.0 million or 80% of eligible accountsreceivable as defined in the loan agreement. This revolving line of creditexpires in March 2005 and bears interest at either prime plus 0.25% orLIBOR plus 2.75%, at our option. Equipment advances pursuant to the equipmentline of 

44

----

credit are available to usthrough August 2004 and will be repayable in twenty four equal monthlyinstallments commencing September 1, 2004 bearing interest at either primeor LIBOR plus 2.5%, at our option. Quarterly and annual financial covenants arecontained within this revised agreement. 

In October 2002, we financed a $351,000 insurancepremium at an interest rate of 5.75%. Monthly payments of $40,000 were duethrough June 2003. This was repaid in full during 2003.

We leased certain software and equipment under leaseagreements accounted for as capital leases. All such leases matured during2003.

In October 1999, we entered into a non-cancelableoperating lease through July 2003 for our principal operating facility.This lease requires average monthly rental payments of approximately $133,000and was secured by a certificate of deposit in the amount of $283,000, whichwas included in prepaid expenses and other current assets on our 2002 balancesheet. Under the terms of the original lease agreement, this securityrequirement was not required after July 2003 and therefore we no longermaintain a certificate of deposit. In December 2002, we entered into anon-cancelable operating lease renewal for our principal operating facility,including an additional 30,000 square feet of space in an adjacent building,that commenced in August 2003 and expires in July 2010. The leaserequires initial average monthly rental payments of $76,000 and provides for 3%annual rent increases thereafter. 

In June 2001, in connection with our acquisitionof CMD, we acquired the lease of an operating facility in Irvine, Californiawith average monthly rental payments of approximately $100,000 through November 2005.We have subleased parts of this facility to three separate third parties. Twoof these sublease agreements are coterminous leases and extend through November 2005,while the other sublease is on a month-to-month basis. These subleasescollectively generate monthly sublease income of approximately $41,000 tooffset our payment obligations. Additionally, in connection with ouracquisition of SCL in July 2001, we acquired the lease of a facility inMilpitas, California with average monthly rental payments of approximately$18,000 per month. We do not occupy the Milpitas facility and are attempting tosublease the space. We also lease office space in Taiwan and Japan.

Rentexpense, net of sublease income, totaled $1,902,000, $2,529,000 and $2,419,000in 2003, 2002 and 2001, respectively. Future minimum lease payments underoperating leases have not been reduced by expected sublease rental income or bythe amount of our restructuring accrual that relates to leased facilities.Future minimum payments for our operating leases, debt and inventory relatedpurchase obligations outstanding at December 31, 2003 are as follows (inthousands):
| ** **                       | ** ** | ** ** | ** ** | **Payments due in** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------|------------|
| **Contractual obligations** | ** ** | ** ** | ** ** | **Total**                     | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5 years** | ** ** |
| Debt obligations                 |       | $          | 1,732      |                          |       | $ | 1,692 |   |   | $ | 40 |   | $ | — |   |   | $ | — |   |   |
| Operating lease  obligations     |       | 9,748      |       |                          | 2,495      |   |   | 3,498 |   | 2,049 |   |   | 1,706 |   |   |
| Inventory  purchase obligations  |       | 6,017      |       |                          | 6,017      |   |   | — |   | — |   |   | — |   |   |
| Total                            |       | $          | 17,497     |                          |       | $ | 10,204 |   |   | $ | 3,538 |   | $ | 2,049 |   |   | $ | 1,706 |   |   |
|                                  |            |            |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We plan to spend approximately $2.5 million during thenext 12 months for equipment, furniture and software.

Based on our estimatedcash flows for 2004, we believe our existing cash and short-term investmentsare sufficient to meet our capital and operating requirements for at least thenext 12 months. Our future operating and capital requirements depend on manyfactors, including the levels at which we generate product revenue and relatedmargins, the timing and extent of development, licensing and royalty revenues,investments in inventory and accounts receivable, the cost of securing accessto adequate manufacturing capacity, our operating expenses, including legal andpatent defense costs, and general economic conditions. In addition, cash may berequired for future acquisitions should we choose to pursue 

45

----

any. Tothe extent existing resources and cash from operations are insufficient tosupport our activities, we may need to raise additional funds through public orprivate equity or debt financing. These funds may not be available, or ifavailable, we may not be able to obtain them on terms favorable to us.

**Factors Affecting Future Results**

*You should carefully consider the following riskfactors, together with all other information contained or incorporated byreference in this filing, before you decide to purchase shares of our commonstock. These factors could cause our future results to differ materially fromthose expressed in or implied by forward-looking statements made by us.Additional risks and uncertainties not presently known to us or that wecurrently deem immaterial may also harm our business. The trading price of ourcommon stock could decline due to any of these risks, and you may lose all orpart of your investment.*

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

The revenue and incomepotential of our business and the markets we serve is unproven. The DigitalVisual Interface (“DVI”) specification, which is based on technology developedby us and used in many of our products, was first published in April 1999.We completed our first generation of consumer electronics and storage ICproducts in mid-to-late 2001. In addition, the preliminary serial ATAspecification was first published in August 2001 and the High DefinitionMultimedia Interface (“HDMI”) specification was first released in December 2002.Accordingly, we face risks and difficulties frequently encountered by companiesin new and rapidly evolving markets. If we do not successfully address theserisks and difficulties, our results of operations could be negatively affected.

**We have a history of losses and may not becomeprofitable.**

We have incurred net lossesin each fiscal year since our inception, including net losses of $12.8 millionand $40.1 million for the years ended December 31, 2003 and 2002,respectively. We expect to continue to incur net losses for the foreseeablefuture. Accordingly, we may not achieve and sustain profitability.

**Our quarterly operating results may fluctuatesignificantly and are difficult to predict.**

Our quarterlyoperating results are likely to vary significantly in the future based on anumber of factors over which we have little or no control. These factorsinclude, but are not limited to:

·       thegrowth, evolution and rate of adoption of industry standards for our keymarkets, including digital-ready PCs and displays, consumer electronics andstorage devices;

·       thefact that our licensing revenue is heavily dependent on a few key deals beingcompleted for any given period, the timing of which is not always predictableand is especially susceptible to delay beyond the period in which completion isexpected, and our concentrated dependence on a few licensees in any period forsubstantial portions of our expected licensing revenue;

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

·       averageselling prices of our products, which are influenced by competition andtechnological advancements, among other factors;

46

----

·       governmentregulations regarding the timing and extent to which digital content must bemade available to consumers;

·       theavailability of other semiconductors or other key components that are requiredto produce a complete solution for the customer; usually, we supply one of manynecessary components;

·       thecost of components for our products and prices charged by the third parties whomanufacture, assemble and test our products;

·       fluctuationsin the price of our common stock, which drive a substantial portion of ournon-cash stock compensation expense;

·       thenature and extent of litigation activities, particularly our patentinfringement suit against Genesis, and any subsequent legal proceedings relatedto the matters raised in that suit; and.

·       anylegal matters resulting from the recent audit committee examination, inparticular the shareholder and derivative lawsuits against the company and itsdirectors and some of its officers.

Because we have little orno control over these factorsand/ortheir magnitude, our operating results are difficult to predict. Anysubstantial adverse change in any of these factors could negatively affect ourbusiness and results of operations.

**Our future quarterly operating results are highlydependent upon how well we manage our business.**

Our quarterlyoperating results may fluctuate based on how well we manage our business. Someof the factors that may affect how well we manage our business include thefollowing:

·       ourability to manage product introductions and transitions;

·       ourability to successfully manage our business in multiple markets such as PC,storage and CE;

·       ourability to close licensing deals and timely make deliverables and milestones onwhich recognition of revenue often depends;

·       ourability to engineer customer solutions that adhere to industry standards in atimely, cost-effective manner;

·       ourability to achieve acceptable manufacturing yields and develop automated testprograms within a reasonable time frame for our new products;

·       ourability to manage joint projects, design services, and our supply chainpartners;

·       ourability to monitor the activities of our licensees to ensure compliance withlicense restrictions and remittance of royalties;

·       ourability to structure our organization to enable achievement of our operatingobjectives and to meet the needs of our customers and markets;

·       thesuccess of the distribution channels through which we choose to sell ourproducts; and

·       ourability to manage expense and inventory levels.

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

**The licensing component of our business strategyincreases business risk and volatility.**

Part of our businessstrategy is to license certain of our technology to companies that addressmarkets in which we do not want to directly participate. We have limitedexperience marketing and selling our technology on a licensing basis. Inconjunction with the business strategy we adopted in late 2001, we 

47

----

signedour first license contract in December 2001, and have signed others sincethen. There can be no assurance that additional companies will be interested inlicensing our technology on commercially favorable terms or at all. We alsocannot ensure that companies who license our technology will introduce and sellproducts incorporating our technology, will accurately report royalties owed tous, will pay agreed upon royalties, will honor agreed upon market restrictions,will not infringe upon or misappropriate our intellectual property and willmaintain the confidentiality of our proprietary information. Licensingcontracts are complex and depend upon many factors including completion ofmilestones, allocation of values to delivered items, and customer acceptances.Many of these factors require significant judgments. Licensing revenues couldfluctuate significantly from period to period because it is heavily dependenton a few key deals being completed in a particular period, the timing of whichis difficult to predict. Because of their high margin content, licensingrevenues can have a disproportionate impact on gross margins and profitability.Also, generating revenue from licensing arrangements is a lengthy and complexprocess that may last beyond the period in which efforts begin, and once anagreement is in place, the timing of revenue recognition may be dependent oncustomer acceptance of deliverables, achievement of milestones, our ability totrack and report progress on contracts, customer commercialization of thelicensed technology, and other factors. In addition, in any period, ourexpectation of licensing revenue is or may be dependent on one or a fewlicenses being completed. Licensing that occurs in the course of actual orcontemplated litigation is subject to risk that the adversarial nature of thetransaction will induce non-compliance or non-payment. The accounting rules associatedwith recognizing revenue from licensing transactions are increasingly complexand subject to interpretation. Due to these factors, the amount of licenserevenue recognized in any period may differ significantly from ourexpectations.

**We face additional risks and costs as a result of thedelayed filing of our quarterly report on Form 10-Q for the quarter ended September 30,2003 and our recent Audit Committee examination.**

As a result of the delayed filing of our Form 10-Qfor the quarter ended September 30, 2003, and the Audit Committee’sexamination, we have experienced additional risks and costs. The AuditCommittee’s examination has been time-consuming, required us to incuradditional expenses and has affected management’s attention and resources. Further,the measures to strengthen internal controls being implemented may requiregreater management time and company resources to implement and monitor. Weincurred approximately $1.1 million of costs associated with the AuditCommittee examination in the fourth quarter of 2003 and will incur additionalcosts associated with this examination in the first quarter of 2004. Weestimate that the costs associated with conduct of the Audit Committeeexamination to be approximately $0.8 million during the first quarter of 2004. Pendinglitigation costs associated with the examination cannot be accurately projectedfor the following quarters and could be significant. In addition, measuresbeing implemented as a result of this examination, which are described under“Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Audit Committee Examination,” may adversely affect our operations.

Further, certain of our officers and directors havebeen named as defendants in shareholder derivative litigation, which alleges,among other matters, that as a result of the examination, we will be requiredto restate our financial results for 2002 and 2003 and that such a restatementwould be due to breaches by the individual defendants of the fiduciary dutiesto us. In addition, we and certain of our officers and directors have beennamed as defendants in securities class-action litigation, which alleges thatwe had materially overstated our licensing revenue, net income and financialresults during the time period from April 15, 2002 to November 15,2003. Although the Audit Committee has completed its examination and concludedthat no changes to our financial statements or the results previously announcedfor the quarter ended September 30, 2003, are required, these lawsuits maybe amended or continued, or new suits may be brought in connection with thedelayed filing of the Form 10-Q or the Audit Committee’s examination. Suchlitigations could be time-consuming, require us to incur significant expensesand could divert our 

48

----

management’s attention andresources. In addition, any unfavorable outcome of any of such litigation couldadversely impact our business, financial condition and results of operations.

In addition, we have been informed by the NASDAQ staffthat the continued listing of our common stock is conditioned on our timelyfiling of all periodic reports under the Securities Exchange Act of 1934, suchas our annual report on Form 10-K, quarterly reports on Form 10-Q,and current reports on Form 8-K, for all reporting periods ending onor before December 31, 2004. Should we fail to timely make any suchfiling, NASDAQ has informed us that we will not be entitled to a new hearingwith the NASDAQ staff and our common stock may be transferred to the NASDAQSmallCap Market, provided we could demonstrate compliance with applicablemaintenance criteria for such market and an ability to sustain long-termcompliance, or immediately delisted from the NASDAQ National Market. The NASDAQstaff has reserved the right to reconsider the terms of the foregoing exceptionpermitting continued listing of our common stock upon a review of our publiclyfiled financial statements or if any event, condition or circumstance thatexists or develops that would, in the opinion of the staff, make continuedlisting of our stock inadvisable or unwarranted.

Finally, as a result ofour delayed filing of our Form 10-Q, we will be ineligible to register oursecurities on Form S-3 for sale by us or resale by others until we havetimely filed all periodic reports under the Securities Exchange Act of 1934 forone year. The Company may use Form S-1 to raise capital or completeacquisitions, which could increase transaction costs and adversely affect ourability to raise capital or complete acquisitions of other companies duringthis period.

**We face intense competition in our markets, which maylead to reduced revenue from sales of our products and increased losses.**

The PC, CE and storage markets in which we operate areintensely competitive. These markets are characterized by rapid technologicalchange, evolving standards, short product life cycles and declining sellingprices. Our display products face competition from a number of sources,including analog solutions, DVI-based solutions, dual (analog and DVI based)solutions and other digital interface solutions. We expect competition in thedisplay market to increase. For example, Analog Devices, ATI, Broadcom,Chrontel, Genesis Microchip, Matrox, National Semiconductor, Novatek, nVidia,Phillips, Pixelworks, SIS, Smart ASIC, ST Microelectronics, Sunplus, TexasInstruments, Thine, and Weltrend, are shipping products or have announcedintentions to introduce products and/or other digital interface solutions thatwe expect will compete with our PanelLink products. Other companies haveannounced DVI-based solutions and we expect that additional companies arelikely to enter the market. Current or potential customers, including our ownlicensees, may also develop solutions that could compete with us, directly or indirectly,such as the integration of a DVI transmitter into a graphics processing unit orintegration of a DVI receiver into a monitor controller.

In the CE market, our digital interface products areused to connect cable set-top boxes, satellite set-top boxes and DVD players todigital televisions. These products incorporate DVI and High-bandwidth DigitalContent Protection (“HDCP”), or HDMI with or without HDCP support. Companiesthat have announced or are shipping DVI-HDCP solutions include Texas Instruments(“TI”), Thine, Broadcom and Genesis Microchip (“Genesis”). In addition, ourvideo processing products face competition from products sold by AV Science,Broadcom, Focus Enhancements, Genesis, Mediamatics, Micronas Semiconductor,Oplus, Philips, Pixelworks and Trident. We also compete, in some instances,against in-house processing solutions designed by large original equipmentmanufacturers. We expect competition for HDMI products from the other HDMIfounders and adopters, including Hitachi, Matsushita, Philips, Sony, Thomsonand Toshiba.

In the storage market, our fibre channel products facecompetition from companies selling similar discrete products, includingAgilent, PMC Sierra and Vitesse, from other fibre channel Serializer-

49

----

Deserializer (“SerDes”)providers who license their core technology, such as LSI Logic, and fromcompanies that sell Host Bust Adapters (“HBA”) controllers with integratedSerDes, such as QLogic and Agilent. In the future, our current or potentialcustomers may also develop their own proprietary solutions that may includeintegration of SerDes.

Our serial ATA products compete with similar productsfrom Marvell and Promise. In addition, other companies such as Adaptec, APT,ATI, Intel, LSI Logic, ServerWorks and Vitesse, have developed or announcedintentions to develop serial ATA controllers. We also compete against Intel andother motherboard chipset makers that have integrated serial ATA functionalityinto their chipsets.

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

Some of these competitorshave already established supplier or joint development relationships withcurrent or potential customers and may be able to leverage their existingrelationships to discourage these customers from purchasing products from us orpersuade them to replace our storage products with theirs. Many of ourcompetitors have longer operating histories, greater presence in key markets,better name recognition, access to larger customer bases and significantlygreater financial, sales and marketing, manufacturing, distribution, technicaland other resources than we do. In addition, some of our competitors couldmerge (for example, Genesis and Pixelworks announced, and then terminated, sucha merger), which may enhance their market presence. As a result, they may beable to adapt more quickly to new or emerging technologies and customerrequirements, or devote more resources to the promotion and sale of theirproducts. We cannot assure you that we can compete successfully against currentor potential competitors, or that competition will not reduce our revenue andincrease our losses.

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

Our success is largelydependent upon the rapid and widespread adoption of the DVI specification,which defines a high-speed data communication link between computers anddigital displays. We cannot predict the rate at which manufacturers ofcomputers and digital displays will adopt the DVI specification. To date,relatively few systems implementing all of the electrical and mechanicalaspects of the DVI specification have been shipped. The DVI adoption rate inthe PC market was reported to be approximately 12% , and, 7% in 2002 and 2001,respectively. The 2003 DVI adoption rate is estimated to be in the range of 15-20%.Adoption of the DVI specification may be affected by the availability ofcomputer components able to communicate DVI-compliant signals, such astransmitters, receivers, connectors and cables necessary to implement thespecification. Other specifications may also emerge that could adversely affectthe acceptance of the DVI specification. For example, a number of companieshave promoted alternatives to the DVI specification using other interfacetechnologies, such as low voltage differential signaling, or LVDS. Furtherdelays in the widespread adoption of the DVI specification could reduceacceptance of our products, limit or reduce our revenue growth and increase ourlosses.

**Our success depends on the growth of the digitaldisplay market.**

Our PC businessdepends on the growth of the digital display market. The potential size of thedigital display market and its rate of development are uncertain and willdepend on many factors, including:

·       thenumber of digital-ready computers that are being produced and consumer demandfor these computers;

·       therate at which display manufacturers replace analog or non-compliant DVIinterfaces with fully DVI-compliant interfaces;

50

----

·       theavailability of cost-effective semiconductors that implement a fullyDVI-compliant interface; and

·       improvementsto analog technology, which may decrease consumer demand for our digitaldisplay products.

In order for the digitaldisplay market to grow, digital displays must be widely available andaffordable to consumers. In the past, the supply of digital displays, such asflat panels, has been cyclical and consumers have been very price sensitive.Also, some manufacturers have implemented DVI interfaces that are not fullyDVI-compliant. These interfaces often interfere with the operability of ourproducts which function best with a fully DVI-compliant interface. Our abilityto sustain or increase our revenue may be limited should there not be anadequate supply of, or demand for, affordable digital displays with fullyDVI-compliant interfaces.

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

A large portion of our revenue is directly orindirectly related to the PC industry and the adoption of new or emergingtechnologies within the PC industry. Accordingly, we are highly dependent onthe adoption of new or emerging technologies within the PC industry, whichexperienced a slowdown in growth during the second half of 2000 that hascontinued through 2003. We cannot predict the duration or severity of thedownturn in the PC and display market, or in the general economy, or its effecton our revenue and operating results, including the adoption of these new oremerging technologies. If the market for PCs and PC-related displays continuesto grow at a slow rate or contracts whether due to reduced demand from endusers, macroeconomic conditions or other factors, our business and results ofoperations could be negatively affected.

Although we are attemptingto broaden our product offerings to include more products for the consumerelectronics and storage markets, there can be no guarantee that we will succeedin this effort. To date, we have achieved reasonable success, but if we fail toconsistently achieve design wins in the consumer electronics and storagemarkets, we will remain highly dependent on the PC industry.

**Demand for our consumer electronics products isdependent on the adoption and widespread use of the HDMI 1.0 specification.**

Our success in the consumer electronics market islargely dependent upon the rapid and widespread adoption of the HDMI 1.0specification, which combines high-definition video and multi-channel audio inone digital interface and uses our patented underlying transition minimizeddifferential signaling (“TMDS”®)technology,and optionally Intel’s HDCP technology, as the basis for the interface. Version1.0 of the specification was published for adoption on December 9, 2002.We cannot predict the rate at which manufacturers will adopt the HDMIspecification or if the specification will be adopted at all. Adoption of theHDMI specification may be affected by the availability of consumer products,such as DVD players and televisions, and of computer components that implement thisnew interface. Other competing specifications may also emerge that couldadversely affect the acceptance of the HDMI specification. Delays in thewidespread adoption of the HDMI specification could reduce acceptance of ourproducts, limit or reduce our revenue growth and increase our losses.

We believe that the adoption of our CE products may beaffected in part by U.S. and International regulations relating to digitaltelevision, cable, satellite and over-the-air digital transmissions,specifically regulations relating to the transition from analog to digitaltelevision. The Federal Communications Commission (“FCC”) has adopted rules governingthe transition from analog to digital television, which include rules governingthe requirements for television sets sold in the United States designed tospeed the 

51

----

transition to digitaltelevision. The FCC has delayed such requirements and timetables for phasing indigital television in the past. We cannot predict whether the FCC will furtherdelay its rules relating to the digital television requirements andtimetables. In the event that additional regulatory activity, either in theUnited States or internationally, delay or postpone the transition to digitaltelevision beyond the anticipated time frame, that could reduce the demand forour CE products.

In addition, we believethat the rate of HDMI adoption may be accelerated by the proposed FCC rules requiringthat all high-definition set top boxes distributed by cable operators include aDVI or HDMI interface and that all CE products marketed or labeled as “digitalcable ready” include a DVI or HDMI interface. However, we cannot predictwhether the proposed rules will be adopted in their current form or whenany final rules will be put into effect. In the event that mandatory useof a DVI or HDMI interface were to be delayed beyond the currently anticipatedtime frame or not required at all, that could reduce the demand for our CEproducts, which would adversely affect our business.

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

Our success in the PCmarket depends on increasing sales of our receiver products to displaymanufacturers. To increase sales of our receiver products, we need computermanufacturers to incorporate DVI-compliant transmitters in their systems,making these systems digital-ready. During 2002, we introduced a low-costadd-in card that can be used in conjunction with Intel’s 845G chip set toprovide an all-digital connection to flat panels. Intel’s 845G chip set isintended to provide an all-digital path on the motherboard bus, and should makeit easier to provide digital video out. Use of Intel’s 845G chip set, or anydigital path chip set, is not universal and may not gain market acceptance. Ifcomputers are not digital-ready, they will not operate with digital displays,which will limit and may reduce the demand for our digital host and receiverproducts.

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

Our productdevelopment efforts in the storage market are focused on the development ofproducts using new interface technologies such as fibre channel and serial ATA.The markets for these new interface technologies are at an early stage ofdevelopment, and there can be no assurance that they will replace other storageinterfaces that are now widely used, such as parallel ATA and SCSI. Thepotential size and rate of development of these markets are uncertain and willdepend on many factors, including:

·       therate at which manufacturers of storage subsystems adopt new interfacetechnologies, which may be more costly to implement than existing interfacetechnologies until volumes are sufficient to bring costs to competitive levels;

·       theavailability of cost-effective semiconductors and components for storagesubsystems, such as serial ATA-enabled hard drives and serial ATA enabledoptical drives (CD and DVD), that implement new interface technologies for thestorage market;

·       whetherIntel or other motherboard manufacturers integrate the functionality of ourproducts, such as serial ATA, into their chips and chip sets; and

·       improvementto existing storage interface technologies such as parallel ATA and SCSI, orthe introduction of other new storage interface technologies, either of whichmay decrease consumer demand for our storage products.

In particular, the rate of implementation of theserial ATA interface will depend on how quickly drive manufacturers,motherboard and PC providers and chipmakers are able to resolve technicalcommunication and functionality issues to enable a “plug and play” environmentin which a computer 

52

----

system is automaticallyable to recognize and configure storage devices. Resolution of these issuescould be time-consuming, and will depend in good measure on the ability ofchipmakers to incorporate the required high-speed serial data transfercapabilities into their semiconductors without sacrificing manufacturingyields.

Any delay in acceptance of new interface technologies,or a reduction in the growth or size of the market for systems based on serialATA or fibre channel technologies, would limit sales of our storage productsand reduce our revenue. Any delay in the availability of serial ATA compatibledrives or acceleration of serial ATA or fibre channel SerDes integrationefforts by motherboard or storage controller manufacturers may also reduce ourrevenue.

We have promulgated a SATALite specification to whichwe have invited key industry members to participate. This program includescertain licenses to our technology that we hope will increase market acceptanceof our serial ATA products. There can be no assurance that this program willsucceed, or that SATALite participants will not use our technology to competeagainst us.

To date, we have achieveda number of design wins for our serial ATA and fibre channel storage products.Even after we have achieved a design win from an Original Equipment Manufacturer(OEM), we may not realize any revenue, or significant revenue, from that OEMsince a design win is not a binding commitment to purchase our products and theOEM may not achieve market acceptance for their product. Further delay inserial ATA-enabled drive availability may lead OEMs to re-open their designsand designs we have won may be subject to being lost, which could reduce ourrevenue and increase our operating expenses in competing to re-win designs.

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

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

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

Because our products arebased on new technology and standards, a lengthy sales process, typicallyrequiring several months or more, is often required before potential customersbegin the technical evaluation of our products. This technical evaluation canexceed nine months before the potential customer informs us whether we haveachieved a design win, which is not a binding commitment to purchase ourproducts. After achieving a design win, it can then be an additional ninemonths before a customer commences volume shipments of systems incorporatingour products, if at all. Given our lengthy sales cycle, we may experience adelay between the time we incur expenditures and the time we generate revenue,if any. As a result, our operating results could be seriously harmed if asignificant customer reduces or delays orders, or chooses not to release productsincorporating our products.

53

----

**We depend on a few key customers and the loss of anyof them could significantly reduce our revenue.**

Historically, arelatively small number of customers and distributors have generated asignificant portion of our revenue. For the year ended 2003, shipments to WorldPeace International, an Asian distributor, generated 15% of our revenue, andshipments to Weikeng, a distributor, generated 8% of our revenue. For the yearended December 31, 2002, shipments to World Peace International generated15% of our revenue, and shipments to Weikeng generated 11% of our revenue. Inaddition, an end-customer may buy through multiple distributors, contractmanufacturers, and / or directly, which could create an even greaterconcentration. We cannot be certain that customers and key distributors thathave accounted for significant revenue in past periods, individually or as agroup, will continue to sell our products and generate revenue. As a result ofthis concentration of our customers, our results of operations could be negativelyaffected if any of the following occurs:

·       oneor more of our customers, including distributors, becomes insolvent or goes outof business;

·       oneor more of our key customers or distributors significantly reduces, delays orcancels orders; or

·       oneor more significant customers selects products manufactured by one of ourcompetitors for inclusion in their future product generations.

Due to our participationin multiple markets, our customer base has broadened significantly and wetherefore anticipate being less dependent on a relatively small number ofcustomers to generate revenue. However, as product mix fluctuates from quarterto quarter, we may become more dependent on a small number of customers or asingle customer for a significant portion of our revenue in a particularquarter, the loss of which could adversely affect our operating results.

**We sell our products through distributors, whichlimits our direct interaction with our customers, therefore reducing ourability to forecast sales and increasing the complexity of our business.**

Many originalequipment manufacturers rely on third-party manufacturers or distributors toprovide inventory management and purchasing functions. Distributors generated42% of our revenue for 2003, and 42% of our revenue for the year ended December 31,2002. Selling through distributors reduces our ability to forecast sales andincreases the complexity of our business, requiring us to:

·       managea more complex supply chain;

·       monitorand manage the level of inventory of our products at each distributor;

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

·       monitorthe financial condition and credit-worthiness of our distributors, many ofwhich are located outside of the United States, and the majority of which arenot publicly traded.

Any failure to managethese challenges could disrupt or reduce sales of our products and unfavorablyimpact our financial results.

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

The development ofnew products is highly complex, and we have experienced delays, some of whichexceeded one year, in the development and introduction of new products onseveral occasions in the past. In 2001 and 2002, we announced our firstproducts for the storage market and we expect to introduce new consumerelectronics, storage and DVI products in the future. As our products integratenew, more advanced functions, they become more complex and increasinglydifficult to design, manufacture and 

54

----

debug.Successful product development and introduction depends on a number of factors,including, but not limited to:

·       accurateprediction of market requirements and evolving standards, includingenhancements to existing standards such as DVI, HDCP and SATA, and developmentand adoption of new or emerging standards such as HDMI, or significantmodifications to existing standards such as SATA II;

·       developmentof advanced technologies and capabilities, and new products that satisfycustomer requirements;

·       competitors’and customers’ integration of the functionality of our products into theirproducts, which puts pressure on us to continue to develop and introduce newproducts with new functionality;

·       timelycompletion and introduction of new product designs;

·       managementof product life cycles;

·       useof leading-edge foundry processes and achievement of high manufacturing yieldsand low cost testing; and

·       marketacceptance of new products.

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

55

----

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

Our growth dependsupon market growth and our ability to enhance our existing products andintroduce new products on a timely basis. One of the ways we develop newproducts and enter new markets is through acquisitions. In 2000, we completedthe acquisitions of Zillion and DVDO, and in 2001, we completed theacquisitions of CMD and SCL. In April 2003, we acquired TWN. We mayacquire additional companies or technologies. Acquisitions involve numerousrisks, including, but not limited to, the following:

·       difficultyand increased costs in assimilating employees, including our possible inabilityto keep and retain key employees of the acquired business;

·       disruptionof our ongoing business;

·       discoveryof undisclosed liabilities of the acquired companies and legal disputes withfounders or shareholders of acquired companies;

·       inabilityto successfully incorporate acquired technology and operations into ourbusiness and maintain uniform standards, controls, policies and procedures;

·       inabilityto commercialize acquired technology; and

·       theneed to take impairment charges or write-downs with respect to acquired assets.

No assurance can be giventhat our prior acquisitions or our future acquisitions, if any, will besuccessful or provide the anticipated benefits, or that they will not adverselyaffect our business, operating results or financial condition. Failure tomanage growth effectively and to successfully integrate acquisitions made by uscould materially harm our business and operating results.

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

In the past, thesemiconductor industry has been characterized by significant downturns and widefluctuations in supply and demand. For example, demand in the semiconductorindustry rose to record levels in 1999, and then declining until recently whenit appears to be recovering. The industry has also experienced significantfluctuations in anticipation of changes in general economic conditions. Thiscyclicality has led to significant fluctuations in product demand and in the foundry,test and assembly capacity of third party suppliers. Production capacity forfabricated semiconductors could be subject to allocation, whereby not all ofour production requirements would be met. This may impact our ability to meetdemand and could also increase our production costs. Cyclicality has alsoaccelerated decreases in average selling prices per unit. We may experiencefluctuations in our future financial results because of changes inindustry-wide conditions.

**We depend on third-party sub-contractors tomanufacture, assemble and test nearly all of our products, which reduces ourcontrol over the production process.**

We do not own oroperate a semiconductor fabrication facility. We rely on Taiwan SemiconductorManufacturing Company (“TSMC”), an outside foundry, to produce the vastmajority all of our semiconductor products. We also rely on Kawasaki, UMC andAtmel, for outside foundry services, and on Amkor and ASE to test certain ofour semiconductor products. Our reliance on independent foundries, assembly andtest facilities involves a number of significant risks, including, but notlimited to:

·       reducedcontrol over delivery schedules, quality assurance, manufacturing yields andproduction costs;

56

----

·       lackof guaranteed production capacity or product supply;

·       lackof availability of, or delayed access to, next-generation or key processtechnologies; and

·       ourability to transition to alternate sources if services are unavailable fromprimary suppliers.

In addition, oursemiconductor products are assembled and tested by several independentsubcontractors. We do not have a long-term supply agreement with oursubcontractors, and instead obtain production services on a purchase orderbasis. Our outside sub-contractors have no obligation to supply products to usfor any specific period of time, in any specific quantity or at any specificprice, except as set forth in a particular purchase order. Our requirementsrepresent a small portion of the total production capacity of our outsidefoundries, assembly and test facilities and our sub-contractors may reallocatecapacity to other customers even during periods of high demand for ourproducts. These foundries may allocate or move production of our products todifferent foundries under their control, even in different locations, which maybe time consuming, costly, and difficult, have an adverse affect on quality,yields, and costs, and require us and/or our customers to re-qualify theproducts, which could open up design wins to competition and result in the lossof design wins and design-ins. If our subcontractors are unable or unwilling tocontinue manufacturing our products in the required volumes, at acceptablequality, yields and costs, and in a timely manner, our business will besubstantially harmed. As a result, we would have to identify and qualifysubstitute contractors, which would be time-consuming, costly and difficult.This qualification process may also require significant effort by ourcustomers, and may lead to re-qualification of parts, opening up design wins tocompetition, and loss of design wins and design-ins. Any of these circumstancescould substantially harm our business. In addition, if competition for foundry,assembly and test capacity increases, our product costs may increase and we maybe required to pay significant amounts or make significant purchase commitmentsto secure access to production services.

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

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

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

Although we test ourproducts before shipment, they are complex and may contain defects and errors.In the past we have encountered defects and errors in our products. Because ourproducts are sometimes integrated with products from other vendors, it can bedifficult to identify the source of any particular problem. Delivery ofproducts with defects or reliability, quality or compatibility problems, maydamage our reputation and our ability to retain existing customers and attractnew customers. In addition, product defects and errors could result inadditional development costs, diversion of technical resources, delayed productshipments, increased product returns, warranty and product liability claimsagainst us that may not be fully covered by insurance. Any of thesecircumstances could substantially harm our business.

57

----

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

A substantialportion of our business is conducted outside of the United States. As a result,we are subject to foreign business, political and economic risks. Nearly all ofour products are manufactured in Taiwan or elsewhere in Asia, and for the yearsended December 31, 2003, 2002, and 2001 74%, 72%, and 79% of our revenue respectivelywas generated from customers and distributors located outside of the UnitedStates, primarily in Asia. We anticipate that sales outside of the UnitedStates will continue to account for a substantial portion of our revenue infuture periods. Accordingly, we are subject to international risks, including,but not limited to:

·       difficultiesin managing from afar;

·       politicaland economic instability, including international tension in Iraq, Korea andthe China Strait and lack of normal diplomatic relationships between the UnitedStates and Taiwan;

·       lessdeveloped infrastructures in newly industrializing countries;

·       susceptibilityof foreign areas to terrorist attacks;

·       susceptibilityto interruptions of travel, including those due to international tensions(including the war in and occupation of Iraq), the SARS and Avian Flu epidemics(particularly affecting the Asian markets we serve), and the financialinstability and bankruptcy of major air carriers;

·       biasagainst foreign, especially American, companies;

·       difficultiesin collecting accounts receivable;

·       expenseand difficulties in protecting our intellectual property in foreignjurisdictions;

·       difficultiesin complying with multiple, conflicting and changing laws and regulations,including export requirements, tariffs, import duties, visa restrictions,environmental laws and other barriers;

·       exposureto possible litigation or claims in foreign jurisdictions; and

·       competitionfrom foreign-based suppliers and the existence of protectionist laws andbusiness practices that favor these suppliers, such as withholding taxes onpayments made to us.

These risks couldadversely affect our business and our results of operations. In addition, originalequipment manufacturers that design our semiconductors into their products sellthem outside of the United States. This exposes us indirectly to foreign risks.Because sales of our products are denominated exclusively in United Statesdollars, relative increases in the value of the United States dollar willincrease the foreign currency price equivalent of our products, which couldlead to a reduction in sales and profits in that country.

**The success of our business depends upon our abilityto adequately protect our intellectual property.**

We rely on a combinationof patent, copyright, trademark, mask work and trade secret laws, as well asnondisclosure agreements and other methods, to protect our proprietarytechnologies. We have been issued patents and have a number of pending patentapplications. However, we cannot assure you that any patents will be issued asa result of any applications or, if issued, that any claims allowed willprotect our technology. In addition, we do not file patent applications on aworldwide basis, meaning we do not have patent protection in somejurisdictions. It is possible that existing or future patents may bechallenged, invalidated or circumvented and effective patent, copyright,trademark and trade secret protection may be unavailable or limited in foreigncountries. It may be possible for a third party to copy or otherwise obtain anduse our products or technology without authorization, develop similartechnology independently or design around our patents in the United States andin other jurisdictions. It is also possible that some of 

58

----

ourexisting or new licensing relationships will enable other parties to use ourintellectual property to compete against us. Legal actions to enforceintellectual property rights tend to be lengthy and expensive, and the outcomeoften is not predictable. As a result, despite our efforts and expenses, we maybe unable to prevent others from infringing upon or misappropriating ourintellectual property, which could harm our business. In addition, practicalityalso limits our assertion of intellectual property rights. Patent litigation isexpensive and its results are often unpredictable. Assertion of intellectualproperty rights often results in counterclaims for perceived violations of thedefendant’s intellectual property rights and/or antitrust claims. Certainparties after receipt of an assertion of infringement will cut off allcommercial relationships with the party making the assertion, thus makingassertions against suppliers, customers, and key business partners unwise. Accordingly,if we forgo making such claims, we may risk creating legal and equitabledefenses for an infringer.

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

We are a promoterof the DDWG, which published and promotes the DVI specification. Our strategyincludes establishing the DVI specification as the industry standard, promotingand enhancing this specification and developing and marketing products based onthis specification and future enhancements. As a result:

·       wemust license for free specific elements of our intellectual property to othersfor use in implementing the DVI specification; and

·       wemay license additional intellectual property for free as the DDWG promotesenhancements to the DVI specification.

Accordingly, companiesthat implement the DVI specification in their products can use specificelements of our intellectual property for free to compete with us.

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

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

Our strategyincludes establishing the HDMI specification as the industry standard,promoting and enhancing this specification and developing and marketingproducts based on this specification and future enhancements. As a result:

·       wemust license specific elements of our intellectual property to others for usein implementing the HDMI specification; and

·       wemay license additional intellectual property as the HDMI founders grouppromotes enhancements to the HDMI specification.

Accordingly, companiesthat implement the HDMI specification in their products can use specificelements of our intellectual property to compete with us. Although there willbe license fees and royalties associated with the adopters agreements, therecan be no assurance that such license fees and royalties will adequately compensateus for having to license our intellectual property. Fees and royalties received

59

----

duringthe early years of adoption will be used to cover costs we incur to promote theHDMI standard and to develop and perform interoperability tests; in addition,after an initial period, the HDMI founders may reallocate the license fees androyalties amongst themselves to reflect each founder’s relative contribution ofintellectual property to the HDMI specification.

**Our success depends on managing our relationship withIntel.**

Intel has adominant role in many of the markets in which we compete, such as PCs andstorage, and is a growing presence in the CE market. We have a multi-facetedrelationship with Intel that is complex and requires significant managementattention, including:

·       Intelhas been an investor of ours;

·       Inteland we have been parties to a business cooperation agreement;

·       Inteland we are parties to a patent cross-license;

·       Inteland we worked together to develop HDCP;

·       AnIntel subsidiary has the exclusive right to license HDCP, of which we are alicensee;

·       Inteland we were two of the original founders of the Digital Display Working Group (“DDWG”);

·       Intelis a promoter of the serial ATA working group, of which we are a contributor;

·       Intelis a supplier to us and a customer for our products;

·       Webelieve that Intel has the market presence to drive adoption of DVI and serialATA by making them widely available in its chip sets and motherboards, whichcould affect demand for our products;

·       Webelieve that Intel has the market presence to affect adoption of HDMI by eitherendorsing the technology or promulgating a competing standard, which couldaffect demand for our products;

·       Intelmay potentially integrate the functionality of our products, including fibrechannel, serial ATA or DVI, into its own chips and chip sets, therebydisplacing demand for some of our products;

·       Intelmay design new technologies that would require us to re-design our products forcompatibility, thus increasing our R&D expense and reducing our revenue;

·       Intel’stechnology, including its 845G chip set, may lower barriers to entry to otherparties who may enter the market and compete with us; and

·       Intelmay enter into or continue relationships with our competitors that can put usat a relative disadvantage.

Our cooperation andcompetition with Intel can lead to positive benefits if managed effectively. Ifour relationship with Intel is not managed effectively, it could seriously harmour business, negatively affect our revenue, and increase our operatingexpenses.

**We have granted Intel rights with respect to ourintellectual property, which could allow Intel to develop products that competewith ours or otherwise reduce the value of our intellectual property.**

We have entered into apatent cross-license agreement with Intel in which each of us granted the othera license to use the grantor’s patents, except for identified types ofproducts. We believe that the scope of our license to Intel excludes ourcurrent products and anticipated future products. Intel could, however,exercise its rights under this agreement to use our patents to develop andmarket other products that compete with ours, without payment to us.Additionally, Intel’s rights to our patents could reduce the 

60

----

value ofour patents to any third party who otherwise might be interested in acquiringrights to use our patents in such products. Finally, Intel could endorsecompeting products, including a competing digital interface, or develop its ownproprietary digital interface. Any of these actions could substantially harmour business and results of operations.

**We are and may continue to become the target ofsecurities class action suits which could result in substantial costs anddivert management attention and resources.**

Securities class actionsuits are often brought against companies, particularly technology companies,following periods of volatility in the market price of their securities.Defending against these suits, even if meritless, can result in substantial coststo us and could divert the attention of our management. We and certain of ourofficers and directors, together with certain investment banks, have been namedas defendants in a securities class action suit filed against us on behalf ofpurchasers of our securities between October 5, 1999 and December 6,2000. It is alleged that the prospectus related to our initial public offeringwas misleading because it failed to disclose that the underwriters of ourinitial public offering had solicited and received excessive commissions fromcertain investors in exchange for agreements by investors to buy our shares inthe aftermarket for predetermined prices. Due to inherent uncertainties inlitigation, we cannot accurately predict the outcome of this litigation; however,a proposed settlement has been negotiated that has yet to be reviewed andapproved by the Court. In the event that the settlement is not approved, webelieve that these claims are without merit and we intend to defend vigorouslyagainst them. We and certain of our officers, together with certain investmentbanks and their current or former employees, were named as defendants in asecurities class action suit filed against us on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.The plaintiff in this matter has filed an amended complaint in which SiliconImage, and the named officers, were dropped as defendants. We believe that thesettlement described above, if approved, would encompass the claims in thiscase. We believe that these claims were without merit and, if revived, and notsubject to the settlement, we intend to defend vigorously against them. Certain of our officers and directors have beennamed as defendants in consolidated shareholder derivative litigation. Thelawsuit alleges that as a result of the examination conducted by our AuditCommittee, we will be required to restate our financial results for 2002 and2003. The lawsuit further alleges that such a restatement would be due tobreaches by the individual defendants of their fiduciary duties to us, thatcertain of the individual defendants are liable to us for insider trading underCalifornia law, and that the individual defendants are liable to us formismanagement, abuse of control, and waste. We and certain of our officers have also been named as defendantsin consolidated securities class action litigation. Plaintiffs filed the actionon behalf of a putative class of shareholders who purchased our stock between April 15,2002 and November 15, 2003. The lawsuit alleges that we had materiallyoverstated our licensing revenue, net income and financial results during thistime period, and that were being forced to restate our financial results. Withthe announcement by the Audit Committee of Silicon Image’s Board of Directorsthat it has completed its examination and that it has concluded that no changesto Silicon Image’s previously announced financial results are required,, thepreceding two lawsuits may be moot in whole or in part, although plaintiffs mayamend the complaint once as a matter of right. We believe that theseclaims are without merit and we intend to defend vigorously against them.However, these suits and any others that may be brought, even if meritless,could require us to incur expenses and could divert our management’s attentionand resources. In addition, any unfavorable outcome of either of theselitigations could adversely impact our business, financial condition andresults of operations.

61

----

**We are currently engaged in intellectual propertylitigation that is time-consuming and expensive to prosecute. We may becomeengaged in additional intellectual property litigation that could betime-consuming, maybe be expensive to prosecute or defend, and could adverselyaffect our ability to sell our product.**

In recent years, there has been significant litigationin the United States and in other jurisdictions involving patents and otherintellectual property rights. This litigation is particularly prevalent in thesemiconductor industry, in which a number of companies aggressively use theirpatent portfolios to bring infringement claims. In addition, in recent years,there has been an increase in the filing of so-called “nuisance suits,”alleging infringement of intellectual property rights. These claims may beasserted as counterclaims in response to claims made by a company alleginginfringement of intellectual property rights. These suits pressure defendantsinto entering settlement arrangements to quickly dispose of such suits,regardless of merit. In addition, as is common in the semiconductor industry,from time to time we have been notified that we may be infringing certainpatents or other intellectual property rights of others. Responding to suchclaims, regardless of their merit, can be time consuming, result in costlylitigation, divert management’s attention and resources and cause us to incursignificant expenses. As each claim is evaluated, we may consider the desirabilityof entering into settlement or licensing agreements. No assurance can be giventhat settlements will occur or that licenses can be obtained on acceptableterms or that litigation will not occur. In the event there is a temporary orpermanent injunction entered prohibiting us from marketing or selling certainof our products, or a successful claim of infringement against us requiring usto pay damages or royalties to a third party, and we fail to develop or licensea substitute technology, our business, results of operations or financialcondition could be materially adversely affected.

In April 2001, we filed suit against GenesisMicrochip for infringement of one of our U.S. patents. At that time, we alsofiled a complaint against Genesis for unlawful trade practices related to theimportation of articles infringing our patent. In February 2002, ourmotion to dismiss the unlawful trade practices complaint was granted and wefiled an amended complaint against Genesis alleging infringement of two of ourU.S. patents. These patents relate to our DVI receiver products, which generatea significant portion of our revenue. The amended complaint seeks a declarationthat Genesis has infringed our patents, that Genesis’s behavior is notlicensed, an injunction to halt the importation, sale, manufacture and use ofGenesis DVI receiver chips that infringe our patents, and monetary damages. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. We filed a motion to dismiss certain of Genesis’s counterclaims. Inaddition, we filed a motion to bifurcate trial of the counterclaims to theextent the court does not dismiss them. In May 2002, the Court granted ourmotion to dismiss certain of the counterclaims, with leave to amend. Genesisre-filed counterclaims against us for fraud and patent misuse. We filed anothermotion to dismiss these counterclaims. In August 2002, the Court grantedour motion and dismissed Genesis’s re-filed counterclaims with prejudice. In December 2002,the parties entered into a memorandum of understanding (“MOU”) to settle thecase. In January, the parties presented different interpretations of the MOU tothe Court. On July 15, 2003, the Court granted our motion to interpret theMOU in the manner we requested, and ruled that Genesis had engaged in effortsto avoid its obligations under the MOU. On August 6, 2003, the Courtentered a final judgment order based on its July 15, 2003 ruling. Underthe final judgment order, Genesis was ordered to make a substantial cashpayment, and to make royalty payments; although Genesis has made and continuesto make cash payments to the Court, it may not have made all the payments thatare required under the final judgment order. We filed motions for reimbursementof some of some of expenses, including some of our legal fees, and formodification and/or clarification of certain items of the judgment, and to holdGenesis in contempt of Court for breaching the protective order in the case bydisclosing secret information to at least one of our competitors. On December 19,2003, the Court granted our motions in part and denied them in part: the courtissued an amended judgment, and held Genesis in contempt of Court for breachingthe protective order. On January 16, 2004, Genesis filed a notice ofappeal.

62

----

There can be no assurance that Genesis will notundertake further efforts to avoid its obligations under the MOU, and thatfurther proceedings (lawsuits, contempt citations, etc.) against Genesis, andcertain of its executives, its counsel, and others may not be required toobtain compliance or to obtain redress for non-compliance. There can be noassurance that an appellate court will uphold the Court’s rulings or the MOU. Therecan be no assurance that further delays or noncompliance will not occur. TheCourt’s rulings of July 15, 2003 and December 19, 2003 indicate thatGenesis violated certain provisions of the MOU, and of the protective order in thecase, including disclosure of confidential information to Pixelworks. On August 5,2003, Genesis and Pixelworks issued a joint press release terminating theirproposed merger. In that press release, Genesis and Pixelworks jointly statedthat “Pixelworks has confirmed that prior to signing the merger agreement, itreviewed the Memorandum of Understanding that purported to settle the lawsuitbetween Genesis Microchip and Silicon Image, Inc.” While this litigation,including any appeal or any possible derivative proceedings, is pending,Genesis can use the technology covered by these patents to develop productsthat might compete with ours. If we are unsuccessful in this litigation, wecould be unable to prevent Genesis or others from using the technology coveredby these patents. Even if we prevail in this litigation, uncertaintiesregarding the outcome prior to that time may reduce demand for our products, orGenesis’s use of our technology in products that compete with our products mayreduce demand or pricing for our products. In addition, even if the MOU isupheld on appeal, future disputes may occur, including those regarding whetherand what intellectual property licenses were granted and the scope of any suchlicenses and the royalty rates and payment terms for such licenses, whether theMOU was breached, whether consent was fraudulently obtained, and whether amerger partner may succeed to the rights and/or the obligations under the MOU.These disputes may result in additional costly and time-consuming litigation orthe license of additional elements of our intellectual property for free.

Any potentialintellectual property litigation against us could also force us to do one ormore of the following:

·       stopselling products or using technology that contain the allegedly infringingintellectual property;

·       attemptto obtain a license to the relevant intellectual property, which license maynot be available on reasonable terms or at all; and

·       attemptto redesign products that contain the allegedly infringing intellectualproperty.

If we take any of theseactions, we may be unable to manufacture and sell our products. We may beexposed to liability for monetary damages, the extent of which would be verydifficult to accurately predict. In addition, we may be exposed to customerclaims, for potential indemnity obligations, and to customer dissatisfactionand a discontinuance of purchases of our products while the litigation ispending. Any of these consequences could substantially harm our business andresults of operations.

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

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

63

----

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

Our success depends to a significant extent upon thecontinued contributions of our key management, technical and sales personnel,many of who would be difficult to replace. The loss of one or more of theseemployees could harm our business. Although we have entered into a limitednumber of employment contracts with certain executive officers, we generally donot have employment contracts with our key employees. We do not have key personlife insurance for any of our key personnel. Our success also depends on ourability to identify, attract and retain qualified technical, sales, marketing,finance and managerial personnel. Competition for qualified personnel isparticularly intense in our industry and in our location. This makes itdifficult to retain our key personnel and to recruit highly qualified personnel.We have experienced, and may continue to experience, difficulty in hiring andretaining candidates with appropriate qualifications. To be successful, we needto hire candidates with appropriate qualifications and retain our keyexecutives and employees.

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

We use contractors toprovide services to the company, which often involves contractual complexity,tax and employment law compliance, and being subject to audits and othergovernmental actions. We have been audited for our contracting policies in thepast, and may be in the future. Burdening our ability to freely use contractorsto provide services to the company may increase the expense of obtaining suchservices, and/or require us to discontinue using contractors and attempt tofind, interview, and hire employees to provide similar services. Such potentialemployees may not be available in a reasonable time, or at all, or may not behired without undue cost.

**In the past, we implemented mandatory unpaidcompany-wide shutdowns as a cost reduction measure, but we may not continue toimplement these programs.**

In the last two fiscalyears and in each of the four quarters of 2003, we implemented mandatorycompany-wide shutdowns. Although these shutdown periods represent a costsavings to us, they may be perceived negatively by our customers, vendors andemployees. We currently intend to implement a company-wide shutdown during thefourth quarter of 2004. In addition, we may continue to implement company-wideshutdowns in future periods, which may negatively impact employee morale or theperception of our company by our customers and vendors. If we elect not to implementthese shutdowns, our operating expenses will increase.

**Our workforce reductions may seriously harm ourbusiness.**

In connection with therestructuring program we began in the third quarter of 2001 to focus ourbusiness on products and technology in which we have, or believe we canachieve, a leadership position, and the reorganization of the company in thefirst quarter of 2003 into lines of business, we have 

64

----

implementedfour workforce reductions, eliminating a total of 136 positions. As a result ofthe elimination of these positions, our marketing, sales and customer supportcapabilities could be reduced, our ability to respond to unexpected challengesmay be impaired, we may become dependent on a few key employees, and we may beunable to take advantage of new opportunities. These workforce reductions, orfuture workforce reductions, if any, may reduce employee morale and createconcern among existing employees about job security, which could lead toincreased turnover. Workforce reductions may also raise concerns amongcustomers, suppliers and other corporate partners regarding our continuedviability. Further, these workforce reductions may subject us to the risk oflitigation, which could be costly to defend, divert the attention of managementand subject us to possible liability for damages.

**Industry cycles may strain our management andresources.**

Cycles of growthand contraction in our industry may strain our management and resources. Tomanage these industry cycles effectively, we must:

·       improveoperational and financial systems;

·       trainand manage our employee base;

·       successfullyintegrate operations and employees of businesses we acquire or have acquired;

·       attract,develop, motivate and retain qualified personnel with relevant experience; and

·       adjustspending levels according to prevailing market conditions.

If we cannot manage industry cycleseffectively, our business could be seriously harmed.

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

Our operations are headquartered in the San FranciscoBay Area, which is susceptible to earthquakes, and the operations of CMD, whichwe acquired, are based in the Los Angeles area, which is also susceptible toearthquakes. TSMC and UMC, the outside foundries that produce the majority ofour semiconductor products, are located in Taiwan. Advanced SemiconductorEngineering, or ASE, one of the subcontractors that assembles and tests oursemiconductor products, is also located in Taiwan. For the year ended December 31,2003, customers and distributors located in Taiwan generated 34% of our revenueand customers and distributors located in Japan generated 15% of our revenue.For the year ended December 31, 2002, customers and distributors locatedin Taiwan generated 34% of our revenue and customers and distributors locatedin Japan generated 12% of our revenue. Both Taiwan and Japan are susceptible toearthquakes, typhoons and other natural disasters.

Our business wouldbe negatively affected if any of the following occurred:

·       anearthquake or other disaster in the San Francisco Bay Area or the Los Angelesarea damaged our facilities or disrupted the supply of water or electricity toour headquarters or our Irvine facility;

·       anearthquake, typhoon or other disaster in Taiwan or Japan resulted in shortagesof water, electricity or transportation, limiting the production capacity ofour outside foundries or the ability of ASE to provide assembly and testservices;

·       anearthquake, typhoon or other disaster in Taiwan or Japan damaged the facilitiesor equipment of our customers and distributors, resulting in reduced purchasesof our products; or

·       an earthquake, typhoon orother disaster in Taiwan or Japan disrupted the operations of suppliers to ourTaiwanese or Japanese customers, outside foundries or ASE, which in turndisrupted the 

65

----

operations of thesecustomers, foundries or ASE and resulted in reduced purchases of our productsor shortages in our product supply.

**Changes in environmental rules and regulationscould increase our costs and reduce our revenue.**

Several jurisdictions areconsidering whether to implement rules that would require that certainproducts, including semiconductors, be made lead-free. We anticipate that somejurisdictions may finalize and enact such requirements. Some jurisdictions arealso considering whether to require abatement or disposal obligations forproducts made prior to the enactment of any such rules. Although several of ourproducts are available to customers in a lead-free condition, most of ourproducts are not lead-free. Any requirement that would prevent or burden thedevelopment, manufacture or sales of lead-containing semiconductors wouldlikely reduce our revenue for such products and would require us to incur coststo develop substitute lead-free replacement products, which may take time andmay not always be economically or technically feasible, and may requiredisposal of non-compliant inventory. In addition, any requirement to dispose orabate previously sold products would require us to incur the costs of settingup and implementing such a program.

**Provisions of our charter documents and Delaware lawcould prevent or delay a change in control, and may reduce the market price ofour common stock.**

Provisions of ourcertificate of incorporation and bylaws may discourage, delay or prevent amerger or acquisition that a stockholder may consider favorable. Theseprovisions include:

·       authorizingthe issuance of preferred stock without stockholder approval;

·       providingfor a classified board of directors with staggered, three-year terms;

·       prohibitingcumulative voting in the election of directors;

·       requiringsuper-majority voting to amend some provisions of our certificate ofincorporation and bylaws;

·       limitingthe persons who may call special meetings of stockholders; and

·       prohibitingstockholder actions by written consent.

Provisions of Delaware lawalso may discourage, delay or prevent someone from acquiring or merging withus.

**The price of our stock fluctuates substantially andmay continue to do so.**

The stock markethas experienced extreme price and volume fluctuations that have affected themarket valuation of many technology companies, including Silicon Image. Thesefactors, as well as general economic and political conditions, may materiallyand adversely affect the market price of our common stock in the future. Themarket price of our common stock has fluctuated significantly and may continueto fluctuate in response to a number of factors, including, but not limited to:

·       actualor anticipated changes in our operating results;

·       changesin expectations of our future financial performance;

·       changesin market valuations of comparable companies in our markets;

·       changesin market valuations or expectations of future financial performance of ourvendors or customers;

·       changesin our key executives and technical personnel; and

66

----

·       announcementsby us or our competitors of significant technical innovations, design wins,contracts, standards or acquisitions.

Due to these factors, theprice of our stock may decline. In addition, the stock market experiencesvolatility that is often unrelated to the performance of particular companies. Thesemarket fluctuations may cause our stock price to decline regardless of ourperformance.

**We are in the process of implementing an enterpriseresource platform**

We are in the process ofimplementing an enterprise resource platform (ERP) system, and of hosting thatsystem on our site. The system is comprised of hardware and software, andservices, all of which we acquired from vendors; however, we are alsocustomizing portions of the system with in-house resources. This requirescareful management of the skills and resources to implement the ERP system andto establish disaster recovery plans. If we are unsuccessful, or if thehardware or software should fail, we could lose access to the data needed tobook and fill customer orders, ship products, and produce financial reports,which would have a material adverse effect on our business.

**Continued terrorist attacks or war could lead tofurther economic instability and adversely affect our operations, results ofoperations and stock price.**

The United States hastaken, and continues to take, military action against terrorism and has engagedin war with Iraq and currently has an occupation force there and inAfghanistan. In addition, the current nuclear arms crises in North Korea andIran could escalate into armed hostilities or war. Acts of terrorism or armedhostilities may disrupt or result in instability in the general economy andfinancial markets and in consumer demand for the OEM’s products thatincorporate our products. Disruptions and instability in the general economycould reduce demand for our products or disrupt the operations of ourcustomers, suppliers, distributors and contractors, many of whom are located inAsia, which would in turn adversely affect our operations and results ofoperations. Disruptions and instability in financial markets could adverselyaffect our stock price. Armed hostilities or war in South Korea could disruptthe operations of the research and development contractors we utilize there,which would adversely affect our research and development capabilities andability to timely develop and introduce new products and product improvements.

**We are in the process of establishing an office inJapan**

We are in theprocess of establishing an office in Japan. Accordingly, we are subject torisks, including, but not limited to:

·       being subject to Japanese tax laws andpotentially liable for paying taxes in Japan;

·       profits,if any, earned in Japan will be subject to local tax laws and may not berepatriable to the United States;

·       wewill enter into employment agreements in connection with hiring personnel forthe Japanese office and will be governed by the provisions of the Japaneselabor laws; and

·       the operations of the localoffice will be subject to the provisions of other local laws and regulations.

**We are in the process of establishing an office in theRepublic of Korea (South Korea)**

We are in theprocess of establishing an office in the Republic of Korea (South Korea).Accordingly, we are subject to risks, including, but not limited to:

·       being subject to South Korean tax lawsand potentially liable for paying taxes in South Korea;

67

----

·       profits,if any, earned in South Korea will be subject to local tax laws and may not berepatriable to the United States;

·       wewill enter into employment agreements in connection with hiring personnel forthe South Korea office and will be governed by the provisions of the SouthKorean labor laws; and

·       the operations of the localoffice will be subject to the provisions of other local laws and regulations.

**Item 7A. Quantitative and Qualitative Disclosures ofMarket Risk**

**InterestRate Risk**

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

**Foreign Currency Exchange Risk**

All of our sales aredenominated in U.S. dollars, and substantially all of our expenses are incurredin U.S. dollars, thus limiting our exposure to foreign currency exchange risk.We currently do not enter into forward exchange contracts to hedge exposuresdenominated in foreign currencies and do not use derivative financialinstruments for trading or speculative purposes. The direct effect of animmediate 10% change in foreign currency exchange rates should not have amaterial effect on our future operating results or cash flows; however, a longterm increase in foreign currency rates would likely result in increased wafer,packaging, assembly or testing costs. Additionally, many of our foreigndistributors price our products in the local currency of the countries in whichthey sell. Therefore, significant strengthening of the U.S. dollar relative tothose foreign currencies could result in reduced demand or lower U.S. dollarprices for our products, which would negatively affect our operating results.

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

The Financial Statementsand Supplemental Data required by this item are set forth at the pages indicatedat Item 15(a).

**Item 9. Changes in and Disagreements with Accountantson Accounting and Financial Disclosure**

Not applicable.

**Item 9A. Controls and Procedures**

(a)   For theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures pursuant toExchange Act Rule 13a-15(e). The evaluation took into account the conductof and results of the Audit Committee examination completed in February 2004,and the receipt of notice from the Company’s independent auditors that, inconnection with the 2003 year-end audit, they have identified a reportablecondition relating to internal controls. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our controls andprocedures as of the end of the period 

68

----

covered by this reportwere effective, except that as the number and complexity of licensingtransactions increase, the Company’s control environment could and should beenhanced, as discussed below.

(b)   *Changes in Internal Controls.*   TheCompany is in the process of adopting a policy requiring additionaldocumentation of items necessary for licensing revenue recognition decisions;increasing the standardization of licensing deliverables and post-contractcustomer support for revenue recognition purposes; and formalizing itslicensing deal review process. The Company is also in the process of adoptingand implementing internal measures designed to enhance the Company’s overall internalcontrol environment and to increase the level of communication within themanagement team and between the management team and the Board of Directors,including the Audit Committee. These measures include restructuring somereporting relationships among management, and evaluating and redefining managementroles and responsibilities.

A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitations in all control systems, no evaluation of controls can provideabsolute assurance that all errors, control issues and instances of fraud, ifany, within the company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. The design of anysystem of controls is also based in part on certain assumptions regarding thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, controls may become inadequate because of changes in conditions, orthe degree of compliance with the policies and procedures may deteriorate.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

69

----

**PART III**

**Item 10. Directors and Executive Officers of theRegistrant**

The information requiredby this Item, which will be set forth under the captions “Proposal No. 1Election of Directors,” “Executive Officers” and “Section 16(a) BeneficialOwnership Compliance” in Silicon Image’s Proxy Statement for its 2004 AnnualMeeting of Stockholders, is incorporated herein by reference.

**Item 11. Executive Compensation**

The information requiredby this Item, which will be set forth under the captions “Director Compensation,”“Executive Compensation” and “Compensation Committee Interlocks and InsiderParticipation” in Silicon Image’s Proxy Statement for its 2004 Annual Meetingof Stockholders, is incorporated herein by reference.

**Item 12. Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

The information requiredby this Item regarding ownership of Silicon Image’s securities, which will beset forth under the caption “Security Ownership of Certain Beneficial Ownersand Management” in Silicon Image’s Proxy Statement for its 2004 Annual Meetingof Stockholders, is incorporated herein by reference. The information requiredby this Item regarding Silicon Image’s equity compensation plans, which will beset forth under the caption “Equity Compensation Plans” in Silicon Image’sProxy Statement for its 2004 Annual Meeting of Stockholders, is incorporatedherein by reference.

**Item 13. Certain Relationships and RelatedTransactions**

The information requiredby this Item, which will be set forth under the caption “Certain Relationshipsand Related Transactions” in Silicon Image’s Proxy Statement for its 2004Annual Meeting of Stockholders, is incorporated herein by reference.

**Item 14. Principal Accountant Fees and Services**

The information requiredby this Item, which will be set forth under the caption “Audit and Related Fees”in Silicon Image’s Proxy Statement for its 2004 Annual Meeting of Stockholders,is incorporated herein by reference.

**PART IV**

**Item 15. Exhibits, Financial Statement Schedules, andReports on Form 8-K**

(a)           The following documentsare filed as a part of this Form:

1.                FinancialStatements:
| ** **                                                                                                    | **Page** |
|---------------------------------------------------------------------------------------------------------------|----------|
| Consolidated Statements of  Operations for the three years ended December 31, 2003                       | 72       |
| Consolidated  Balance Sheets at December 31, 2003 and December 31, 2002                             | 73       |
| Consolidated  Statements of Stockholders’ Equity for the three years ended  December 31, 2003  | 74       |
| Consolidated  Statements of Cash Flows for the three years ended December 31, 2003                       | 75       |
| Notes  to Consolidated Financial Statements                                                                   | 76       |
| Report of Independent Auditors                                                                                | 106      |

 

70

----

 

2.                FinancialStatement Schedules.

Financial statement schedules have been omittedbecause the required information is not present or not present in amountssufficient to require submission of the schedule, or because the informationrequired is included in the financial statements or the notes to thosefinancial statements.

3.                Exhibits.

The exhibits listed in the Index to Exhibits are filedas a part of this Report on Form 10-K.

(b)          Reports on Form 8-K:

On October 7, 2003, we furnished a current reporton Form 8-K to furnish under Item 12 our press release and conference calltranscript for the revision to our financial outlook for the quarter ended September 30,2003.

On October 23, 2003, we furnished a currentreport on Form 8-K to furnish under Item 12 our earnings release andconference call transcript for the quarter ended September 30, 2003.

71

----

 

**SILICONIMAGE, INC.**CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)
| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Revenue:                                         |       |                                       |       |   |   |   |   |
| Product                                          |       | $                                          | 89,335     |   | $ | 74,884 |   | $ | 51,966 |   |
| Development, licensing and royalties             |       | 14,190                                     |       | 6,655 |   | — |   |
| Total revenue                                    |       | 103,525                                    |       | 81,539 |   | 51,966 |   |
| Cost of revenue and  operating expenses:         |       |                                       |       |   |   |   |   |
| Cost of revenue(1)                               |       | 46,609                                     |       | 38,110 |   | 25,063 |   |
| Research and development(2)                      |       | 36,523                                     |       | 32,809 |   | 25,473 |   |
| Selling, general and administrative(3)           |       | 18,401                                     |       | 17,454 |   | 18,773 |   |
| Stock compensation                               |       | 9,988                                      |       | 11,107 |   | 12,390 |   |
| Amortization of goodwill and intangible assets   |       | 1,103                                      |       | 3,482 |   | 14,124 |   |
| In-process research and development              |       | 5,482                                      |       | — |   | 1,500 |   |
| Impairment of goodwill and intangible assets     |       | —                                     |       | 5,200 |   | 29,880 |   |
| Restructuring                                    |       | 986                                        |       | 7,193 |   | 1,452 |   |
| Patent defense and acquisition integration costs |       | 2,152                                      |       | 7,034 |   | 1,841 |   |
| Total cost of  revenue and operating expenses    |       | 121,244                                    |       | 122,389 |   | 130,496 |   |
| Loss from  operations                            |       | (17,719                                    | )          | (40,850 | ) | (78,530 | ) |
| Gain on escrow  settlement, net                  |       | 4,618                                      |       | — |   | — |   |
| Interest income                                  |       | 498                                        |       | 998 |   | 2,731 |   |
| Interest expense  and other, net                 |       | (207                                       | )          | (240 | ) | (309 | ) |
| Loss before  provision for income taxes          |       | (12,810                                    | )          | (40,092 | ) | (76,108 | ) |
| Provision for  income taxes                      |       | —                                     |       | — |   | — |   |
| Net loss                                         |       | $                                          | (12,810    | ) | $ | (40,092 | ) | $ | (76,108 | ) |
| Net loss per share:                              |       |                                       |       |   |   |   |   |
| Basic and diluted                                |       | $                                          | (0.18      | ) | $ | (0.62 | ) | $ | (1.32 | ) |
| Weighted average  shares                         |       | 69,412                                     |       | 64,283 |   | 57,790 |   |

 

(1)          Excludes non-cash stockcompensation expense of $583,000, $1.2 million and $279,000 for 2003, 2002 and2001, respectively.

(2)          Excludes non-cash stockcompensation expense of $6.9 million, $7.4 million and $9.3 million for 2003,2002, and 2001, respectively.

(3)          Excludes non-cash stockcompensation expense of $2.5 million, $2.5 million and $2.8 million for 2003,2002 and 2001, respectively.

See accompanying Notes to Consolidated Financial Statements.

72

----

 

**SILICON IMAGE, INC.CONSOLIDATED BALANCE SHEETS(in thousands, except share and per share amounts)**
| ** **                                                                                                                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                    | ** ** | **2003**              | ** ** | **2002** | ** ** |
| Assets                                                                                                                                        |       |                  |       |   |   |
| Current Assets:                                                                                                                               |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                     |       | $                     | 24,059     |   | $ | 26,263 |   |
| Short-term investments                                                                                                                        |       | 13,195                |       | 9,570 |   |
| Accounts receivable, net of allowances for doubtful  accounts of $670 in 2003 and $519 in 2002                                                |       | 12,754                |       | 11,589 |   |
| Inventories                                                                                                                                   |       | 10,312                |       | 7,301 |   |
| Prepaid expenses and other current assets                                                                                                     |       | 2,703                 |       | 2,510 |   |
| Total current assets                                                                                                                          |       | 63,023                |       | 57,233 |   |
| Property and equipment,  net                                                                                                                  |       | 7,411                 |       | 6,653 |   |
| Goodwill                                                                                                                                      |       | 13,021                |       | 13,021 |   |
| Intangible  assets, net                                                                                                                       |       | 3,028                 |       | — |   |
| Other assets                                                                                                                                  |       | 1,259                 |       | 709 |   |
| Total assets                                                                                                                                  |       | $                     | 87,742     |   | $ | 77,616 |   |
| Liabilities and  Stockholders’ Equity                                                                                                    |       |                  |       |   |   |
| Current Liabilities:                                                                                                                          |       |                  |       |   |   |
| Accounts payable                                                                                                                              |       | $                     | 6,442      |   | $ | 10,314 |   |
| Accrued liabilities                                                                                                                           |       | 9,901                 |       | 11,183 |   |
| Debt obligations and capital leases                                                                                                           |       | 1,732                 |       | 3,816 |   |
| Deferred margin on sales to distributors                                                                                                      |       | 7,274                 |       | 4,133 |   |
| Total current liabilities                                                                                                                     |       | 25,349                |       | 29,446 |   |
| Commitments and  contingencies (Notes 7 and 11)                                                                                               |       |                  |       |   |   |
| Stockholders’  Equity:                                                                                                                   |       |                  |       |   |   |
| Convertible preferred stock, par value $0.001;  5,000,000 shares authorized; no shares issued or outstanding                                  |       | —                |       | — |   |
| Common stock, par value $0.001; 150,000,000 shares  authorized; shares issued and outstanding: 72,367,129—2003 and  66,639,522—2002 |       | 72                    |       | 67 |   |
| Additional paid-in capital                                                                                                                    |       | 243,171               |       | 214,459 |   |
| Notes receivable from stockholders                                                                                                            |       | —                |       | (109 | ) |
| Unearned compensation                                                                                                                         |       | (8,196                | )          | (6,403 | ) |
| Accumulated deficit                                                                                                                           |       | (172,654              | )          | (159,844 | ) |
| Total stockholders’ equity                                                                                                               |       | 62,393                |       | 48,170 |   |
| Total liabilities  and stockholders’ equity                                                                                              |       | $                     | 87,742     |   | $ | 77,616 |   |

 

See accompanying Notes to Consolidated Financial Statements.

73

----

 

**SILICON IMAGE, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(in thousands)**
| ** **                                        | ** ** | **Common Stock** | ** ** | **Additional  Paid-in ** | ** ** | **Notes  Receivable  From ** | ** ** | **Unearned ** | ** ** | **Accumulated ** | ** ** | ** **  | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------------------------------|------------|--------------------|------------|-----------------------|------------|-------------|------------|
| ** **                                        | ** ** | **Shares**            | ** ** | **Amount**                    | ** ** | **Capital**                       | ** ** | **Stockholders**   | ** ** | **Compensation**      | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance at December 31,  2000                |       | 53,949                |       |                          | $          | 54                                |       |               |       | $                     | 137,147    |        |       |   | $ | (162 | ) |   |   | $ | (10,198 | ) |   |   | $ | (43,644 | ) |   | $ | 83,197 |   |
| Net issuances of common  stock               |       | 845                   |       |                          | 2          |                              |       |               | 569        |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 571 |   |
| Common stock issued for  ESPP                |       | 342                   |       |                          | —     |                              |       |               | 1,491      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 1,491 |   |
| Common stock issued for  acquisitions (Note 2)    |       | 7,931                 |       |                          | 8          |                              |       |               | 45,477     |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 45,485 |   |
| Common stock issued for  warrant exercise         |       | 449                   |       |                          | —     |                              |       |               | —     |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Expense on option  acceleration              |       | —                |       |                          | —     |                              |       |               | 303        |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 303 |   |
| Interest on notes  receivable                     |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | (5         | ) |   |   | — |   |   |   | — |   |   | (5 | ) |
| Unearned compensation                             |       | —                |       |                          | —     |                              |       |               | 6,892      |                  |       |        | —     |   |   |   | (6,892 | ) |   |   | — |   |   | — |   |
| Stock compensation  expense                       |       | —                |       |                          | —     |                              |       |               | 2,401      |                  |       |        | —     |   |   |   | 9,989 |   |   |   | — |   |   | 12,390 |   |
| Net loss                                          |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | —     |   |   |   | — |   |   |   | (76,108 | ) |   | (76,108 | ) |
| Balance at  December 31, 2001                |       | 63,516                |       |                          | 64         |                              |       |               | 194,280    |                  |       |        | (167       | ) |   |   | (7,101 | ) |   |   | (119,752 | ) |   | 67,324 |   |
| Net issuances of common  stock               |       | 2,456                 |       |                          | 2          |                              |       |               | 5,693      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 5,695 |   |
| Common stock issued for  ESPP                |       | 593                   |       |                          | 1          |                              |       |               | 2,125      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 2,126 |   |
| Common stock issued for  acquisitions (Note 2)    |       | 75                    |       |                          | —     |                              |       |               | —     |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Expense on option  acceleration              |       | —                |       |                          | —     |                              |       |               | 1,952      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 1,952 |   |
| Repayments of note  receivable                    |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | 70         |   |   |   | — |   |   |   | — |   |   | 70 |   |
| Interest on notes  receivable                     |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | (12        | ) |   |   | — |   |   |   | — |   |   | (12 | ) |
| Unearned compensation                             |       | —                |       |                          | —     |                              |       |               | (459       | )                     |       |        | —     |   |   |   | 459 |   |   |   | — |   |   | — |   |
| Stock compensation  expense                       |       | —                |       |                          | —     |                              |       |               | 10,868     |                  |       |        | —     |   |   |   | 239 |   |   |   | — |   |   | 11,107 |   |
| Net loss                                          |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | —     |   |   |   | — |   |   |   | (40,092 | ) |   | (40,092 | ) |
| Balance at  December 31, 2002                |       | 66,640                |       |                          | 67         |                              |       |               | 214,459    |                  |       |        | (109       | ) |   |   | (6,403 | ) |   |   | (159,844 | ) |   | 48,170 |   |
| Net issuances of common  stock               |       | 3,488                 |       |                          | 3          |                              |       |               | 9,223      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 9,226 |   |
| Common stock issued for  ESPP                |       | 613                   |       |                          | —     |                              |       |               | 2,263      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 2,263 |   |
| Common stock issued for  acquisitions (Note 2)    |       | 2,576                 |       |                          | 2          |                              |       |               | 9,491      |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 9,493 |   |
| Stock reacquired pursuant  to settlement (Note 2) |       | (950                  | )          |                          | —     |                              |       |               | (4,692     | )                     |       |        | —     |   |   |   | — |   |   |   | — |   |   | (4,692 | ) |
| Expense on option  modification                   |       | —                |       |                          | —     |                              |       |               | 646        |                  |       |        | —     |   |   |   | — |   |   |   | — |   |   | 646 |   |
| Repayments of note  receivable                    |       | —                |       |                          | —     |                              |       |               | —     |                  |       |        | 109        |   |   |   | — |   |   |   | — |   |   | 109 |   |
| Unearned compensation                             |       | —                |       |                          | —     |                              |       |               | 4,606      |                  |       |        | —     |   |   |   | (4,606 | ) |   |   | — |   |   | — |   |
| Stock compensation  expense                       |       | —                |       |                          | —     |                              |       |               | 7,175      |                  |       |        | —     |   |   |   | 2,813 |   |   |   | — |   |   | 9,988 |   |
| Net loss                                          |       | —                |       |                          | —     |                              |       |               |       |                  |       |        | —     |   |   |   | — |   |   |   | (12,810 | ) |   | (12,810 | ) |
| Balance at December 31, 2003                 |       | 72,367                |       |                          | $          | 72                                |       |               |       | $                     | 243,171    |        |       |   | $ | — |   |   |   | $ | (8,196 | ) |   |   | $ | (172,654 | ) |   | $ | 62,393 |   |

 

See accompanying Notes to Consolidated Financial Statements.

74

----

** **

**SILICON IMAGE, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash flows from operating activities:                                    |       |                                       |       |   |   |   |   |
| Net loss                                                                 |       | $                                          | (12,810    | ) | $ | (40,092 | ) | $ | (76,108 | ) |
| Adjustments to reconcile net loss to cash used in  operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                           |       | 4,734                                      |       | 3,731 |   | 2,805 |   |
| Provision for doubtful  accounts                                         |       | 151                                        |       | 69 |   | 160 |   |
| Stock compensation  expense                                              |       | 9,988                                      |       | 11,107 |   | 12,390 |   |
| Amortization of goodwill  and intangible assets                          |       | 1,103                                      |       | 3,482 |   | 14,124 |   |
| In-process research and  development                                     |       | 5,482                                      |       | — |   | 1,500 |   |
| Impairment of goodwill  and intangible assets                            |       | —                                     |       | 5,200 |   | 29,880 |   |
| Non-cash restructuring                                                   |       | 646                                        |       | 3,965 |   | 353 |   |
| Non-cash gain on escrow  settlement, before cash costs                   |       | (4,692                                     | )          | — |   | — |   |
| Changes in assets and liabilities, net of amounts  acquired:             |       |                                       |       |   |   |   |   |
| Accounts receivable                                                      |       | (1,316                                     | )          | (4,183 | ) | 2,905 |   |
| Inventories                                                              |       | (3,011                                     | )          | (765 | ) | 2,290 |   |
| Prepaid expenses and  other assets                                       |       | (851                                       | )          | 382 |   | 53 |   |
| Accounts payable                                                         |       | (3,904                                     | )          | 5,149 |   | (1,222 | ) |
| Accrued liabilities                                                      |       | (1,554                                     | )          | 2,346 |   | (1,893 | ) |
| Deferred margin on sales  to distributors                                |       | 3,141                                      |       | 731 |   | (1,387 | ) |
| Cash used in operating  activities                                       |       | (2,893                                     | )          | (8,878 | ) | (14,150 | ) |
| Cash flows from investing activities:                                    |       |                                       |       |   |   |   |   |
| Purchases of short-term  investments                                     |       | (15,675                                    | )          | (2,815 | ) | (12,963 | ) |
| Proceeds from sales of  short-term investments                           |       | 12,050                                     |       | 15,517 |   | 30,347 |   |
| Purchases of property  and equipment                                     |       | (5,096                                     | )          | (3,703 | ) | (1,789 | ) |
| Acquisition costs, net  of cash acquired                                 |       | 149                                        |       | — |   | (2,983 | ) |
| Cash provided by (used  in) investing activities                         |       | (8,572                                     | )          | 8,999 |   | 12,612 |   |
| Cash flows from financing activities:                                    |       |                                       |       |   |   |   |   |
| Proceeds from issuances  of common stock                                 |       | 11,489                                     |       | 7,821 |   | 2,062 |   |
| Net repayments of  stockholders’ notes receivable                   |       | 109                                        |       | 58 |   | — |   |
| Borrowings                                                               |       | —                                     |       | 3,596 |   | — |   |
| Repayments of debt                                                       |       | (2,467                                     | )          | (5,289 | ) | (2,111 | ) |
| Security deposits on  leasing arrangements                               |       | 130                                        |       | 1,010 |   | (2,691 | ) |
| Cash provided by (used  in) financing activities                         |       | 9,261                                      |       | 7,196 |   | (2,740 | ) |
| Net increase (decrease)  in cash and cash equivalents                    |       | (2,204                                     | )          | 7,317 |   | (4,278 | ) |
| Cash and cash  equivalents—beginning of period                      |       | 26,263                                     |       | 18,946 |   | 23,224 |   |
| Cash and cash  equivalents—end of period                            |       | $                                          | 24,059     |   | $ | 26,263 |   | $ | 18,946 |   |
| Supplemental cash flow information:                                      |       |                                       |       |   |   |   |   |
| Acquisitions of property  and equipment under capital lease arrangements |       | $                                          | 383        |   | $ | — |   | $ | — |   |
| Cash payments for  interest                                              |       | $                                          | 140        |   | $ | 208 |   | $ | 282 |   |
| Stock and options issued  with the TransWarp acquisition                 |       | $                                          | 14,371     |   | $ | — |   | $ | — |   |
| Cash payments (refunds) for income taxes                                 |       | $                                          | —     |   | $ | — |   | $ | (225 | ) |

 

See accompanying Notes to Consolidated Financial Statements.

75

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE**1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES

***The Company***

Silicon Image is a leader in multi-gigabitsemiconductor solutions for the secure transmission, storage and display ofrich digital media. Silicon Image establishes industry-standard, high-speeddigital interfaces and builds market momentum and leadership through itsfirst-to-market, standards-based IC products

The semiconductor industryis characterized by rapid technological change, competitive pricing pressuresand cyclical market patterns. Our financial results are affected by a widevariety of factors, including general global economic conditions, economicconditions specific to the semiconductor industry, the timely implementation ofnew manufacturing technologies, the ability to safeguard patents andintellectual property in a rapidly evolving market and reliance on assembly andtest subcontractors, third-party wafer fabricators and independentdistributors. In addition, the semiconductor market has historically beencyclical and subject to significant economic downturns at various times. As aresult, we may experience significant period-to-period fluctuations in futureoperating results due to the factors mentioned above or other factors.

***Basis of presentation***

The preparation of financialstatements in conformity with generally accepted accounting principles requiresus to make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. Actual results could differmaterially from these estimates. Areas where significant judgment and estimatesare applied include revenue recognition, allowance for doubtful accounts,inventory valuation, realization of long lived assets, including goodwill,income taxes, accrued liabilities, including restructuring, stock basedcompensation and legal matters. The consolidated financial statements includethe accounts of Silicon Image, Inc. and our subsidiaries after eliminationof inter-company balances and transactions.

***Liquidity***

We have incurred net lossesin each fiscal year since inception, including net losses of $12.8 million,$40.1 million and $76.1 million for the years ended December 31, 2003,2002 and 2001, respectively. We believe our existing cash, cash equivalents andshort-term investments are sufficient to meet our capital expenditures andoperating requirements for at least the next twelve months.

***Revenue recognition***

For products sold directly to end-users, or todistributors that do not receive price concessions and do not have rights of return,we recognize revenue upon shipment and title transfer if we believe collectionis reasonably assured. Reserves for sales returns and allowances are estimatedbased primarily on historical experience and are provided at the time ofshipment.

For sales to distributors with agreements allowing forprice concessions and product returns, we recognize revenue based on our bestestimate of when the distributor sold the product to its end customer. Ourestimate of distributor sell-through to end customers is based on point ofsales reports received from our distributors. Due to the timing of receipt ofthese reports, we recognize distributor sell-through using information thatlags quarter end by one month. Revenue is not recognized upon shipment since,due to various forms of price concessions, the sales price is not substantiallyfixed or determinable at that time. 

76

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

Additionally, these distributorshave contractual rights to return products, up to a specified amount for agiven period of time. Revenue is earned when the distributor sells the productto an end-user, at which time our sales price to the distributor becomes fixed.Pursuant to our distributor agreements, older or end-of-life products are soldwith no right of return and are not eligible for price concessions. For theseproducts, revenue is recognized upon shipment and title transfer if we believecollection is reasonable assured.

At the time of shipment to distributors, we record atrade receivable for the selling price since there is a legally enforceableright to payment, relieve inventory for the carrying value of goods shippedsince legal title has passed to the distributor, and record the gross margin in“deferred margin on sales to distributors”, a component of current liabilitieson the balance sheet. Deferred margin represents the gross margin on the saleto the distributor; however, the amount of gross margin we recognize in futureperiods could be less than the deferred margin as a result of future priceconcessions. We do not reduce deferred margin by estimated future priceconcessions; instead, price concessions are recorded when incurred, which isgenerally at the time the distributor sells the product to an end-user. Thedifference between deferred margin and the margin actually recognized has notbeen material in the past; however, since price concessions are highlydependent upon market conditions, there can be no assurance that the differencewill not be material in the future. Price concessions are not granted foramounts in excess of the deferred margin.

License revenue isrecognized when an agreement with a licensee exists, the price is fixed ordeterminable, delivery or performance has occurred, and collection isreasonably assured. Generally, we expect to meet these criteria and recognizerevenue at the time we deliver the agreed-upon items. However, we may deferrecognition of revenue until cash is received if collection is not reasonablyassured at the time of delivery. A number of our license agreements requirecustomer acceptance of deliverables, in which case we would defer recognitionof revenue until the licensee has accepted the deliverables and either paymenthas been received or is expected within 90 days of acceptance. Certainlicensing agreements provide for royalty payments based on agreed upon royaltyrates. Such rates can be fixed or variable depending on the terms of theagreement. The amount of revenue we recognize is determined based on a timeperiod or on the agreed-upon royalty rate, extended by the number of unitsshipped by the customer. To determine the number of units shipped, we rely uponactual royalty reports from our customers when available, and rely uponestimates in lieu of actual royalty reports when we have a sufficient historybase of receiving royalties from a specific customer for us to make an estimatebased on available information from the licensee such as quantities held,manufactured and other information. These estimates for royalties necessarilyinvolve the application of management judgment. As a result of our use ofestimates, period-to-period numbers are “trued-up” in the following period toreflect actual units shipped. To date, such “true-up” adjustments have not beensignificant. In cases where royalty reports and other information are notavailable to allow us to estimate royalty revenue, we recognize revenue onlywhen royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement, and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure. Ourlicense revenue recognition depends upon many factors including completion ofmilestones, allocation of values to delivered items and customer acceptances.Many of these factors require significant judgments, and if our judgments arein error it could lead to inaccurate reporting of our revenues and income.

77

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

***Allowance for Doubtful Accounts***

We review collectibilityof accounts receivable on an on-going basis and provide an allowance foramounts we estimate will not be collectible. During our review, we consider ourhistorical experience, the age of the receivable balance, the credit-worthinessof the customer, and the reason for the delinquency. Write-offs to date havebeen minimal.

***Inventories***

We record inventories at the lower of standard cost,determined on a first-in first-out basis, or market. Standard cost approximatesactual cost. Standard costs are determined based on our estimate of materialcosts, manufacturing yields, costs to assemble, test and package our products,and allocable indirect costs. We review differences between standard and actualcosts, and, based on the nature of the difference, determine whether to recordthe amount on our balance sheet to state our inventory at actual or in ourstatement of operations. Standard costs are evaluated at least annually.

Provisions are recordedfor excess and obsolete inventory, and are estimated based on a comparison ofthe quantity and cost of inventory on hand to management’s forecast of customerdemand. Customer demand is dependent on many factors and requires us to usesignificant judgment in our forecasting process. We must also make assumptionsregarding the rate at which new products will be accepted in the marketplaceand at which customers will transition from older products to newer products.Generally, inventories in excess of six months demand are written down to zeroand the related provision is recorded as a cost of revenue. Once a provision isestablished, it is maintained until the product to which it relates is sold orotherwise disposed of, even if in subsequent periods we forecast demand for theproduct. This treatment is in accordance with Accounting Research Bulletin No. 43and Staff Accounting Bulletin No. 100. 

***Long-lived assets***

Consideration paid in connection with acquisitions isrequired to be allocated to the assets, including identifiable intangibleassets, and liabilities acquired. Acquired assets and liabilities are recordedbased on our estimate of fair value, which requires significant judgment withrespect to future cash flows and discount rates.

For certain long-lived assets, primarily fixed assetsand intangible assets, we are required to estimate the useful life of the assetand recognize its cost as an expense over the useful life. We use thestraight-line method to depreciate long-lived assets. We evaluate therecoverability of our long lived assets in accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.” We regularlycompare the carrying value of long-lived assets to our projection of futureundiscounted cash flows, attributable to such assets and in the event that thecarrying value exceeds the future undiscounted cash flows, we record animpairment charge against income equal to the excess of the carrying value overthe asset’s fair value. Predicting future cash flows attributable to a particularasset is difficult, and requires the use of significant judgment.

We assign the followinguseful lives to our fixed assets—three years for computers and software, one tofive years for equipment and five to seven years for furniture and fixtures. Leaseholdimprovements and assets held under capital leases are amortized on astraight-line basis over the shorter of the lease term or 

78

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

theestimated useful life, which ranges from two to five years. As at December 31,2003 and 2002, we had $23.5 million and $19.7 million, respectively inlong-lived assets, all of which are located in the United States. Depreciationand amortization expense was $4.7 million, $3.7 million and $2.8 million forthe years ended December 31, 2003, 2002 and 2001, respectively.

***Goodwill and intangible assets***

In July 2001, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 142 requires goodwillto be tested for impairment on an annual basis and between annual tests incertain circumstances, and written down when impaired, rather than beingamortized as previous accounting standards required. Furthermore, SFAS 142requires purchased intangible assets other than goodwill to be amortized overtheir useful lives unless these lives are determined to be indefinite.

SFAS 142 was effective for fiscal years beginningafter December 15, 2001. We adopted the accounting standard effective January1, 2002. We completed the first step of the transitional goodwill impairmenttest as of the beginning of fiscal 2002, and the results of that test indicatedthat our goodwill and intangible assets were not impaired at January 1, 2002(See Note 3 for discussion of 2002 goodwill and impairment expenses). As atJanuary 1, 2002 we also identified $1.8 million of net identifiable intangibleassets (acquired workforce) to be reclassified to goodwill pursuant to the newdefinition of intangible assets. Based on the annual impairment test performedfor 2003 in accordance with SFAS No. 142, there was no impairment of goodwillor intangible assets at December 31, 2003. The impairment analysis was based onour estimates of forecasted discounted cash flows as well as our marketcapitalization at that time. 

Purchased intangible assets are carried at cost lessaccumulated amortization. Amortization is computed over the estimated useful livesof the respective assets, generally 18 to 48 months.

Componentsof intangible assets, were as follows (in thousands):
| ** **                                      | ** ** | **December 31, 2003** | ** ** | **December 31, 2002** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization**   | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Intangible assets  subject to amortization:     |       |                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Acquired technology                             |       |                            | $          | 1,780                           |       |   |   | $ | (375 | ) |   |   | $ | 10,726 |   |   |   | $ | (10,726 | ) |   |
| Non-compete agreement                           |       |                            | 1,849      |                            |       |   | (472 | ) |   |   | — |   |   |   | — |   |   |
| Assembled workforce                             |       |                            | 502        |                            |       |   | (256 | ) |   |   | — |   |   |   | — |   |   |
| Patents and other                               |       |                            | —     |                            |       |   | — |   |   |   | 2,599 |   |   |   | (2,599 | ) |   |
|                                            |       |                            | $          | 4,131                           |       |   |   | $ | (1,103 | ) |   |   | $ | 13,325 |   |   |   | $ | (13,325 | ) |   |
| Intangible assets not  subject to amortization: |       |                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       |                            | $          | 13,021                          |       |   |   | $ | — |   |   |   | $ | 13,021 |   |   |   | $ | — |   |   |

 

Amortization of intangible assets was $1.1 million and$3.5 million for the years ended December 31, 2003 and 2002. Amortizationof goodwill and intangible assets was $14.1 million for the year ended December 31,2001. 

79

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

Estimated futureamortization expense for our intangible assets is as follows for the fiscalyears ending December 31 (in thousands):
| ** ** | ** ** | **Amortization  expense** | ** ** |
|------------|------------|---------------------------|------------|
| 2004       |       |                      | $          | 1,345 |   |   |
| 2005       |       |                      | 1,097      |   |   |
| 2006       |       |                      | 508        |   |   |
| 2007       |       |                      | 78         |   |   |
|       |       |                      | $          | 3,028 |   |   |

 

Our net loss, excludinggoodwill amortization expense for the year ended December 31, 2001 wouldhave been as follows had we adopted SFAS No. 142 on January 1, 2001(in thousands, except share and per share amounts)
| Net loss-as  reported                                   |   | $     | (76,108 | ) |
|---------------------------------------------------------|--------|-------|---------|---|
| SFAS 142  amortization adjustment                       |   | 6,995 |    |
| Net loss—adjusted                                  |   | $     | (69,113 | ) |
| Basic and diluted  net loss per share—as  reported |   | $     | (1.32   | ) |
| Impact of SFAS  142 amortization adjustment             |   | 0.12  |    |
| Basic and diluted net  loss per share—adjusted     |   | $     | (1.20   | ) |

 

***Income taxes***

We account for incometaxes using an asset and liability approach, which requires recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been recognized in our financial statements, but have not beenreflected in our taxable income. A valuation allowance is established to reducedeferred tax assets to their estimated realizable value. Therefore, we providea valuation allowance to the extent we do not believe it is more likely thannot that we will generate sufficient taxable income in future periods torealize the benefit of our deferred tax assets. Predicting future taxableincome is difficult, and requires the use of significant judgment. At December 31,2003, we had a net operating loss carry-forward for federal income tax purposesof approximately $75.1 million, against which a full valuation allowance hasbeen provided.

***Accrued liabilities***

Certain of our accruedliabilities are based largely on estimates. For instance, we record a liabilityon our balance sheet each period for the estimated cost of goods and servicesrendered to us, for which we have not received an invoice. Additionally, acomponent of our restructuring reserve related to a loss we expect to incur forexcess leased facility space is based on numerous assumptions and estimates,such as the market value of the space and the time it will take to sublease thespace. Our estimates are based on historical experience, input from sourcesoutside the company, and other relevant facts and circumstances. Actual amountscould differ materially from these estimates.

80

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 1—THECOMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

***Guarantees, Indemnifications and Warranty Liabilities***

Certain of our licensing agreements indemnify ourcustomers for expenses or liabilities resulting from claimed infringements ofpatent, trademark or copyright by third parties related to the intellectualproperty content of our products. Certain of these indemnification provisionsare perpetual from execution of the agreement and, in some instances, themaximum amount of potential future indemnification is not limited. To date, wehave not paid any such claims or been required to defend any lawsuits withrespect to a claim. 

At the time of revenuerecognition, we provide an accrual for estimated costs to be incurred pursuantto our warranty obligation. Our estimate is based primarily on historicalexperience.
| ** **                                         | ** ** | **Year Ended  December 31,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                         | ** ** | **2003**                               | ** ** | **2002** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                | ** ** |
| Balance at  January 1                         |       | $                                      | 223        |   | $ | 473 |   |
| Provision for  warranties issued during the period |       | 630                                    |       | 71 |   |
| Reduction to  pre-existing warranties              |       | —                                 |       | (186 | ) |
| Cash and other  settlements made during the period |       | (582                                   | )          | (135 | ) |
| Balance at  December 31                       |       | $                                      | 271        |   | $ | 223 |   |

 

***Stock-based compensation***

Statement of Financial Accounting Standards No. 148,“Accounting for Stock-Based Compensation—Transitionand Disclosure, an Amendment of FASB Statement No. 123,” amends thedisclosure requirements of Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” (“SFAS 123”), to require moreprominent disclosures in both annual and interim financial statements regardingthe method of accounting for stock-based employee compensation and the effectof the method used on reported results.

The Company accounts for stock-based awards toemployees and directors using the intrinsic value method of accounting inaccordance with Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”). Under the intrinsic value method,because the exercise price of the Company’s employee stock options equals themarket price of the underlying stock on the date of grant, no compensationexpense is recognized in the Company’s Consolidated Statements of Operations. 

The Company is required under SFAS 148 to disclose proforma information regarding option grants made to its employees based onspecified valuation techniques that produce estimated compensation charges. Weprovide pro forma net income loss and pro forma net loss per share disclosuresfor stock-based awards made during fiscal 2003, 2002 and 2001, as if thefair-value-based method defined in SFAS 123 had been applied. The fair value ofthe stock-based awards was estimated using the Black-Scholes model.

We are required to determinethe fair value of stock option grants to non-employees, and to record theamount as an expense over the period during which services are provided to us.Management calculates the fair value of these stock option grants using theBlack-Scholes model, which requires us to estimate the life of the stockoption, the volatility of our stock, an appropriate risk-free interest rate,and our dividend 

81

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

yield.The calculation of fair value is highly sensitive to the expected life of thestock option and the volatility of our stock, both of which we estimate basedprimarily on historical experience.

***Pro forma Net Loss***

Had werecorded compensation cost for our options based on the grant-date fair valueas prescribed by SFAS 123 and SFAS 148, our net loss would have been as follows(in thousands):
| ** **                                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net loss-as  reported                                                                          |       | $                                          | (12,810    | ) | $ | (40,092 | ) | $ | (76,108 | ) |
| Stock-based  employee compensation expense determined using fair value method                  |       | (21,019                                    | )          | (24,766 | ) | (29,944 | ) |
| Stock-based  employee compensation cost included in the determination of net loss as  reported |       | 7,078                                      |       | 8,803 |   | 10,068 |   |
| Pro forma net  loss                                                                            |       | $                                          | (26,751    | ) | $ | (56,055 | ) | $ | (95,984 | ) |
| Basic and diluted  net loss per share—pro forma                                           |       | $                                          | (0.39      | ) | $ | (0.87 | ) | $ | (1.66 | ) |
| Basic and diluted net  loss per share—as reported                                         |       | $                                          | (0.18      | ) | $ | (0.62 | ) | $ | (1.32 | ) |

 

***Cash equivalents and short-term investments***

We consider all highly-liquid investments maturingwithin three months from the date of purchase to be cash equivalents. All ofour short-term investments are categorized as available-for-sale at the balancesheet dates, and have been presented at fair value, which approximatesamortized cost. When material, any temporary difference between the cost andfair value of an investment would be presented as a separate component ofstockholder’s equity. At December 31, 2003, the average remainingcontractual maturity of all short-term investments was approximately sevenmonths.

Cash equivalents andshort-term investments, by security type, were as follows (in thousands):
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2003**              | ** ** | **2002** | ** ** |
| Cash and Cash  Equivalents:         |       |                  |       |   |   |
| Cash                                |       | $                     | 2,741      |   | $ | 2,100 |   |
| Commercial paper                    |       | 6,968                 |       | 8,763 |   |
| Market auction preferred securities |       | 6,125                 |       | 11,350 |   |
| Money market funds                  |       | 8,225                 |       | 4,050 |   |
|                                |       | $                     | 24,059     |   | $ | 26,263 |   |
| Short-term investments:             |       |                  |       |   |   |
| Corporate notes and bonds           |       | $                     | 4,987      |   | $ | 9,570 |   |
| US government agencies              |       | 3,317                 |       | — |   |
| Commercial Paper                    |       | 4,891                 |       | — |   |
|                                |       | $                     | 13,195     |   | $ | 9,570 |   |

 

82

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE1—THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES (Continued)**

***Concentration of credit risk***

Financial instruments thatpotentially subject us to significant concentrations of credit risk consistprimarily of cash equivalents, short-term investments and accounts receivable.We may invest in a variety of financial instruments and, by policy, we limitthe amount of credit exposure through diversification and by investing only ininstruments of high-grade government or commercial issuers. We perform on-goingcredit evaluations of our customers’ financial condition and may requirecollateral, such as letters of credit, to secure accounts receivable if deemednecessary. We maintain an allowance for potentially uncollectible accountsreceivable based on our assessment of collectibility.

***Advertising and Research and Development***

Advertising and researchand development costs are expensed as incurred.

***Comprehensive loss***

Comprehensive lossapproximated reported net loss for all periods presented.

***Net loss per share***

Basicnet loss per share is based on weighted average common shares outstanding,excluding shares subject to repurchase, and diluted net loss per share is basedon weighted average common shares and dilutive equivalents outstanding, if any.The following tables set forth the computation of basic and diluted net lossper share (in thousands, except per share amounts):
| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Numerator:                                         |       |                                       |       |   |   |   |   |
| Net loss                                           |       | $                                          | (12,810    | ) | $ | (40,092 | ) | $ | (76,108 | ) |
| Denominator:                                       |       |                                       |       |   |   |   |   |
| Weighted average shares                            |       | 70,042                                     |       | 64,758 |   | 59,322 |   |
| Less: unvested common shares subject to repurchase |       | (630                                       | )          | (475 | ) | (1,532 | ) |
|                                               |       | 69,412                                     |       | 64,283 |   | 57,790 |   |
| Net loss per share:                                |       |                                       |       |   |   |   |   |
| Basic and diluted  net loss per share              |       | $                                          | (0.18      | ) | $ | (0.62 | ) | $ | (1.32 | ) |

 

83

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 1—THE COMPANY AND ITSSIGNIFICANT ACCOUNTING POLICIES (Continued)**

As a result of our netlosses, all common share equivalents would have been anti-dilutive and havetherefore been excluded from the diluted net loss per share calculation. Thefollowing table summarizes weighted average securities outstanding that wereanti-dilutive and excluded from our calculation of diluted net loss per share(in thousands):
| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2003**              | ** ** | **2002** | ** ** | **2001** | ** ** |
| Unvested common  shares subject to repurchase |       | 630                   |       | 475 |   | 1,532 |   |
| Stock options                                 |       | 21,074                |       | 20,028 |   | 14,712 |   |
| Common stock  warrants                        |       | —                |       | — |   | 180 |   |
|                                          |       | 21,704                |       | 20,503 |   | 16,424 |   |

 

Had we been profitable for the year ended December 31,2003, the number of weighted average securities outstanding that would havebeen added to weighted average shares for purposes of calculating dilutedearnings per share would have been (in thousands):
| Unvested common  shares subject to repurchase |   | 609   |   |
|-----------------------------------------------|--------|-------|--------|
| Stock options                                 |   | 6,533 |   |

 

***Recent accounting pronouncements***

In January 2003, the Financial AccountingStandards Board (“FASB”) issued Interpretation Number (“FIN”) 46, “Consolidationof Variable Interest Entities.” In general, a variable interest entity is acorporation, partnership, trust, or any other legal structure used for businesspurposes that either (a) does not have equity investors with voting rightsor (b) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN 46 requires certainvariable interest entities to be consolidated by the primary beneficiary of theentity if the investors do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. The consolidation requirements of FIN 46 apply immediately tovariable interest entities created after January 31, 2003. Theconsolidation requirements apply to older entities as early as our first fiscalquarter of 2004. Certain of the disclosure requirements apply to all financialstatements issued after January 31, 2003, regardless of when the variable interestentity was established. The effective dates of certain elements of FIN 46 havebeen deferred. We do not believe that the adoption of this standard will have amaterial impact on our consolidated financial statements.

84

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 2—BUSINESSCOMBINATIONS**

***Transwarp Networks, Inc (“TWN”)***

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

Thetotal purchase price was approximately $14.5 million, consisting of theissuance of approximately 2.5 million shares of Silicon Image common stock,valued at $11.4 million, 0.8 million shares of Silicon Image common stockissuable upon exercise of options, valued at $3.0 million, and transactioncosts of $0.1 million. The purchase price was allocated as follows (inthousands):
| Assembled  workforce                 |   | $     | 502    |   |
|--------------------------------------|--------|-------|--------|--------|
| Core technology                      |   | 1,251 |   |
| Developed  technology                |   | 529   |   |
| In-process  research and development |   | 5,482 |   |
| Non-compete  agreement               |   | 1,849 |   |
| Net tangible  assets acquired        |   | 93    |   |
| Unearned  compensation               |   | 4,819 |   |
| Total                                |   | $     | 14,525 |   |

 

The total purchase price was revised from $14.7 millionto $14.5 million during the quarter ended September 30, 2003, to reflectactual expenses relating to legal fees incurred in connection with theacquisition of TWN.

The assembled workforce will be amortized over 18months. Developed technology and the non-compete agreement will be amortizedover a period of three years (the length of the non-compete agreement), andcore technology will be amortized over a period of four years. Unearnedcompensation will be amortized over the remaining employee vesting period,which ranges from 27 months to 57 months.

The value allocated to in-process research anddevelopment (“IPR&D”) was calculated using established valuation techniquesaccepted in the high technology industry. These techniques give considerationto relevant market sizes and growth factors, expected industry trends, theanticipated nature and timing of new product introductions by us and by ourcompetitors, individual product sales cycles, and the estimated lives of eachof the product’s underlying technology. The value of IPR&D reflects therelative value and contribution of the acquired research and development. Indetermining the value assigned to IPR&D, we considered the R&D’s stageof completion, the complexity of the work completed to date, the difficulty ofcompleting the remaining development, costs already incurred, and the projectedcost to complete the project. As of the acquisition date, there was oneidentified development project that met the necessary criteria—“Polaris.” Thevalue of this project was determined by estimating the future cash flows fromthe time it was expected to be commercially feasible, discounting the net cashflows to 

85

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE2—BUSINESS COMBINATIONS (Continued)**

present value, andapplying a percentage of completion to the calculated values. The net cashflows from the identified project were based on estimates of revenue, cost ofrevenue, research and development expenses, selling, general and administrativeexpenses, and applicable income taxes. Revenue for Polaris is expected tocommence in 2004 and extend through 2007. A discount rate of 30% was used todetermine the net present value of estimated cash flows for this project. Thepercentage of completion for this project was based on research and developmentexpenses incurred immediately prior to the acquisition as a percentage of thetotal estimated research and development expenses required to bring thisproject to technological feasibility. As of the date of the acquisition, weestimated that Polaris was 17% complete, with total projected costs ofapproximately $3,250,000.

The values assigned to core technology and developedtechnology were based upon discounted cash flows related to the existingproduct’s projected income stream. Elements of the projected income streamincludes revenue, cost of sales, SG&A expenses and R&D expenses. Thediscount rates used in the present value calculations range from 20% to 25% andwere generally derived from a weighted average cost of capital, adjusted upwardto reflect the additional risks inherent in the development life cycle. Suchrisks include the useful life of the technology, profitability levels of thetechnology, and the uncertainty of the technology advances that are known atthe date of the acquisition.

Assembled workforce was valued based on the estimatedcosts to replace the existing staff, including recruiting, hiring and trainingcosts for employees in all categories, and to fully deploy a work force ofsimilar size and skill to the same level of productivity as the existing workforce.

The value of thenon-compete agreement was based on the income approach, which measures thedifference between cash flows generated assuming the existence of thenon-compete agreement (assuming no competition exists for the individualscovered by the non-compete) and the cash flows assuming competition. Theresulting net cash flows were discounted using a discount rate of 25%.

***CMD Technology (“CMD”)***

On June 7, 2001, we issued approximately 6.4 millionshares, including 1.4 million that were held in escrow, of our common stock inexchange for all outstanding shares of CMD, a provider of storage subsystemsand semiconductors. The total purchase price for this acquisition was $45.1million, consisting of common stock with a fair value of $30.6 million, 3.7million stock options with a fair value of $13.6 million, and transactioncosts, consisting of investment advisory, legal and other professional servicefees, of $865,000. Common stock was valued at $4.94 per share using our averageclosing stock price for the four-day period ended June 7, 2001, and wasreduced for known contingencies pursuant to an Escrow Agreement. Stock optionswere valued using the Black-Scholes option pricing model, applying a weightedaverage expected life of 2.75 years, a weighted average risk-free rate of 5.0%,an expected dividend yield of zero percent, a volatility of 90% and a deemedfair value of $4.94 per share. The intrinsic value of the unvested options,totaling approximately $6.3 million, was recorded as unearned compensation.

A certain number of shares were being held in escrowas our security for indemnification obligations of CMD’s shareholders. On August 7,2002, we filed a demand for arbitration with the American ArbitrationAssociation, file #74 Y 117 01399 02 GAP, against the principal shareholders ofCMD relating to shares held in escrow in connection with our acquisition ofCMD. Pursuant to agreements by which we acquired CMD, a portion of the SiliconImage common stock issued to the principal stockholders of CMD 

86

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE2—BUSINESS COMBINATIONS (Continued)**

was held in two separateescrow pools as collateral for the indemnification obligations of theseshareholders. We previously made indemnification claims against these escrowpools for the release of escrow shares with a value of approximately $5.4million, which claims were contested by the principal shareholders of CMD. On February 28,2003, we and the principal shareholders of CMD entered into a settlementagreement and mutual release, pursuant to which our indemnification claims wereresolved. As a result of the settlement, we received 949,780 of the escrowedshares, valued at approximately $4.7 million, and recorded a net non-operatinggain of $4.6 million for the year ended December 31, 2003.

Theallocation of the aggregate purchase price was based on management’s analysisand estimates of the fair values of tangible assets, intangible assets andin-process research and development, which was expensed during the quarterended September 30, 2001. Intangible assets recorded in connection withthis acquisition will be amortized to expense ratably over the estimated usefullives referenced below. However, effective January 1, 2002, when weadopted SFAS No. 142, goodwill acquired was no longer amortized toexpense. The purchase price allocation and related amortization periods aresummarized below (in thousands):
| Net assets  acquired                         |   | $      | 4,155  |          |   |   |
|----------------------------------------------|--------|--------|--------|---------------|--------|--------|
| Acquired  technology                         |   | 10,178 |   | 18-42  months |   |
| Unearned  compensation                       |   | 6,314  |   | 30  months    |   |
| Assembled  workforce                         |   | 2,340  |   | 24  months    |   |
| Customer  agreement                          |   | 1,939  |   | 24  months    |   |
| In-process  research and development expense |   | 1,500  |   |          |   |
| Trade name                                   |   | 435    |   | 42  months    |   |
| Goodwill                                     |   | 18,270 |   | 42  months    |   |
|                                         |   | $      | 45,131 |          |   |   |

 

Refer to Note 3 for discussion of impairment ofcertain intangible assets during 2002. As of December 31, 2003, allamortizing intangible assets recorded in connection with the CMD acquisitionhave been fully amortized and $1.9 million of goodwill associated with theacquisition is carried on our balance sheet.

CMD’s in-process research and development was valuedat the discounted expected future cash flows attributable to the in-processtechnology. To arrive at this amount, the estimated future cash flows derivedfrom the technology was multiplied by the percentage of completion of thein-process technology, and was then discounted using a rate of 25%, whichSilicon Image believed was appropriate based on the risk associated with technologythat is not commercially feasible. Future cash flow was estimated taking intoconsideration the percentage of completion of products utilizing thistechnology, utilization of pre-existing technology, the risks related to thecharacteristics and applications of the technology, existing and futuremarkets, and the technological risk associated with completing development ofthe technology. The percentage of completion for each in-process project is theratio of elapsed time invested in the project to the total expected timerequired to complete the project to technical and commercial feasibility.

87

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE2—BUSINESS COMBINATIONS (Continued)**

Acquired technology was valued at the discountedexpected future cash flows attributable to products that were commerciallyfeasible at the acquisition date. Future expected cash flows were discountedusing rates of 15% to 20%, which we believe were appropriate given the businessrisks inherent in manufacturing and marketing these products. Factorsconsidered in estimating future cash flows include risks related to thecharacteristics and applications of the technology, existing and futuremarkets, and assessment of the age of the technology relative to its expectedlife span.

Assembled workforce was valued based on the estimatedcosts to replace the existing staff, including recruiting, hiring and trainingcosts for employees in all categories, and to fully deploy a work force ofsimilar size and skill to the same level of productivity as the existing workforce. The customer agreement was valued based on the estimated contributedgross margin of product to be sold over the agreement’s two-year remaininglife. The trade name was valued based on the estimated amount a third partywould pay to use and benefit from the trade name.

Upon closing, we refinanced $3.1 million of CMD’soutstanding bank debt. The loan matured in April 2002 and was subsequentlyrefinanced (see Note 7).

Thefollowing unaudited pro forma information gives effect to the acquisition ofCMD as if it had occurred on January 1, 2001 (in thousands).
| ** **                            | ** ** | **Year Ended  December 31, 2001** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **                            | ** ** | **Pro forma**                               | ** ** | **As reported** | ** ** |
| Revenue                               |       | $                                                | 64,296     |   |   | $ | 51,966 |   |   |
| Net loss                              |       | $                                                | (93,332    | ) |   | $ | (76,108 | ) |   |
| Basic and diluted  net loss per share |       | $                                                | (1.54      | ) |   | $ | (1.32 | ) |   |
| Weighted average shares               |       | 60,526                                           |       |   | 57,790 |   |   |

 

Unaudited pro formainformation is not necessarily indicative of the actual results of operationsthat would have been reported if the acquisition had actually occurred as ofthe beginning of the period indicated above, nor is such information indicativeof our future results of operations. In the opinion of management, alladjustments necessary to present fairly such pro forma information have beenmade.

***Silicon Communication Lab, Inc. (“SCL”)***

On July 6, 2001, we completed our acquisition ofSCL, a provider of mixed-signal and high-speed circuit designs, includinganalog-to-digital converters, for the purpose of enhancing our engineeringdesign team. In connection with this transaction, we acquired all outstandingshares of SCL in exchange for approximately 1.3 million shares of our commonstock and $2.3 million in cash. The acquisition was accounted for using thepurchase method of accounting. The total purchase price for this acquisitionwas $12.2 million, consisting of $2.3 million of cash, common stock with a fairvalue of $5.6 million, stock options to purchase 1.0 million common shares witha fair value of $4.1 million, and transaction costs, consisting of legal andother professional service fees, of $150,000. Common stock was valued at $4.30per share using our average closing stock price for the five-day period ending June 29,2001. Stock options were valued using the Black-Scholes option pricing model,applying a weighted average expected life of 3-3.5 years, a weighted averagerisk-free interest rate of 5.0%, an expected dividend yield of zero percent, avolatility of 90% resulting in a deemed fair value of $4.30 per share. Theintrinsic value of the unvested 

88

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE2—BUSINESS COMBINATIONS (Continued)**

options, totalingapproximately $2.1 million, was recorded as unearned compensation and is beingamortized to expense over the vesting periods.

Escrow shares and cash were held as our security forindemnification obligations of SCL’s shareholders. No claims were submitted byus, and in July 2002, the escrow shares and cash were released to the SCLshareholders.

The allocation of the aggregate purchase price wasbased on management’s analysis and estimates of the fair values of tangible andintangible assets. Goodwill recorded in connection with this acquisition willnot be amortized to expense, but will be subject to periodic testing forimpairment in accordance with SFAS No. 142. As of December 31, 2003, ourbalance sheet includes $10.9 million of goodwill from the SCL acquisition.Unearned compensation was amortized to expense over a period of 24 months usingan accelerated method, and acquired technology was amortized to expense ratablyover 24 months. The purchase price allocation is summarized below (inthousands):
| Net liabilities  acquired |   | $      | (977   | )      |
|---------------------------|--------|--------|--------|--------|
| Unearned  compensation    |   | 2,102  |   |
| Acquired  technology      |   | 162    |   |
| Goodwill                  |   | 10,863 |   |
|                      |   | $      | 12,150 |   |

 

Thefair values of SCL’s net liabilities as of the acquisition date were (inthousands):
| Cash                 |   | $    | 226    |   |
|----------------------|--------|------|--------|--------|
| Accounts  receivable |   | 12   |   |
| Fixed assets         |   | 43   |   |
| Other assets         |   | 18   |   |
| Accounts payable     |   | (120 | )      |
| Accrued  liabilities |   | (656 | )      |
| Short term debt      |   | (500 | )      |
|                 |   | $    | (977   | )      |

 

Acquired technology was valued at the discountedexpected future cash flows attributable to products that were commerciallyfeasible at the acquisition date. Future expected cash flows were discountedusing rates of 15% to 20%, which we believe were appropriate given the businessrisks inherent in manufacturing and marketing these products. Factorsconsidered in estimating future cash flows include risks related to thecharacteristics and applications of the technology, existing and futuremarkets, and assessment of the age of the technology relative to its expectedlife span.

We did not expect to continue development of productsthat SCL was developing as of the acquisition date, or to incorporate SCL’sexisting technology into our future products. Accordingly, no value wasassigned to in-process research and development.

SCL’s results ofoperations prior to the acquisition date were not material in relation to thoseof Silicon Image for any of the periods presented herein.

89

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE2—BUSINESS COMBINATIONS (Continued)**

***Zillion Technologies, LLC (“Zillion”)***

During the quarter ended June 30,2000, we completed our acquisition of Zillion, a privately-held developer ofhigh-speed transmission technology for data storage applications. In exchangefor all membership interests in Zillion, we agreed to issue 300,000 shares ofour common stock ratably over a four-year period. The vesting of these sharesis based on continuing employment of these members. The total value of theshares to be issued was $5.5 million, which is being expensed over the issuanceperiod using an accelerated method. A total of $2.3 million was expensed in2000. Net assets acquired, and the related acquisition costs, were immaterial.In the fourth quarter of 2001, an additional 120,544 shares were issued to theZillion stockholders based upon a contractual below-market guarantee. Noadditional shares will be issued in connection with the below-market guarantee.

**NOTE 3—ASSET IMPAIRMENTAND RESTRUCTURING ACTIVITIES**

During the third quarter of 2001, we began a programto focus our business on products and technology, including those obtainedthrough acquisitions, in which we have, or believe we can achieve, a marketleadership position. As part of this program, we decided to cancel numerousproducts under development, to remove certain projects from our developmentplan, to phase out or de-emphasize certain existing products and to integratethe operations of two acquired companies—CMD Technology (“CMD”) and SiliconCommunication Lab (“SCL”).

In connection with this program, we reduced ourworkforce in the fourth quarter of 2001 by approximately 60 people, or 20%.This workforce reduction was the initial step in eliminating duplicate positionsthat resulted from our acquisitions, and also represented the elimination ofother positions based on our new product and technology focus. Positions wereeliminated from all functional areas—operations, R&D and SG&A. Becauseof this workforce reduction, we recorded a restructuring expense of $1.5million in the fourth quarter of 2001, consisting of cash severance-relatedcosts of $599,000, non-cash severance-related costs of $303,000 representingthe intrinsic value of modified stock options, an expected loss on leasedfacilities of $500,000 and fixed asset write-downs of $50,000. In addition, wereversed $286,000 of unearned compensation, a component of stockholders’equity, for unvested stock options that were cancelled in connection withemployee terminations.

For 2001, we recorded $29.9 million of expense for theimpairment of goodwill and intangible assets recorded in connection with theacquisitions of DVDO and CMD. DVDO goodwill and intangible assets becameimpaired primarily as a result of our decision to phase out or de-emphasizecertain existing digital video processing products and to cease funding ofcertain digital video processing development projects. Additionally, prevailingeconomic and industry conditions and the departure of certain key DVDOemployees during the quarter ended September 30, 2001 also contributed tothe impairment expense of $13.9 million. We recorded impairment expense of$16.0 million in the fourth quarter of 2001 related to goodwill and intangibleassets recorded in connection with our CMD acquisition. This impairmentresulted from a decrease in our initial estimate of future revenue from CMD’sproducts.

In the first quarter of 2002, we implemented a secondworkforce reduction in connection with the program discussed above, eliminatingan additional 35 positions, or 13% of our workforce. Positions were eliminatedfrom all functional areas. This reduction resulted from the continuedintegration of acquired 

90

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE3—ASSET IMPAIRMENT AND RESTRUCTURING ACTIVITIES (Continued)**

companies, as well ascontinued execution of our product and technology strategy, whereby we decidedto phase out the legacy storage subsystem board products we acquired from CMDand to develop new board products only if we believed it would facilitate oraccelerate the use of our storage semiconductor products. In connection withthis workforce reduction, we recorded a restructuring expense of $2.2 millionin the first quarter of 2002, consisting of cash severance-related costs of$198,000, non-cash severance-related costs of $318,000 representing theintrinsic value of modified stock options, an expected loss on leasedfacilities of $1.2 million and fixed asset write-downs of $500,000 for assetsto be disposed of. In addition, we reversed $76,000 of unearned compensation, a componentof stockholders’ equity, for unvested stock options that were cancelled inconnection with employee terminations.

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

In connection with our decision to stop selling boardproducts and to transition to a licensing model, we assessed recoverability ofour intangible assets subject to amortization in accordance with SFAS No. 144.During the quarter ended September 30, 2002, an impairment expense of $749,000was recognized for acquired technology and $60,000 was recognized for patentand other intangible assets, based upon our projection of significantly reducedfuture cash flows. Additionally, we reduced our estimate of the useful lives ofthe remaining intangible assets subject to amortization such that these assetswere fully amortized by the end of 2002. We also tested the carrying value ofgoodwill for impairment in accordance with SFAS No. 142. As a result of ourimpairment test, a goodwill impairment expense of $4.4 million was recognizedduring the second quarter of 2002. To determine the amount of the impairment,we estimated the fair value of our storage systems business based primarily onexpected future cash flows. We then reduced this amount by the fair value ofidentifiable tangible and intangible assets other than goodwill (also basedprimarily on expected future cash flows), and compared the unallocated fairvalue of the business to the carrying value of goodwill. To the extent goodwillexceeded the unallocated fair value of the business, an impairment expense wasrecognized.

In December 2002, we revised our estimate of theloss we expect to incur on subleased facilities and recorded a restructuringexpense of $1.5 million. Real estate market conditions deteriorated in thefourth quarter of 2002, causing us to reassess the length of time it would taketo find tenants and the fair value lease rate of our available space. As of December 31,2003, our expected loss on subleased facilities was based on estimated subleaseincome of approximately $1.0 million over the remaining lease terms. To theextent we are unable to generate $1.0 million of sublease income, our futureresults of operations and financial condition will be negatively affected.

In March 2003, we reorganized parts of themarketing and product engineering activities of the company into lines ofbusiness for personal computer (“PC”), consumer electronics (“CE”) and storage 

91

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE3—ASSET IMPAIRMENT AND RESTRUCTURING ACTIVITIES (Continued)**

products to enable us tobetter manage our long-term growth potential The central engineering, sales,manufacturing, and general and administrative activities were not organizedinto the line of business structure. In connection with this reorganization, wereduced our workforce by 27 people, or approximately 10%. These reductions wereprimarily in engineering and operations functions. Because of this workforcereduction, we recorded restructuring expense of $1.0 million in the firstquarter of 2003, consisting of cash severance-related costs of $340,000 andnon-cash severance-related costs of $646,000, representing the intrinsic valueof modified stock options.

Severance related costs were determined based on theamount of pay people received that was not for services performed and bymeasuring the intrinsic value of stock options that were modified to thebenefit of terminated employees. For those employees terminated in the threemonth period ending March 31, 2003, the remaining service period from thecommunication date did not exceed 60 days. The expected loss on leasedfacilities resulted from our plan to consolidate our remaining workforce to theextent practicable and sublease any excess space. To determine the expectedloss, we compared our lease and operating costs for the space to our estimateof the net amount we would be able to recover by subleasing the space. Thisestimate was based on a number of assumptions, including the length of time itwill take to secure a tenant, the sublease rate per square foot, the cost ofnecessary improvements or modifications and real estate broker commissions. Thefixed asset write-downs in 2001 and 2002 were determined based on the estimatedfair value of assets, primarily computer hardware and software that would nolonger be utilized after the employees’ termination dates.

Severanceand benefits payments are substantially complete. Lease payments will be madein the form of cash through the end of the related lease term of November 2005.The following table presents restructuring activity for 2001 through December 31,2003 (in thousands):
| ** **                            | ** ** | **Severance  and Benefits** | ** ** | **Leased   Facilities** | ** ** | **Fixed Assets** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|------------------------------|------------|-----------------------|------------|-----------|------------|
| 2001 provision                        |       |                             | $          | 902                          |       |                  |       | $         | 500        |   |   |   | $ | 50 |   |   | $ | 1,452 |   |
| Cash payments                         |       |                             | (191       | )                            |       |                  | —     |      |       |   | — |   |   | (191 | ) |
| Non-cash activity                     |       |                             | (303       | )                            |       |                  | (115       | )         |       |   | — |   |   | (418 | ) |
| Balance as of  December 31, 2001 |       |                             | 408        |                         |       |                  | 385        |      |       |   | 50 |   |   | 843 |   |
| 2002 provision                        |       |                             | 2,547      |                         |       |                  | 2,633      |      |       |   | 2,013 |   |   | 7,193 |   |
| Cash payments                         |       |                             | (865       | )                            |       |                  | (420       | )         |       |   | — |   |   | (1,285 | ) |
| Non-cash activity                     |       |                             | (1,952     | )                            |       |                  | —     |      |       |   | (2,063 | ) |   | (4,015 | ) |
| Balance as of  December 31, 2002 |       |                             | 138        |                         |       |                  | 2,598      |      |       |   | — |   |   | 2,736 |   |
| 2003 provision                        |       |                             | 986        |                         |       |                  | —     |      |       |   | — |   |   | 986 |   |
| Cash payments                         |       |                             | (441       | )                            |       |                  | (760       | )         |       |   | — |   |   | (1,201 | ) |
| Non-cash activity                     |       |                             | (646       | )                            |       |                  | —     |      |       |   | — |   |   | (646 | ) |
| Balance as of  December 31, 2003 |       |                             | $          | 37                           |       |                  |       | $         | 1,838      |   |   |   | $ | — |   |   | $ | 1,875 |   |

 

92

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE 4—RELATED PARTY TRANSACTIONS**

In 1999, we issued1,485,000 shares of Common Stock to several of our officers in exchange fornotes receivable totaling $1,385,000. The notes outstanding at December 31,2002 bore interest at rates ranging from 5.30% to 5.98% per annum, and were duein June and September 2004. Principal and interest payments totaling$70,000 and $1,293,000 were received in 2002 and 2000, respectively. Theoutstanding principal and interest under these notes at December 31, 2002was $109,000, all of which was owed by a single officer. All the notes werepaid in full during 2003.

**NOTE5—BALANCE SHEET COMPONENTS**
| ** **                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2003**                | ** ** | **2002** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| **Inventories:**                     |       |                    |       |   |   |
| Raw materials                        |       | $                       | 3,128      |   | $ | 1,376 |   |
| Work in process                      |       | 2,532                   |       | 2,487 |   |
| Finished goods                       |       | 4,652                   |       | 3,438 |   |
|                                 |       | $                       | 10,312     |   | $ | 7,301 |   |
| **Property and equipment:**          |       |                    |       |   |   |
| Computers and software               |       | $                       | 12,829     |   | $ | 9,953 |   |
| Equipment                            |       | 8,574                   |       | 7,181 |   |
| Furniture and fixtures               |       | 1,250                   |       | 1,305 |   |
|                                 |       | 22,653                  |       | 18,439 |   |
| Less: accumulated depreciation       |       | (15,242                 | )          | (11,786 | ) |
|                                 |       | $                       | 7,411      |   | $ | 6,653 |   |
| **Accrued liabilities:**             |       |                    |       |   |   |
| Accrued payroll and related expenses |       | $                       | 2,533      |   | $ | 2,502 |   |
| Restructuring accrual (see Note 3)   |       | 1,875                   |       | 2,736 |   |
| Accrued legal fees                   |       | 1,137                   |       | 1,865 |   |
| Warranty accrual                     |       | 271                     |       | 223 |   |
| Deferred license revenue             |       | 1,175                   |       | 400 |   |
| Other accrued liabilities            |       | 2,910                   |       | 3,457 |   |
|                                 |       | $                       | 9,901      |   | $ | 11,183 |   |

 

**NOTE 6—INCOME TAXES**

Noprovision for income taxes was recorded for the years ended December 31,2003, 2002 and 2001 since we generated both book and tax losses. Our effectivetax rate differs from the federal statutory tax rate due to the following (inthousands):
| ** **                             | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | **2003**                                    | ** ** | **2002** | ** ** | **2001** | ** ** |
| Tax benefit at  federal statutory rate |       | $                                           | (4,355     | ) | $ | (14,032 | ) | $ | (26,638 | ) |
| Nondeductible  expenses                |       | 3,690                                       |       | 6,926 |   | 20,263 |   |
| Tax losses not  benefited              |       | 665                                         |       | 7,106 |   | 6,375 |   |
| Tax provision                          |       | $                                           | —     |   | $ | — |   | $ | — |   |

 

93

----

**SILICON IMAGE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**NOTE6—INCOME TAXES (Continued)**

Deferred income tax assetsreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. The components of net deferred income taxassets were (in thousands):
| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2003**              | ** ** | **2002** | ** ** |
| Net operating  loss carryforwards     |       | $                     | 25,764     |   | $ | 22,302 |   |
| Deferred revenue                      |       | 3,365                 |       | 1,998 |   |
| Tax credits                           |       | 7,976                 |       | 4,336 |   |
| Inventory  valuation                  |       | 4,301                 |       | 3,824 |   |
| Research and  Development             |       | 3,651                 |       | — |   |
| Other items not  currently deductible |       | 2,274                 |       | 2,039 |   |
|                                  |       | 47,331                |       | 34,499 |   |
| Less: valuation  allowance            |       | (47,331               | )          | (34,499 | ) |
|                                  |       | $                     | —     |   | $ | — |   |

 

Tax benefits from employee stock transactions of $4.0million, $6.0 million and $243,000 were generated in 2003, 2002 and 2001,respectively. If realized, such benefits will be recorded as a reduction ofincome taxes payable, with a corresponding increase to stockholders’ equity.Therefore, these benefits will not have the effect of reducing any futureincome tax provision.

Management believes that available objective evidencecreates sufficient uncertainty regarding the realizability of the Company’sdeferred tax assets, and therefore a full valuation allowance has been recordedto reduce the carrying value of such assets to zero. Objective evidence includesour history of losses, the highly-competitive industry in which we operate andthe uncertainty regarding continued market acceptance of our products. We willcontinue to assess the realizability of deferred tax assets based on actual andforecasted operating results.

At December 31, 2003, we had a net operating losscarryforward for federal income tax purposes of approximately $75.1 millionthat expires through 2023. In the event of a cumulative ownership change ofgreater than 50%, the availability of net operating losses to offset futuretaxable income may be limited.

94

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE 7—DEBT, LEASE ANDOTHER OBLIGATIONS**

In October 2002, we entered into a $3.6 millionterm loan to refinance $3.1 million of debt acquired in connection with ouracquisition of CMD and $500,000 of other bank debt. This loan bears interest atprime (4.0% at December 31, 2003) plus 0.25% and requires monthly paymentsthrough its maturity of October 1, 2004. During the three months ended March 31,2003, we borrowed $383,000 to finance certain capital equipment. This term loanbears interest at 5% and requires monthly payments through its maturity in February 2005.As of December 31, 2003, $1,732,000 was outstanding under these termloans. Our debt facilities contain certain quarterly and annual financialcovenants with which we must comply. In the fourth fiscal quarter of 2003, wefell out of compliance with the lending institution’s quarterly covenantsregarding providing periodic financial statements. We were granted a waiverfrom the lending institution and were not in default of the loan agreement. Dueto the nature of the underlying covenants, we have classified all amountsoutstanding as current liabilities as of December 31, 2003. Subsequent to December 31,2003, we entered into an agreement to extend this debt facility by way of arevolving line of credit with an availability of up to $10.0 million, and anequipment line of credit of up to $3.0 million. Borrowings under the revolvingline are limited to the lesser of $10.0 million or 80% of eligible accountsreceivable as defined in the loan agreement. This revolving line of creditexpires in March 2005 and bears interest at either prime plus 0.25% orLIBOR plus 2.75%, at our option. Equipment advances pursuant to the equipmentline of credit are available to us through August 2004 and will berepayable in twenty four equal monthly installments commencing September 1,2004 bearing interest at either prime or LIBOR plus 2.5%, at our option.Quarterly and annual financial covenants are contained within this revisedagreement.

In October 2002, we financed a $351,000 insurancepremium at an interest rate of 5.75%. Monthly payments of $40,000 were duethrough June 2003. This was repaid in full during 2003.

We leased certain software and equipment under leaseagreements accounted for as capital leases. All such leases matured during2003.

In October 1999, we entered into a non-cancelableoperating lease through July 2003 for our principal operating facility.This lease requires average monthly rental payments of approximately $133,000and was secured by a certificate of deposit in the amount of $283,000, whichwas included in prepaid expenses and other current assets on our 2002 balancesheet. Under the terms of the original lease agreement, this securityrequirement was not required after July 2003 and therefore we no longermaintain a certificate of deposit. In December 2002, we entered into anon-cancelable operating lease renewal for our principal operating facility,including an additional 30,000 square feet of space in an adjacent building,that commenced in August 2003 and expires in July 2010. The leaserequires initial average monthly rental payments of $76,000 and provides for 3%annual rent increases thereafter.

In June 2001, in connection with our acquisitionof CMD, we acquired the lease of an operating facility in Irvine, Californiawith average monthly rental payments of approximately $100,000 through November 2005.We have subleased parts of this facility to three separate third parties. Oneof these sublease agreements is a coterminous lease and extends through November 2005,while the other two subleases are on a month-to-month basis. These subleasescollectively generate monthly sublease income of approximately $41,000 tooffset our payment obligations. Additionally, in connection with ouracquisition of SCL in July 2001, we acquired the lease of a facility inMilpitas, California with average 

95

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE7—DEBT, LEASE AND OTHER OBLIGATIONS (Continued)**

monthly rental payments ofapproximately $18,000 per month. We do not occupy the Milpitas facility and areattempting to sublease the space. We also lease office space in Taiwan andJapan.

Rentexpense, net of sublease income, totaled $1,902,000, $2,529,000 and $2,419,000in 2003, 2002 and 2001, respectively. Future minimum lease payments underoperating leases have not been reduced by expected sublease rental income or bythe amount of our restructuring accrual that relates to leased facilities.Future minimum payments for our operating leases and debt obligationsoutstanding at December 31, 2003 are as follows (in thousands):
| ** **                       | ** ** | ** ** | ** ** | **Payments due in** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------|------------|
| **Contractual obligations** | ** ** | ** ** | ** ** | **Total**                     | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Debt obligations                 |       | $          | 1,732      |                          |       | $ | 1,692 |   |   | $ | 40 |   | $ | — |   |   | $ | — |   |   |
| Operating lease obligations      |       | 9,748      |       |                          | 2,495      |   |   | 3,498 |   | 2,049 |   |   | 1,706 |   |   |
| Total                            |       | $          | 11,480     |                          |       | $ | 4,187 |   |   | $ | 3,538 |   | $ | 2,049 |   |   | $ | 1,706 |   |   |
|                                  |            |            |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 8—STOCKHOLDERS’EQUITY**

***Stock warrants***

In September 1998, weentered into an agreement with Intel to develop and promote the adoption of adigital display interface specification. In connection with this agreement, wegranted Intel a warrant to purchase 285,714 shares of our common stock at $1.75per share. This warrant was immediately exercisable. Under the same agreement,we granted Intel a warrant to purchase 285,714 shares of our common stock at$0.18 per share upon achievement of a specified milestone. This warrant becameexercisable during the quarter ended March 31, 1999 when the milestone wasachieved. Both of these warrants were exercised in May 2001. We recordedexpense of $595,000 in 1999 associated with these warrants. Additionally, if asecond specified milestone is achieved, which we do not believe is likely, wewill grant Intel another warrant to purchase 285,714 shares of our common stockat $0.18 per share. Upon achievement of the milestone, we will record anexpense equal to the fair value of the warrant at the time of issuance. Theestimated fair value of the warrant at December 31, 2003 was $2.0 million.This warrant expires in September 2008.

***1999 Equity Incentive Plan (the “1999 Plan”)***

In September 1995, the Board of Directors adoptedthe 1995 Equity Incentive Plan (the “1995 Plan), which provides for thegranting of incentive stock options (“ISOs”) and non-qualified stock options (“NSOs”)to employees, directors and consultants. In accordance with the 1995 Plan, thestated exercise price shall not be less than 100% and 85% of the fair marketvalue of our common stock on the date of grant for ISOs and NSOs, respectively.In September 1998, the 1995 Plan was amended to allow ISOs to be exercisedprior to vesting. We have the right to repurchase such shares at their originalpurchase price if the optionee is terminated from service prior to vesting.Such right expires as the options vest.

In October 1999, the 1999 Plan became thesuccessor to the 1995 Plan and was changed to prohibit early exercise of stockoptions. The number of shares reserved for issuance under the 1999 Plan will be

96

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE8—STOCKHOLDERS’ EQUITY (Continued)**

increased automatically onJanuary 1 of each year by an amount equal to 5% of our total outstandingcommon shares as of the immediately preceding December 31.

In June and July 2001, in connection withthe CMD and SCL acquisitions, we assumed all outstanding options and optionsavailable for issuance under the CMD 1999 Stock Incentive Plan and SCL 1999Stock Option Plan. In April 2003, in connection with the TransWarpacquisition, we assumed all outstanding options and options available forissuance under the TransWarp Stock Option Plan. The terms of these Plans arevery similar to those of the 1999 Plan. Our assumption of the CMD, SCL andTransWarp Plans and the outstanding options did not require the approval of,and was not approved by, our stockholders.

Options granted under allPlans are exercisable over periods not to exceed ten years and vest overperiods ranging from one to five years. Some options provide for acceleratedvesting if certain identified milestones are achieved.

***Non-plan options***

In 2003 and 2001, ourBoard of Directors granted non-plan options to purchase 625,000 and 1.6 millionshares, respectively, of our common stock to four executives and an employee.There were no non-plan options granted in 2002. In 2001, 350,000 of the optionsgranted in 2000 were repriced in connection with our stock option exchangeprogram and are included in the 2001 option grants described above. Therepriced options are expensed in accordance with APB 25/FIN 44. All non-planoptions were granted with exercise prices equal to the fair market value on thedate of grant and with vesting periods ranging from four to five years, andexpire in ten years, except that the repriced options were priced above ourstock’s fair market value on the date of the repricing and expire in six years.500,000 of the shares granted in 2001 may be exercised prior to vesting. Ournon-plan option grants did not require the approval of, and were not approvedby, our stockholders.

97

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE8—STOCKHOLDERS’ EQUITY (Continued)**

***Option Data***

Thefollowing table summarizes information with respect to our stock option Plans,including options granted outside of the Plans (in thousands except per sharedata):
| ** **                 | ** ** | **Options Available  for Future Issuance** | ** ** | **Number of Option Shares Outstanding** | ** ** |
|----------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                 | ** ** | ** **                                                | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                 | ** ** | ** **                                                | ** ** | **Non-Stockholder  Approved Plans From**          | ** ** | ** ** | ** ** | **Non-Stockholder** | ** ** | **Average  Exercise** | ** ** |
| ** **                 | ** ** | **1995 and**                                         | ** ** | **Acquisitions**                                            | ** ** | **Stockholder** | ** ** | **Approved** | ** ** | **Price** | ** ** |
| ** **                 | ** ** | **1999  Plans**                                           | ** ** | **CMD  Plan**                                               | ** ** | **SCL  Plan** | ** ** | **TWN  Plan** | ** ** | **Approved  Plan** | ** ** | **Plans From  Acquisitions** | ** ** | **Non-  Plan*** | ** ** | **per  Share** | ** ** |
| At  December 31, 2000 |       |                                                      | 774        |                                                        |       | — |   | — |   | — |   |   | 8,029 |   |   |   | 17 |   |   | 758 |   |   | $ | 7.09 |   |   |
| Authorized                 |       |                                                      | 2,697      |                                                        |       | 6,238 |   | 1,971 |   | — |   |   | — |   |   |   | — |   |   | — |   |   | — |   |   |
| Assumed                    |       |                                                      | —     |                                                        |       | (3,723 | ) | (956 | ) | — |   |   | — |   |   |   | 4,679 |   |   | — |   |   | 1.88 |   |   |
| Granted                    |       |                                                      | (5,865     | )                                                           |       | (2,602 | ) | (1,002 | ) | — |   |   | 5,865 |   |   |   | 3,604 |   |   | 1,600 |   |   | 2.88 |   |   |
| Canceled                   |       |                                                      | 2,457      |                                                        |       | 303 |   | 92 |   | — |   |   | (2,457 | ) |   |   | (395 | ) |   | (350 | ) |   | 10.09 |   |   |
| Exercised                  |       |                                                      | —     |                                                        |       | — |   | — |   | — |   |   | (476 | ) |   |   | (364 | ) |   | (5 | ) |   | 0.50 |   |   |
| At  December 31, 2001 |       |                                                      | 63         |                                                        |       | 216 |   | 105 |   | — |   |   | 10,961 |   |   |   | 7,541 |   |   | 2,003 |   |   | 3.56 |   |   |
| Authorized                 |       |                                                      | 3,176      |                                                        |       | — |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   |   | — |   |   |
| Granted                    |       |                                                      | (3,053     | )                                                           |       | (580 | ) | (101 | ) | — |   |   | 3,053 |   |   |   | 681 |   |   | — |   |   | 5.15 |   |   |
| Canceled                   |       |                                                      | 1,000      |                                                        |       | 632 |   | 73 |   | — |   |   | (1,032 | ) |   |   | (710 | ) |   | (27 | ) |   | 2.26 |   |   |
| Exercised                  |       |                                                      | —     |                                                        |       | — |   | — |   | — |   |   | (898 | ) |   |   | (1,599 | ) |   | (72 | ) |   | 4.33 |   |   |
| At  December 31, 2002 |       |                                                      | 1,186      |                                                        |       | 268 |   | 77 |   | — |   |   | 12,084 |   |   |   | 5,913 |   |   | 1,904 |   |   | 3.96 |   |   |
| Authorized                 |       |                                                      | 3,332      |                                                        |       | — |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   |   | — |   |   |
| Assumed                    |       |                                                      | —     |                                                        |       | — |   | — |   | 162 |   |   | — |   |   |   | 632 |   |   | — |   |   | 1.27 |   |   |
| Granted                    |       |                                                      | (3,596     | )                                                           |       | (787 | ) | (167 | ) | (64 | ) |   | 3,596 |   |   |   | 1,147 |   |   | 625 |   |   | 5.86 |   |   |
| Canceled                   |       |                                                      | 1,058      |                                                        |       | 670 |   | 239 |   | — |   |   | (1,058 | ) |   |   | (957 | ) |   | (234 | ) |   | 3.73 |   |   |
| Exercised                  |       |                                                      | —     |                                                        |       | — |   | — |   | — |   |   | (1,399 | ) |   |   | (1,752 | ) |   | (340 | ) |   | 2.64 |   |   |
| At December 31,  2003 |       |                                                      | 1,980      |                                                        |       | 151 |   | 149 |   | 98 |   |   | 13,223 |   |   |   | 4,983 |   |   | 1,955 |   |   | $ | 4.63 |   |   |

*                    primarily usedas inducements for new officers

At December 31, 2003, 8,363,000 options werevested and 377,000 unvested shares had been exercised and remain subject to ourrepurchase rights. Of the options outstanding at December 31, 2003, and inthe absence of acceleration of vesting or cancellations, approximately4,160,000 shares will vest in 2004, 3,513,000 in 2005, 2,306,000 in 2006,1,356,000 in 2007 and 463,000 in 2008 and thereafter.

98

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE8—STOCKHOLDERS’ EQUITY (Continued)**

Information with respectto options outstanding at December 31, 2003 is as follows:
| ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** **                   | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                              | ** ** | **(in thousands)**      | ** ** | ** **                   | ** ** | **(in years)** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $0.06 - $ 1.14                     |       |                         | 3,432      |                         |       |   | $ | 0.93 |   |   |   | 7.29 |   |   |   | 1,587 |   |   |   | $ | 0.68 |   |   |
| $1.37 - $ 3.31                     |       |                         | 3,059      |                         |       |   | 2.57 |   |   |   | 6.99 |   |   |   | 2,205 |   |   |   | 2.48 |   |   |
| $3.34 - $ 4.44                     |       |                         | 3,222      |                         |       |   | 4.06 |   |   |   | 8.35 |   |   |   | 965 |   |   |   | 3.64 |   |   |
| $4.45 - $ 5.43                     |       |                         | 1,276      |                         |       |   | 5.18 |   |   |   | 7.34 |   |   |   | 444 |   |   |   | 5.27 |   |   |
| $5.44 - $ 5.63                     |       |                         | 3,540      |                         |       |   | 5.62 |   |   |   | 3.64 |   |   |   | 2,421 |   |   |   | 5.62 |   |   |
| $5.77 - $ 6.21                     |       |                         | 2,927      |                         |       |   | 6.11 |   |   |   | 8.89 |   |   |   | 473 |   |   |   | 6.19 |   |   |
| $6.23 - $26.50                          |       |                         | 2,705      |                         |       |   | 9.21 |   |   |   | 8.29 |   |   |   | 959 |   |   |   | 13.80 |   |   |
|                                    |       |                         | 20,161     |                         |       |   | $ | 4.63 |   |   |   | 7.14 |   |   |   | 9,054 |   |   |   | $ | 4.66 |   |   |
|                                         |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theweighted average grant-date fair value of options granted was $4.23, $3.72 and$1.89 per option during 2003, 2002 and 2001, respectively. The grant-date fairvalue was estimated using the Black-Scholes pricing model with the followingassumptions:
| ** **               | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2003**                               | ** ** | **2002** | ** ** | **2001** | ** ** |
| Expected life  (years)   |       | 5.0                                    |       | 5.0 |   | 5.0 |   |
| Risk-free  interest rate |       | 3.3                                    | %          | 3.5 | % | 3.5 | % |
| Dividend yield           |       | —                                 |       | — |   | — |   |
| Volatility               |       | 90                                     | %          | 90 | % | 90 | % |

 

***Stock Option Exchange (Repricing)***

On December 22, 2000,we implemented an option exchange program to allow employees and certainconsultants to exchange approximately 3,000,000 stock options with a weightedaverage exercise price of $25.39 for new options with an exercise price of$5.63 (the fair market value on that date). On April 4, 2001, this programwas extended to executives at the December 22, 2000 price (which was greaterthan the fair market value of our stock on April 4, 2001). Under thisprogram, new options vest over a four-year period and expire in six years.Compensation expense associated with the option exchange program will berecorded until the options are exercised or expire and the expense or benefitfor the increase or decrease, respectively, in the fair market value of ourcommon stock in excess of the option’s exercise price is recognized immediatelyfor vested options and is recognized over the vesting period using anaccelerated method for unvested employee options.

***Employee Stock Purchase Plan***

In October 1999, we adopted the 1999 EmployeeStock Purchase Plan (the “Purchase Plan”) and reserved 500,000 shares of commonstock for issuance under the Purchase Plan. The Purchase Plan authorizes thegranting of stock purchase rights to eligible employees during two-yearoffering periods with 

99

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE8—STOCKHOLDERS’ EQUITY (Continued)**

exercise dates every sixmonths. Shares are purchased using employee payroll deductions at purchaseprices equal to 85% of the lesser of the fair market value of our common stockat either the first day of each offering period or the date of purchase. In2003, 2002 and 2001, 613,000, 593,000 and 342,000 shares of common stock,respectively, were sold under the Purchase Plan at average prices of $3.69,$3.59 and $4.36 per share, respectively. A total of 1,115,000 shares werereserved for future issuance at December 31, 2003. The number of sharesreserved for issuance under the Purchase Plan is increased automatically on January 1of each year by an amount equal to 1% of our total outstanding common shares asof the immediately preceding December 31.

Theweighted average, grant-date fair value of stock purchase rights granted in2003 and 2002 was $2.60 and $2.64 per share. The grant date fair value wasestimated using the Black-Scholes pricing model with the following assumptions:
| ** **               | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2003**                               | ** ** | **2002** | ** ** | **2001** | ** ** |
| Expected life  (years)   |       | 1.42                                   |       | 1.49 |   | 1.49 |   |
| Risk-free  interest rate |       | 1.5                                    | %          | 1.7 | % | 1.8 | % |
| Dividend yield           |       | —                                 |       | — |   | — |   |
| Volatility               |       | 90                                     | %          | 90 | % | 90 | % |

 

***Stock compensation expense***

Thefollowing table summarizes the components of our stock compensation expense forthe years ended December 31, 2003, 2002 and 2001 (in thousands):
| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Options granted  to employees                    |       | $                                          | 353        |   | $ | 1,943 |   | $ | 2,643 |   |
| Options granted  to non-employees                |       | 1,977                                      |       | 2,304 |   | 2,322 |   |
| Option repricings                                |       | 4,704                                      |       | 2,935 |   | — |   |
| Options assumed  in connection with acquisitions |       | 2,954                                      |       | 3,925 |   | 7,425 |   |
|                                             |       | $                                          | 9,988      |   | $ | 11,107 |   | $ | 12,390 |   |

 

Unearned stockcompensation is amortized to expense over the vesting period using anaccelerated method, and may decrease if employees terminate service prior tovesting.

***Option Grants to Non-employees***

During 2003, 2002 and2001, we granted non-employees options to purchase 454,000, 305,000 and 757,000shares of our stock at weighted average exercise prices of $5.28, $4.35 and$4.15 per share, respectively in return for engineering, administration andconsultancy services. In 2001, 300,000 of the options granted in 2000 wererepriced in connection with our stock option exchange program and are includedin the 2001 option grants above. The expense associated with these optiongrants is determined 

100

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE8—STOCKHOLDERS’ EQUITY (Continued)**

usingthe Black-Scholes model, and is recognized over the term of the consultingagreement or service period.

**NOTE 9—BENEFIT PLANS**

Effective January 1, 1995, we adopted a 401(k)Savings Plan that allows all employees age 21 or older to make salary deferralcontributions ranging from 1% to 20% of their eligible earnings. We werepermitted to make discretionary contributions to the 401(k) Savings Plan uponapproval by the Board of Directors; however, we made no contributions to thePlan.

Effective June 7, 2001, we assumed the CMDTechnology 401(k) Profit Sharing Plan that allows all employees age 18 or olderto make salary deferral contributions ranging from 1% to 20% of their eligibleearnings. We have made no contributions to this Plan.

On March 1, 2002,these two Plans were merged to form the Silicon Image 401(k) Savings Plan. ThisPlan allows all employees age 18 or older to make salary deferral contributionsranging from 1% to 20% of their eligible earnings. We may make discretionarycontributions to the 401(k) Savings Plan upon approval by the Board ofDirectors; however, we have made no contributions to date.

**NOTE 10—SEGMENT AND GEOGRAPHICINFORMATION**

We operate in a single industry segment (as defined bySFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation”) encompassing the design, development and sale of solutions forapplications that require high-bandwidth cost-effective solutions forhigh-speed data communications.

Revenueby geographic area was as follows (in thousands):
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Taiwan        |       | $                                          | 35,534     |   | $ | 27,540 |   | $ | 12,816 |   |
| Japan         |       | 15,980                                     |       | 9,585 |   | 8,252 |   |
| United States |       | 27,259                                     |       | 22,992 |   | 10,831 |   |
| Hong Kong     |       | 6,025                                      |       | 8,853 |   | 3,485 |   |
| Korea         |       | 4,871                                      |       | 6,386 |   | 8,450 |   |
| Other         |       | 13,856                                     |       | 6,183 |   | 8,132 |   |
|          |       | $                                          | 103,525    |   | $ | 81,539 |   | $ | 51,966 |   |

 

Revenueby product line was as follows (in thousands):
| ** **                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| PC                                    |       | $                                          | 33,163     |   | $ | 47,405 |   | $ | 36,535 |   |
| Consumer  Electronics                 |       | 25,762                                     |       | 8,993 |   | 4,082 |   |
| Storage IC                            |       | 28,070                                     |       | 12,291 |   | 2,489 |   |
| Storage Systems                       |       | 2,340                                      |       | 6,195 |   | 8,860 |   |
| Development,  licensing and royalties |       | 14,190                                     |       | 6,655 |   | — |   |
|                                  |       | $                                          | 103,525    |   | $ | 81,539 |   | $ | 51,966 |   |

** **

101

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE10—SEGMENT AND GEOGRAPHIC INFORMATION (Continued)**

For all periods presented, substantially all of ourlong-lived assets were located within the United States.

In 2003, one customergenerated 15% of total revenue and at December 31, 2003, three customersrepresented 17%, 12% and 10% of gross accounts receivable. In 2002, twocustomers generated 15% and 11% of total revenue, and at December 31,2002, two customers represented 13% and 10% of gross accounts receivable. In2001, three customers generated 12%, 12%, and 11% of total revenue. Our topfive customers, including distributors, generated 41%, 41%, and 51% of ourrevenue in 2003, 2002 and 2001, respectively.

**NOTE 11—LEGAL PROCEEDINGS**

On April 24, 2001, we filed suit in the U.S.District Court for the Eastern District of Virginia against Genesis MicrochipCorp. and Genesis Microchip, Inc. (collectively, “Genesis”) forinfringement of our U.S. patent number 5,905,769 (USDC E.D. Virginia CivilAction No.: CA-01-266-R) (the “Federal Suit”). On April 24, 2001, we alsofiled a complaint against Genesis with the International Trade Commission ofthe United States government (“ITC”) for unlawful trade practices related tothe importation of articles infringing our patent (the “ITC investigation”).The actions sought injunctions to halt the importation, sale, manufacture anduse of Genesis DVI receiver chips that infringe our patent, and monetarydamages. We voluntarily moved to dismiss the ITC investigation, with noticethat we would proceed directly in the Federal Suit. Our motion to dismiss wasgranted on February 7, 2002. We filed an amended complaint in the FederalSuit as of February 28, 2002, adding a claim for infringement of our U.S.patent number 5,974,464. In April 2002, Genesis answered and madecounterclaims against us for non-infringement, license, patent invalidity,fraud, antitrust, unfair competition and patent misuse. Also in April 2002,we filed a motion to dismiss certain of Genesis’s counterclaims. In addition,we filed a motion to bifurcate trial of the counterclaims to the extent thecourt does not dismiss them. In May 2002, the Court granted our motion todismiss certain of the counterclaims, with leave to amend. Genesis re-filedcounterclaims against us for fraud and patent misuse. We filed another motionto dismiss these counterclaims. In December 2002, the parties entered intoa memorandum of understanding (MOU) to settle the case. In January, the partiespresented different interpretations of the MOU to the Court. On July 15,2003, the Court granted our motion to interpret the MOU in the manner werequested, and ruled that Genesis had engaged in efforts to avoid itsobligations under the MOU. On August 6, 2003, the Court entered a finaljudgment based on its July 15, 2003 ruling. Under the final judgmentorder, Genesis was ordered to make a substantial cash payment, and to makeroyalty payments; although Genesis has made a cash payment to the Court, it hasnot made all the payments that are required under the final judgment order. We filedmotions for reimbursement of some of our expenses, including some of our legalfees, and for modification and/or clarification of certain items of thejudgment, and to hold Genesis in contempt of Court for breaching the protectiveorder in the case by disclosing secret information to at least one of ourcompetitors. On December 19, 2003, the Court granted our motions in partand denied them in part: the court issued an amended judgment, and held Genesisin contempt of Court for breaching the protective order. Under the amended judgment, Genesis wasordered to make a substantial cash payment, royalty payments, and interest;although Genesis has made and continues to make cash payments to the Court, itmay not have made all the payments that are required under the amended judgment.The Court has not ruled on pending motions regarding the disposition of themoney held by the Court. On January 16, 2004, 

102

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE 11—LEGALPROCEEDINGS (Continued)**

Genesis filed a notice ofappeal. To date, we have not received any cash payments nor have we recognizedany revenue associated with this litigation. Due to the continuing andcontentious nature of this litigation, we will not record any income or revenuerelated to this matter until the litigation is complete and all other incomeand revenue recognition criteria have been satisfied. Management intends toprosecute our position vigorously until this matter is resolved. Through December 31,2003, we have spent approximately $10.4 million on this matter and expect tocontinue to incur significant costs through at least the fourth quarter of2004.

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01CV 10903 (SDNY 2001) pending in Federal District Court for the SouthernDistrict of New York. The lawsuit alleges that all defendants were part of ascheme to manipulate the price of Silicon Image’s stock in the aftermarketfollowing Silicon Image’s initial public offering in October 1999.Response to the complaint and discovery in this action on behalf of SiliconImage and individual defendants has been stayed by order of the court. Thelawsuit is proceeding as part of a coordinated action of over 300 such casesbrought by plaintiffs in the Southern District of New York. Pursuant to atolling agreement, individual defendants have been dropped from the suit forthe time being. In February 2003, the Court denied the underwriters’motion to dismiss and ordered that the case may proceed against issuersincluding against Silicon Image. A proposed settlement has been negotiated thathas yet to be reviewed and approved by the Court. In the event that thesettlement is approved, we do not expect it to have a material effect on ourresults of operations or financial position. In the event that the settlementis not approved, we could not accurately predict the outcome the litigation,but we intend to defend this matter vigorously.

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al.,No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court for theSouthern District of Florida. Plaintiff filed an action on behalf of a putativeclass of shareholders who purchased stock from some or all of approximately 50issuers whose public offerings were underwritten by Credit Suisse First Boston.The lawsuit alleges that Silicon Image and certain officers were part of ascheme by Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.Silicon Image has not been served with a copy of the complaint. The plaintiffin this matter has filed an amended complaint in which Silicon Image, and thenamed officers, were dropped as defendants. We believe that the proposedsettlement described above, if approved, would encompass the claims in thiscase. We believe that these claims were without merit and, if revived, and notsubject to the settlement, we would defend this matter vigorously.

Certain officers and directors of Silicon Image havebeen named as defendants in consolidated shareholder derivative litigation,captioned “In re Silicon Image, Inc. Derivative Litigation, No. 1:03CV010302”,commenced on December 4, 2003 and pending in the Superior Court ofCalifornia, County of Santa Clara. Plaintiffs purport to sue the individualdefendants on behalf of Silicon Image. The lawsuit alleges that as a result ofthe recently completed examination conducted by the Audit Committee of SiliconImage’s Board of Directors, Silicon Image will be required to restate itsfinancial results for 2002 and 2003. The lawsuit further alleges that such arestatement would be due to breaches by the individual defendants of theirfiduciary duties to Silicon Image; that certain of the individual defendantsare liable to Silicon Image for insider trading under California law; and thatthe individual defendants are liable to 

103

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE11—LEGAL PROCEEDINGS (Continued)**

Silicon Image formismanagement, abuse of control, and waste. Before filing suit, plaintiffs didnot make a demand upon the board of directors to pursue any such claimsdirectly on behalf of Silicon Image. With the announcement by the Audit Committeeof Silicon Image’s Board of Directors that it has completed its examination andthat it has concluded that no changes to Silicon Image’s previously announcedfinancial results are required, the lawsuit may be moot in whole or in part,although plaintiffs may amend the complaint once as a matter of right. Theindividual defendants believe the lawsuit is without merit, and they intend todefend the action vigorously if plaintiffs do not amend it. We cannot predictwhat claims plaintiffs might assert in an amended complaint.

Silicon Image and certain of its officers have beennamed as defendants in consolidated securities class action litigationcaptioned “In re Silicon Image, Inc. Securities Litigation, No. C-03-5579JW PVT”, commenced on December 11, 2003 and pending in the United StatesDistrict Court for the Northern District of California. Plaintiffs filed theaction on behalf of a putative class of shareholders who purchased SiliconImage stock between April 15, 2002 and November 15, 2003. The lawsuitalleges that Silicon Image had materially overstated its licensing revenue, netincome and financial results during this time period, and that Silicon Imagewas being forced to restate its financial results. With the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the lawsuit may be moot inwhole or in part, although plaintiffs may amend the complaint once as a matterof right. We believe the lawsuit is without merit, and intend to defend theaction vigorously if plaintiffs do not amend it. We cannot predict what claimsplaintiffs might assert in an amended complaint.

In addition, we have beennamed as defendants in a number of judicial and administrative proceedingsincidental to our business and may be named again from time to time. We intendto defend such matters vigorously, and although adverse decisions orsettlements may occur in one or more of such cases, the final resolution ofthese matters, individually or in the aggregate, is not expected to have amaterial adverse effect on our results of operations or financial position.

104

----

**SILICON IMAGE, INC.**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

**NOTE12—UNAUDITED QUARTERLY FINANCIAL DATA**
| ** **                                | ** ** | **Three Months Ended**                                                              | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Mar 31**                                                                               | ** ** | **Jun 30** | ** ** | **Sep 30** | ** ** | **Dec 31** | ** ** |
| ** **                                | ** ** | **(in thousands, except footnotes and per share amounts)** | ** ** |
| **2003**                                  |       |                                                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenue                             |       |                                                                                          | $          | 24,676 |   |   |   | $ | 24,332 |   |   |   | $ | 24,190 |   |   |   | $ | 30,327 |   |   |
| Gross margin(1)                           |       |                                                                                          | 13,621     |   |   |   | 13,603 |   |   |   | 12,703 |   |   |   | 16,406 |   |   |
| Loss from  operations(2)                  |       |                                                                                          | (1,496     | ) |   |   | (8,733 | ) |   |   | (2,135 | ) |   |   | (5,355 | ) |   |
| Net income  (loss)(3)                     |       |                                                                                          | 3,231      |   |   |   | (8,666 | ) |   |   | (2,095 | ) |   |   | (5,280 | ) |   |
| Net income (loss)  per share—basic   |       |                                                                                          | $          | 0.05 |   |   |   | $ | (0.13 | ) |   |   | $ | (0.03 | ) |   |   | $ | (0.07 | ) |   |
| Net income (loss)  per share—diluted |       |                                                                                          | $          | 0.04 |   |   |   | $ | (0.13 | ) |   |   | $ | (0.03 | ) |   |   | $ | (0.07 | ) |   |
| Weighted average  shares—basic       |       |                                                                                          | 66,828     |   |   |   | 69,012 |   |   |   | 69,803 |   |   |   | 70,638 |   |   |
| Weighted average  shares—diluted     |       |                                                                                          | 73,696     |   |   |   | 69,012 |   |   |   | 69,803 |   |   |   | 70,638 |   |   |
| **2002**                                  |       |                                                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenue                             |       |                                                                                          | $          | 17,087 |   |   |   | $ | 19,272 |   |   |   | $ | 21,385 |   |   |   | $ | 23,795 |   |   |
| Gross margin(4)                           |       |                                                                                          | 7,678      |   |   |   | 10,728 |   |   |   | 11,732 |   |   |   | 12,101 |   |   |
| Loss from  operations(5)                  |       |                                                                                          | (17,970    | ) |   |   | (9,771 | ) |   |   | (4,809 | ) |   |   | (8,300 | ) |   |
| Net loss(5)                               |       |                                                                                          | (17,700    | ) |   |   | (9,608 | ) |   |   | (4,645 | ) |   |   | (8,139 | ) |   |
| Basic and diluted  net loss per share     |       |                                                                                          | $          | (0.28 | ) |   |   | $ | (0.15 | ) |   |   | $ | (0.07 | ) |   |   | $ | (0.12 | ) |   |
| Weighted average shares                   |       |                                                                                          | 63,360     |   |   |   | 64,580 |   |   |   | 65,587 |   |   |   | 66,198 |   |   |

----

(1)          Includes stockcompensation expense (benefit) of $(135,000), $78,000, $(14,000) and $654,000for the three months ended March 31, June 30, September 30 and December 31,2003, respectively.

(2)          Includes restructuringexpense of $986,000 in the first quarter of 2003, and In-process research anddevelopment expense of $5.5 million in the second quarter of 2003 (See Note 2).

(3)          Includes gain on escrowsettlement of $4.6 million in the first quarter of 2003 (See Note 2).

(4)          Includes stockcompensation expense (benefit) of $923,000, $(544,000), $(144,000) and $955,000for the three months ended March 31, June 30, September 30 and December 31,2002, respectively.

(5)          Includes impairment ofgoodwill and intangible assets of $5.2 million in the second quarter of 2002(See Note 3), and restructuring expense of $2.2 million, $3.5 million and $1.5 millionin the first, second and fourth quarters of 2002, respectively.

105

----

 

**Reportof Independent Auditors**

To the Board of Directorsand Stockholdersof Silicon Image, Inc.:

In our opinion, the consolidatedfinancial statements listed in the index appearing under Item 15(a)(1) presentfairly,in all material respects, the financial position of Silicon Image, Inc.and its subsidiaries at December 31,2003and 2002, and the results oftheiroperations and theircash flows for each of the three years in the period ended December 31,2003 in conformity with accounting principles generally accepted in the UnitedStates of America. These financial statements are the responsibility of theCompany’s management; our responsibility is to express an opinion on thesefinancial statements based on our audits. We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable 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 Companyadopted Statement of Financial Accounting Standards No.142 “Goodwill and otherIntangible Assets” on January 1, 2002.

/s/ PricewaterhouseCoopers LLP

*PricewaterhouseCoopers LLPSan Jose, CaliforniaFebruary 12, 2004*

106

----

 

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities andExchange Act of 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized.
| Dated:  March 12, 2004 | Silicon Image, Inc. |
|-----------------------------|--------------------------|
|                        | By:                      |   | /s/  David D. Lee |
|                        |                     |   | David D. Lee |
|                        |                     |   | *Chief Executive Officer* |

 

**Powerof Attorney**

Each person whose signature appears below constitutesand appoints David D. Lee his attorney-in-fact for him in any and allcapacities, to sign any amendments to this Annual Report on Form 10-K, andto 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 thereof.

Pursuantto the requirements of the Securities and Exchange Act of 1934, this Report hasbeen signed by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated:
| ** **               | **Signature** | ** **                                                                                                                              | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  David D. Lee        |          | Chief Executive Officer  and Chairman of the Board (Principal Executive Officer)                                                        |       | March 12, 2004 |
| David D. Lee             |
| /s/  Robert G. Gargus    |          | Vice President, Finance  and Administration and Chief Financial Officer (Principal Financial Officer  and Principal Accounting Officer) |       | March 12, 2004 |
| Robert G. Gargus         |
| /s/  David A. Hodges     |          | Director                                                                                                                                |       | March 12, 2004 |
| David A. Hodges          |
| /s/  Keith McAuliffe     |          | Director                                                                                                                                |       | March 12, 2004 |
| Keith McAuliffe          |
| /s/  Andrew S. Rappaport |          | Director                                                                                                                                |       | March 12, 2004 |
| Andrew S.  Rappaport     |
| /s/  Ronald V. Schmidt   |          | Director                                                                                                                                |       | March 12, 2004 |
| Ronald V. Schmidt        |
| /s/  Douglas C. Spreng   |          | Director                                                                                                                                |       | March 12, 2004 |
| Douglas C. Spreng        |
| /s/  David Courtney      |          | Director                                                                                                                                |       | March 12, 2004 |
| David Courtney           |

 

107

----

**INDEX TO EXHIBITS**
| **Number** | ** ** | **Title**                                                                                                                                                                                                                                                                                                                              |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.01       |       | Agreement and Plan of  Reorganization, dated June 1, 2001, among the Registrant, Duke Acquisition  Corp., CMD Technology Inc. and the principal shareholders of CMD Technology  Inc. (Incorporated by reference from Exhibit 2.01 of the Form 8-K filed by  Registrant on June 20, 2001).                                         |
| 2.02       |       | Agreement and Plan of Reorganization, dated June 15,  2001, among the Registrant, Slice Acquisition Corp., Silicon Communication  Lab, Inc. and certain shareholders of Silicon Communication Lab, Inc.  (Incorporated by reference from Exhibit 2.01 of the Form 8-K filed by  Registrant on June 20, 2001).                          |
| 3.01       |       | Second Amended and Restated Certificate of  Incorporation of the Registrant (Incorporated by reference from Exhibit 3.03  of the Registrant's Registration Statement on Form S-1 (File No. 333-83665),  as amended, declared effective by the Securities and Exchange Commission on  October 5, 1999 (the "Form S-1")). |
| 3.02       |       | Restated Bylaws of the Registrant (Incorporated by  reference from Exhibit 4.03 of the Form S-8 filed by the Registrant on  January 28, 2003).                                                                                                                                                                                         |
| 3.03       |       | Certificate of Amendment of Second Amended and  Restated Certificate of Incorporation of the Registrant (Incorporated by  reference from Exhibit 3.04 of the Form 10-Q filed by Registrant on August  14, 2001).                                                                                                                       |
| 4.01       |       | Form of Specimen Certificate for Registrant's common  stock (Incorporated by reference from Exhibit 4.01 of the Form S-1).                                                                                                                                                                                                             |
| 4.02       |       | Third Amended and Restated Investors Rights  Agreement dated July 29, 1998, as amended October 15, 1999 (Incorporated by  reference from Exhibit 4.04 of the Form S-1).                                                                                                                                                                |
| 10.01**    |       | Form of Indemnity Agreement entered into between the  Registrant and certain of its directors and officers.                                                                                                                                                                                                                            |
| 10.02**    |       | 1995 Equity Incentive Plan, as amended through July  20, 1999, and related forms of stock option agreements and stock option  exercise agreements (Incorporated by reference from Exhibit 10.02 of the Form  S-1).                                                                                                                     |
| 10.03**    |       | 1999 Equity Incentive Plan, as amended, and related  forms of stock option agreements and stock option exercise agreements.                                                                                                                                                                                                            |
| 10.04**    |       | 1999 Employee Stock Purchase Plan and related  enrollment form, notice of suspension and notice of withdrawal (Incorporated  by reference from Exhibit 10.04 of the Form S-1).                                                                                                                                                         |
| 10.05**    |       | Employment Agreement with Parviz Khodi dated June  10, 1999 (Incorporated by reference from Exhibit 10.06 of the Form S-1).                                                                                                                                                                                                            |
| 10.06**    |       | Amended and Restated Severance Agreement with David  Lee dated August 15, 1997 (Incorporated by reference from Exhibit 10.07 of  the Form S-1).                                                                                                                                                                                        |
| 10.07*     |       | Business Cooperation Agreement dated September 16,  1998 between Intel Corporation and the Registrant, as amended October 30,  1998 (Incorporated by reference from Exhibit 10.12 of the Form S-1).                                                                                                                                    |
| 10.08*     |       | Patent License Agreement dated September 16, 1998  between Intel Corporation and the Registrant (Incorporated by reference from  Exhibit 10.13 of the Form S-1).                                                                                                                                                                       |
| 10.09      |       | Digital Visual Interface Specification Revision 1.0  Promoter's Agreement dated January 8, 1999 (Incorporated by reference from  Exhibit 10.14 of the Form S-1).                                                                                                                                                                       |
| 10.10**    |       | Letter Agreement between Steve Tirado and the  Registrant and Addendum thereto (Incorporated by reference from Exhibit 10.19  of the Form S-1).                                                                                                                                                                                        |
| 10.11**    |       | Form of Nonqualified Stock Option Agreement entered  into between Registrant and its officers (Incorporated by reference from  Exhibit 10.21 of the Form S-1).                                                                                                                                                                         |

 

108

----

 
| **Number** | ** ** | **Title**                                                                                                                                                                                                                            |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12**    |       | Letter Agreement between  Steve Tirado and the Registrant dated November 18, 1999 (Incorporated by  reference from Exhibit 10.25 of the Form 10-K filed by the Registrant on  March 30, 2000).                                       |
| 10.13**    |       | Amendment No. 1 to Amended and Restated Severance  Agreement with David Lee dated January 23, 2000 (Incorporated by reference  from Exhibit 10.26 of the Form 10-K filed by the Registrant on March 30,  2000).                      |
| 10.14**    |       | Amendment No. 2 to Amended and Restated Severance  Agreement with David Lee dated March 29, 2001 (Incorporated by reference from  Exhibit 10.31 of the Form 10-Q filed by the Registrant on May 15, 2001).                           |
| 10.15**    |       | Letter Agreement between Jaime Garcia-Meza and the  Registrant dated April 5, 2001 (Incorporated by reference from Exhibit 10.33  of the Form 10-Q filed by the Registrant on May 15, 2001).                                    |
| 10.16**    |       | Non-Plan Stock Option Agreement between Jaime  Garcia-Meza and the Registrant dated April 5, 2001 (Incorporated by  reference from Exhibit 10.34 of the Form 10-Q filed by the Registrant on May  15, 2001).                    |
| 10.17**    |       | CMD Technology Inc. 1991 Stock Option Plan and  related form of Incentive Stock Option Agreement (Incorporated by reference  from Exhibit 4.05 of the Form S-8 filed by the Registrant on June 26, 2001).                            |
| 10.18**    |       | CMD Technology Inc. 1999 Stock Incentive Plan, as  amended, and related form of Stock Option Agreement (Incorporated by  reference from Exhibit 10.35 of the Form 10-Q filed by the Registrant on  November 14, 2001).               |
| 10.19**    |       | Silicon Communication Lab, Inc. 1999 Stock Option  Plan, as amended, and related form of Stock Option Agreement (Incorporated by  reference from Exhibit 10.35 of the Form 10-Q filed by the Registrant on  November 14, 2001).      |
| 10.20**    |       | Letter Agreement between Robert Gargus and the  Registrant dated October 30, 2001 (Incorporated by reference from Exhibit  10.35 of the Form 10-Q filed by the Registrant on November 14, 2001).                                     |
| 10.21**    |       | Non-Plan Stock Option Agreement between Robert  Gargus and the Registrant dated October 30, 2001. (Incorporated by  reference from Exhibit 10.41 of the Form 10-K filed by the Registrant on  March 29, 2002).                  |
| 10.22**    |       | Non-Plan Stock Option Agreement between Hyun Jong  Shin and the Registrant dated November 6, 2001. (Incorporated by reference  from Exhibit 10.42 of the Form 10-K filed by the Registrant on March 29,  2002).                      |
| 10.23      |       | Lease Agreement dated April 20, 2000 between LBA-VF  III, LLC and CMD Technology (Incorporated by reference from Exhibit 10.43 of  the Form 10-Q filed by the Registrant on May 15, 2002).                                      |
| 10.24      |       | Amended and Restated Loan and Security Agreement  dated October 1, 2002 between Comerica Bank and the Registrant (Incorporated  by reference from Exhibit 10.43 of the Form 10-Q filed by the Registrant  on November 8, 2002). |
| 10.25      |       | Lease Agreement dated December 12, 2002 between  iSTAR Sunnyvale Partners, L.P. and the Registrant. (Incorporated by reference  from Exhibit 10.44 of the Form 10-K filed by the Registrant on March 27, 2003).                      |
| 10.26**    |       | Non-Plan Stock Option Agreement between John  LeMoncheck and the Registrant dated January 6, 2003 (Incorporated by  reference from Exhibit 4.08 of the Form S-8 filed by the Registrant on  January 28, 2003).                       |
| 10.27**    |       | Letter Agreement between John LeMoncheck and the  Registrant dated December 3, 2002 (Incorporated by reference from Exhibit  10.46 of the Form 10-K filed by the Registrant on March 27, 2003).                                      |

 

109

----

 
| **Number** | ** ** | **Title**                                                                                                                                                                                                            |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28**    |       | Non-Plan Stock Option  Agreement between Robert Bagheri and the Registrant dated February 20,  2003 (Incorporated by reference from Exhibit 10.47 of the Form 10-K filed by  the Registrant on March 27, 2003). |
| 10.29**    |       | Letter Agreement between Robert Bagheri and the  Registrant dated February 11, 2003 (Incorporated by reference from Exhibit  10.48 of the Form 10-K filed by the Registrant on March 27, 2003).                      |
| 10.30**    |       | Executive Bonus Plan adopted by Registrant on  December 11, 2002 (Incorporated by reference from Exhibit 10.49 of the Form  10-K filed by the Registrant on March 27, 2003).                                         |
| 10.31      |       | Amendment to Loan and Security Agreement dated  February 20, 2003 between Comerica Bank and the Registrant.                                                                                                          |
| 10.32      |       | Second Amendment to Amended and Restated Loan and  Security Agreement dated March 2, 2004 between Comerica Bank and the Registrant                                                                                   |
| 10.33      |       | TransWarp Networks, Inc. 2002 Stock Option/Stock  Issuance Plan (Incorporated by reference from Exhibit 4.06 of the Form S-8  filed by the Registrant on May 23, 2003).                                              |
| 10.34**    |       | Employment Agreement with Dan Alter dated  June 15, 1998 (Incorporated by reference from Exhibit 10.05 of the Form  S-1).                                                                                       |
| 23.01      |       | Consent of Independent Accountants.                                                                                                                                                                                  |
| 24.01      |       | Power of Attorney (included on signature page).                                                                                                                                                                      |
| 31.1       |       | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
| 31.2       |       | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
| 32.1       |       | Certification by pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                          |
| 32.2       |       | Certification by pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                          |

----

*       Confidentialtreatment has been requested with respect to certain portions of this exhibit.Omitted portions have been filed separately with the Securities and ExchangeCommission.

**   This exhibit is amanagement contract or compensatory plan or arrangement.

110

----