**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**WASHINGTON, D.C.20549

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**FORM 10-K**

**(MarkOne)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934        

**Forthe transition period from                        to**

**Commissionfile number:  000-51560**

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**MathStar, Inc.**(Exactname of registrant as specified in its charter)

| **Delaware**                                 |   | **41-1881957**                        |
|----------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of             |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)              |   |                                  |
| **19075 Tanasbourne Drive, Suite 200,** |   | ** **                            |
| **Hillsboro,  Oregon**                       |   | **97124**                             |
| (Address of  principal executive offices)    |   | (Zip Code)                            |

 

**(503)726-5500**(Registrant’stelephone number, including area code)

**5900Green Oak Drive, Minnetonka, Minnesota 55343**(Formername, former address and former fiscal year, if changed since last report)

Securities registeredpursuant to Section 12(b) of the Act: 

| **Title of each class**        |   | **Name of  each exchange on which registered** |
|--------------------------------|--------|------------------------------------------------|
| Common Stock,  $0.01 par value |   | NASDAQ Global  Market                          |

 

Securities registeredpursuant to Section 12(g) of the Act: None.

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o    No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.  Yes o    No x

Indicate by check markwhether the 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 ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

| Large Accelerated Filer o |   | Accelerated Filer x |   | Non-accelerated  Filer o |
|--------------------------------|--------|--------------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes o    No x

The aggregate market valueof the voting and non-voting common stock held by non-affiliates, computed byreference to the price at which the common stock was last sold as of June 30,2006 as reported on The NASDAQ Global Market, was $91.6 million. Shares ofcommon stock held by each officer, director and holders of 5% or more of theoutstanding common stock have been excluded in that such persons may be deemedto be affiliates. Such determination of affiliate status is not necessarily aconclusive determination for other purposes.

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date. 

| **Class**                                | ** ** | **Outstanding  at March 9, 2007** |
|------------------------------------------|------------|----------------------------------------|
| Common Stock,  $0.01 par value per share |       | 20,931,890 shares                      |

 

**DOCUMENTS INCORPORATED BYREFERENCE**

| **Document**                                                                                                               | ** ** | **Parts  Into Which Incorporated** |
|----------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|
| Certain portions  of the Proxy Statement for the Annual Meeting of Stockholders to be held May  17, 2007 (Proxy Statement) |       | Part III                           |

 

 

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**MathStar, Inc.2006 ANNUAL REPORT ON FORM 10-K**

**TABLEOF CONTENTS**
|                   | ** ** |                                                                                                                    | ** ** | **Page**   |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|------------|
| **PART I**   | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |
| Item 1.           |       | Business                                                                                                           |       |       | 1 | ** ** |
| Item  1A.         |       | Risk Factors                                                                                                       |       |       | 4 | ** ** |
| Item 1B           |       | Unresolved Staff Comments                                                                                          |       |       | 16 | ** ** |
| Item 2.           |       | Properties                                                                                                         |       |       | 16 | ** ** |
| Item  3.          |       | Legal Proceedings                                                                                                  |       |       | 16 | ** ** |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                |       |       | 16 | ** ** |
| **PART II**  | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |       | 17 | ** ** |
| Item  6.          |       | Selected  Financial Data                                                                                           |       |       | 19 | ** ** |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       |       | 20 | ** ** |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       |       | 26 | ** ** |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                        |       |       | 27 | ** ** |
| Item 9.           |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       |       | 49 | ** ** |
| Item 9A.          |       | Controls and Procedures                                                                                            |       |       | 49 | ** ** |
| Item  9B.         |       | Other  Information                                                                                                 |       |       | 50 | ** ** |
| **PART III** | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |
| Item 10.          |       | Directors, Executive Officers and Corporate  Governance                                                            |       |       |   | ** ** |
| Item 11.          |       | Executive Compensation                                                                                             |       |       |   | ** ** |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters     |       |       |   | ** ** |
| Item 13.          |       | Certain Relationships and Related Transactions and  Director’s Independence                                   |       |       |   | ** ** |
| Item 14.          |       | Principal Accountant Fees and Services                                                                             |       |       |   | ** ** |
| **PART IV**  | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                         |       |       | 51 | ** ** |
| Signatures        |       |                                                                                                               | 54         | ** ** |

 

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**PART I**

**Item1.**                        Business

**OurBusiness**

We are a development stagecompany that designs, develops and markets a new class of semiconductorintegrated circuit, or chip, we call field programmable object arrays, orFPOAs. An integrated circuit chip is a small electronic device made out of asemiconductor material that is used for a variety of electronic devices,including personal computers, audio and video equipment, and other electronicproducts and systems. Our FPOAs are high-performance, reprogrammable integratedcircuits based on our proprietary silicon object technology. We believe thatour FPOA chips will provide cost, performance, time-to-market andtime-in-market advantages when compared to existing methods used to designlogic devices. Logic devices are used for managing the interchange andmanipulation of digital signals within an electronic system and are one ofthree broad categories of digital integrated circuits used in electronicsystems.

An FPOA consists of verysmall, pre-designed, high-speed computing and data storage elements, or siliconobjects, arranged in a grid pattern, along with internal and external memoryand data input and output channels. The grid of silicon objects is overlaidwith a high-speed interconnection system, creating the silicon object array.This array of objects and interconnect matrix is programmed to execute uniquecustomer applications using industry-standard and FPOA-specific software designtools. Each of our silicon objects can execute its function at a rate of up to onebillion times per second, which is up to four times faster than commerciallyavailable programmable logic devices. Our first FPOA contains 400 siliconobjects, and each of these can operate simultaneously, creating a chip capableof executing 400 billion computational operations per second.

Currently, two of the mostcommon methods used to design logic devices are the application-specificintegrated circuit method, or ASIC, and the programmable logic device method,or PLD. The field programmable gate array, or FPGA, is a segment of the PLDmarket. ASICs are designed by the end customer with fixed functions for asingle application and cannot be reprogrammed. The primary advantages of usingASIC technology are low per unit cost and high performance. The primarydisadvantages of using ASICs are their high up-front development costs, longtime-to-market and inability to change the chip’s function as applications andalgorithms change. An algorithm is a finite set of well-defined instructionsfor accomplishing a task and can be implemented by computer programs. Incontrast to ASICs, FPGAs, purchased off-the-shelf, are programmed by thecustomer and can be used in a wide range of applications. This inherentflexibility of FPGAs provides the advantages of design change simplicity,shorter time-to-market, lower up-front development cost and longertime-in-market. The primary disadvantages of using FPGAs are their lowerperformance and higher per unit cost as compared to ASICs. We believe thesedisadvantages limit the applications that can be effectively served by the FPGAarchitecture. We have introduced a new chip architecture that combines the costand performance advantages of ASICs with the reprogrammability of FPGAs.

Webelieve FPOA chips offer better performance than ASIC or FPGA chips, low perunit cost advantages comparable to ASIC chips and the time-to-market andtime-in-market advantages of FPGA chips for the following reasons:

·       *S**peed.**  *Each object in the FPOA operates at a speed ofup to one GigaHertz, or GHz, which is up to four times the speed of FPGAs. AGigaHertz is a measure of frequency, or clock speed, and is equal to a billionhertz or a thousand megahertz.

·       *Design simplicity*.   Our FPOAarchitecture simplifies the silicon design process. ASIC and FPGA chips requirethe designer to perform the complex task of implementing algorithms usingmillions of individual logic gates. In electronics and digital circuits, alogic gate is an arrangement of switches used to calculate operations. FPOAdesigners implement these algorithms by programming a few 

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hundredinterconnected objects, reducing design costs and improving overall systemperformance and time-to-market.

·       *Smaller physical size.**  *In high-performanceapplications, we believe our FPOAs will have a per unit manufacturing costadvantage over FPGAs because FPOAs are smaller. In many cases, the FPOAarchitecture will realize solutions that have a higher functional density thantypical FPGAs, reducing the amount of silicon required for a given design.Functional density refers to the number and complexity of functions that can beperformed by a chip of a specific size.

·       *Fewer chips needed.**  *We believe the sizeand performance advantages of FPOAs will enable our customers to use fewerchips to implement electronic system functions as compared to FPGAs, which isexpected to result in space savings and lower overall system power consumption.

·       *Fast time-to-market.**  *FPOAs will have afaster time-to-market than ASICs because FPOAs are available off-the-shelf.

·       *Reprogrammable.**  *Our FPOAs arereprogrammable. This allows our customers to change the functionality of theirsystems in the field, thus increasing time-in-market as compared to ASICs.

We will sell our FPOAchips in a blank state as standard off-the-shelf products. Our chips can beprogrammed for application-specific functionality by using a combination ofindustry standard design tools, our physical layer design tools and our libraryof pre-programmed algorithms. In November 2006, we started samplinglimited quantities of the production version of our ARRIXTM family of FPOAs andexpect to continue shipping them in increasing quantities in 2007.

**OurMarkets**

Ourgoal is to introduce FPOA technology into market applications that requirechips that combine high-speed performance, in-field programmability, low perunit price and rapid time-to-market. Because the FPOA chip is new, there is noindependent research available on the market size for FPOAs. We expect tocompete with FPGAs, ASICs and some types of digital signal processors, or DSPs.DSPs are high-speed single chip microprocessors designed to performmathematically-intensive digital signal processing computational tasks. Most ofour early design wins are with customers in the high definition video, machinevision and military/aerospace markets, and we are now targeting commercialapplications with the following characteristics:

·       applicationsthat demand higher performance than currently can be served by high-performanceDSPs or FPGAs;

·       applications that demandthe reprogrammability of FPGAs but cannot justify the high per unit productioncost of FPGAs;

·       applicationsthat demand high performance but are not expected to generate the productionvolume that would warrant the expense of an ASIC development; and

·       applications wherereprogrammability is a requirement, thus deterring the designer from using anASIC.

We believe the machinevision, test and measurement, high definition video, medical imaging, highperformance imaging, security and surveillance, military/defense and aerospace,digital signal processing and cellular wireless base stations markets have thecharacteristics that make them ideally suited to take advantage of the FPOAarchitecture.

**OurBusiness Strategy**

Our goal is to achieverapid adoption of the FPOA in commercial applications. To achieve this goal, weare using a manufacturers’ representative sales model. We have contracted withmanufacturers’ 

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representativesto cover the 22 territories in North America and have contracted with three inEurope (England, France and Germany). The manufacturers’ representatives aremanaged by our four area sales managers and supported technically by our sevenfield application engineers. We will use this team and our strategic partnersto introduce our FPOA chips to the marketplace, educate the market on the advantagesof our FPOA technology and achieve design wins.

In order to accelerate ourinitial market penetration and compete with larger FPGA suppliers, we offerpotential customers three to four times the performance of FPGAs at similarpricing. Our initial FPOA chip provides the basis for a planned family of FPOAchips that will serve as targeted chip platforms for the implementation of awidening range of customer-specific algorithms. We anticipate that future chipswill consist of various versions of the initial FPOA chip, may containdifferent numbers of object types and will be optimized for either low powerconsumption, high performance, low price or customized intellectual propertyprogramming.

During the first half of2007, MathStar plans to roll out its certified design center plan to acceleratethe acceptance and time-to-market of products using FPOAs. These design centerswill assist customers who want the value associated with an FPOA design butwant a solution at a higher level of integration—either a complete software,board or system-level solution.

Under our businessdevelopment agreement with Summit Design, Inc., we have incorporated ourphysical layer design tools into the Summit Design Visual Elite design toolsuite. We and our customers use the resulting design tool suite to program, ormap, the customers’ intellectual property to our FPOAs. On October 24,2006, Mentor Graphics Corporation announced the completion of its acquisitionof Summit Design. Mentor Graphics has indicated that it plans continued supportfor the Visual Elite Tool Suite, and we anticipate no adverse impact from theacquisition.

**Employees**

As of December 31,2006, we had 63 full-time employees, consisting of three in management, five inadministration, two in information systems, 36 in research and development, twoin operations and 15 in sales and marketing. None of our employees are subjectto a collective bargaining agreement. We have not experienced any work stoppages andbelieve our relationships with our employees to be good.

**DevelopmentStage Company**

We are a development stagecompany. We have a limited operating history and have not yet commercializedany products. To date, we have recognized only nominal revenue from researchservices provided under grants from governmental agencies, engineering servicesand sales of prototype chips and FPOA development kits. We do not know whetheror when we will be able to generate significant product revenue or becomeprofitable. For the year ended December 31, 2006, we had a net loss of$22,643,000 and we had an accumulated deficit of $106,137,000.

**CompanyInformation**

We were incorporated underMinnesota law in April 1997, and we reincorporated under Delaware law on June 14,2005. Our executive offices are located at 19075 N.W. Tanasbourne Drive, Suite 200,Hillsboro, Oregon 97124. Our telephone number is (503) 726-5500. Ourwebsite is www.mathstar.com.The information contained on our website is not a part of this filing. We haveincluded our website address in this filing as an inactive textual referenceonly.

In this Annual Report onForm 10-K, unless otherwise stated or the context otherwise required,references to “MathStar”, “we”, “us”, “our”, “our company” and similar referencesrefer to MathStar, Inc. Additional information about the company can belocated on our web site, www.mathstar.com, or from the SEC.

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**Forward LookingStatements**

*You should read the following discussion and analysisof our financial condition and results of operations together with ourfinancial statements and the related notes appearing at the end of this AnnualReport on Form 10-K. Some of the information contained in thisdiscussion and analysis or set forth elsewhere in this Annual Report on Form 10-K,including information with respect to our plans and strategy for our businessand related financing, includes forward looking statements that involve risksand uncertainties. You should review “Item 1A. Risk Factors” for a discussionof important factors that could cause actual results to differ materially fromthe results described in or implied by the forward-looking statements containedin the following discussion and analysis.*

**Item 1A.**                RiskFactors

**Risks Relating toOur Business**

***Our operations and business are subject to the risksof a development stage company with little or no revenue and a history ofoperating losses.***The report of our independent registered publicaccounting firm included in this Annual Report on Form 10-K contains anexplanatory paragraph expressing substantial doubt about our ability tocontinue as a going concern. We have incurred losses since inception,and we have had only nominal revenue.

We have operated as a development stage company sinceour inception by devoting substantially all of our efforts to raising capitaland research and development. Thus, our financial statements have been preparedin accordance with the accounting and reporting principles prescribed byStatement of Financial Accounting Standards, or SFAS, No. 7, *Accounting and Reporting by Development StageEnterprises,* issued by the Financial Accounting Standards Board, orFASB. The report of our independent registered public accounting firm relatedto our financial statements as of 2005 and 2006 and for each of the three yearsin the period ended December 31, 2006 and cumulatively for the period fromApril 14, 1997, date of inception, to December 31, 2006 contains anexplanatory paragraph expressing substantial doubt about our ability tocontinue as a going concern.

Since inception, we have had only nominal revenue fromthe sale or licensing of our FPOAs, and we have had losses. We had net lossesof $8,749,000, $18,935,000 and $22,643,000 for the years ended December 31,2004, 2005 and 2006. As of December 31, 2006, we had an accumulateddeficit of $106,137,000. We expect to increase our spending significantly as wecontinue to expand our infrastructure. We are using and will use the proceedsfrom our October 2006 private placement and our October 2005 initialpublic offering and any proceeds we receive upon exercise of outstandingwarrants to expand our sales and marketing efforts and continue research anddevelopment. In addition, we will need significant revenue and/or to raiseadditional capital to finance our business. We do not know whether or when wewill become profitable because of the significant uncertainties regarding ourability to generate revenues.

***We may need additional financing in the future, whichmay not be available to us on favorable terms or at all. If we need additionalfinancing but do not obtain it when we need it or on terms that are favorableto us, our business would be adversely and materially affected.***

We may needadditional financing in the future to finance our business. The timing andamount of such additional financing depends on many factors, including thefollowing:

·       delaysin the development and testing of our FPOA chips or design tools;

·       thecosts of expanding our sales and marketing activities;

·       therate and degree of acceptance of our FPOA chips in the marketplace;

·       ourability to establish successful strategic relationships with companies todevelop and market our FPOA chips;

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·       thecost of or delays in producing our chips;

·       thecost of hiring and training qualified application engineers and fieldapplication engineers;

·       the costs of preparing, filing, prosecuting, maintainingand enforcing patent claims and other patent-related costs;

·       thecosts of defending any patent or trademark infringement actions brought againstus by third parties; and

·       thecost of being a public company because of the disclosure, reporting, financialaccounting and other requirements that apply to public companies.

Additional financing may not be available to us whenwe need it or on terms that are favorable to us. If we cannot obtain adequatefinancing on a timely basis or under terms that are favorable to us, we may beforced to delay or limit aspects of our business plan, which could have amaterial adverse effect on our business, revenue, financial condition andresults of operations. In addition, we may be required to seek funds fromsources that will place limits on our operations and management or that requirerights that are superior to those possessed by the holders of our common stock.If we raise additional funds by issuing equity securities, the new equitysecurities may dilute the average per share price or ownership interests of ourstockholders, and the rights of the holders of the equity securities may bemore favorable than those of the holders of our common stock.

***Because our current and planned FPOA chips are highlycomplex, they may contain defects or errors that are detected only afterdeployment in commercial applications, which would harm our reputation andresult in increased liability and expense.***

Our current and planned FPOA chips are highly complexand may contain defects, errors or failures. After the initial fabrication andpackaging of an FPOA chip, we test their functionality and performanceinternally. Our testing may reveal some problems before the chips are deliveredto our customers that would result in significant delays and costs to us.Because our chips are programmable in the field, they can be fully tested onlywhen deployed and functioning in commercial applications. Consequently, ourcustomers may discover errors after our chips have been deployed. Theoccurrence of any defects, errors or failures in our FPOA chips could result inthe cancellation of orders, product returns, repairs or replacements, diversionof our resources, legal actions by our customers or our customers’ end usersand other costs and losses to us or to our customers or end users. Any of theseoccurrences could also result in the loss of or delay in market acceptance ofour FPOA chips and loss of sales, which would adversely affect our business,revenue, financial condition and results of operations. We have experienceddefects in the past and may experience defects in the future. Timing-relateddefects in our original FPOA design caused a low yield of chips that couldoperate at a clock speed of one GHz. As a result, we had to manufactureadditional chips and sort through the available supply of chips to find thosethat worked properly, which increased our costs and delayed the marketing ofour chips. Because the trend in the semiconductor industry is moving towardeven more complex products, this risk probably will intensify over time and mayresult in increased liability and expenses.

***In the fourth quarter of 2006, we began shipping aproduction version of our FPOA chip, but we have not yet achieved commercialacceptance of the chip. Our success depends on effectively introducing our FPOAchips to the market and having them gain market acceptance. The failure of ourFPOA chips to achieve commercial acceptance would have a material adverseeffect on our business, revenue, financial condition and results of operations.***

Our success depends upon our ability to introduce ourFPOA chips to the market in a timely and effective manner and to have our FPOAchips gain widespread market acceptance. We have begun the process ofidentifying strategic markets for our FPOA chips and introducing our FPOA chipsto these 

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markets. However, our FPOAchip is new and has not been used in a product or in an electronic system thathas been commercially distributed. From the time a customer selects our FPOAchips for its electronic system, it may be a considerable period of time beforethe customer starts volume production of its system and purchasing chips involume, if at all. There can be no assurance that design wins will result inany production commitments that generate revenue growth for a number of reasons,including the decision of the customer to terminate the development orproduction of the electronic system for which the FPOA chip was selected.

The targeted markets into which we are introducing andwill introduce our FPOA chips may not accept them. Users may not accept ourFPOA chips as preferable to existing semiconductor chips, including ASICs andFPGAs, or new products in our targeted applications and densities. Electronicequipment manufacturers and other potential customers for our FPOA chips oftenhave a preferred and established supplier of semiconductor chips. It will bedifficult for us to overcome this preference and convince our targetedcustomers to use our FPOA chips rather than chips from their preferred vendors.The acceptance and deployment of our FPOA chips in the market will depend onmany factors, including the availability and effectiveness of our FPOA chipsand competing products from our competitors, the willingness of targetedcustomers to expend resources to test and use our new FPOA chips, theeffectiveness of our marketing and sales personnel and the pricing for our FPOAchips. Any of the foregoing factors, among others, could limit marketacceptance of our FPOA chips. Our failure to effectively introduce our FPOAchips to the market or the market’s failure to accept our chips would have amaterial adverse effect on our business, revenue, financial condition andresults of operations.

***Our future success will depend on our ability todevelop new FPOA chips, introduce them to the market and have them gain marketacceptance. There is no assurance that we can do so successfully or on a timelybasis. Our failure to do so would have a material adverse effect on ourbusiness, revenue, financial condition and results of operations.***

We operate in amarket characterized by rapid technological change. In order to effectivelycompete, we need to develop new FPOA chips on a timely basis that will gainmarket acceptance. The development of new FPOA chips is a highly complex andprecise process, and we will likely experience delays in developing andintroducing them. Our development efforts may not result in the timelyintroduction of new FPOA chips or enhancements to existing chips. Successfulchip development and introduction depends on a number of factors including, butnot limited to:

·       accuratechip definition and specification;

·       timelycompletion of the chip design;

·       establishingsuccessful production arrangements with third-party semiconductorfoundries;

·       establishingsuccessful relationships with strategic partners;

·       establishingsuccessful arrangements with third-party packaging companies;

·       timelyand quality chip fabrication;

·       effectivepost-fabrication testing;

·       receiptof United States government funding by us or our customers;

·       thelack of a benchmark to measure the performance difference between an FPGA andour FPOA;

·       achievingacceptable manufacturing yields; and

·       acceptanceof our FPOA chips by our target customers.

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Due to the complexity and precision of our planned FPOAchips and the many variables involved in their design, we may not be able tosuccessfully develop and introduce our existing and planned FPOA chips to themarketplace on a timely basis or at all. We anticipate that we will need tocontinually invest in semiconductor design engineering talent, state-of-the-artengineering tools and related test equipment. Our failure to develop andintroduce new FPOA chips successfully would materially and adversely affect ourbusiness, revenue, financial condition and results of operations.

***Our success depends on our ability to developeffective FPOA design tools, either alone or in alliances with independentelectronic design automation companies, and to have the design tools gainmarket acceptance. Our failure to do so would delay or prevent thecommercialization of our FPOA chips, which would materially harm our business,revenue, financial condition and results of operations.***

As part of the development process for our FPOA chips,our customers must have design tools so they can program, or map, theirintellectual property applications, or algorithms, to our FPOA chips. Workingwith Summit Design, Inc., which was acquired by Mentor GraphicsCorporation in October 2006, we have developed a suite of FPOA-specificdesign tools. To be successful, we must introduce these design tools to themarket and have them accepted by customers or develop other design tools thatwill be accepted either alone, with Mentor Graphics or with other electronicdesign automation companies. Developing new FPOA design tools is a complexprocess, and we will likely experience delays in developing and introducingthem. Successful product development and introduction depends on a number offactors including, but not limited to, accurate tool definition, userdocumentation and specification, timely completion of the design tools andacceptance of our FPOA design tools by our target customers. In addition, theFPOA-specific design tools run only on *Windows®*operating systems and software, which may delay or prevent theiracceptance by our target customers. We may not be able to successfully developand introduce FPOA design tools to the market on a timely basis or at all. Ourfailure to develop and introduce new design tools successfully would materiallyand adversely affect our business, revenue, financial condition and results ofoperations.

***We presently rely on Mentor Graphics Corporation forthe design tools that are used to map our customers’ algorithms to our FPOAs.If Mentor Graphics could not or would not provide these design tools andrelated support services for any reason, further design tool development wouldbe delayed, which would delay the introduction of our FPOAs to the marketplace.***

Our current strategy for developing the FPOA designtools used to program our customers’ intellectual property applications to ourFPOA chips is to form strategic relationships with electronic design automationcompanies, such as Mentor Graphics Corporation, to jointly develop these designtools. Thus, our success will depend on forming and successfully maintainingthese relationships. Mentor Graphics is the only current source for anintegrated design tool software suite that includes our FPOA-specific designtools. If Mentor Graphics was unable or unwilling to provide these design toolsand related support services for any reason, any further design tooldevelopment would be delayed. In addition, our ability to fix any problems thatarise with respect to the design tools would be limited. We probably would haveto identify and enter into a strategic relationship with another electronicdesign automation company to develop a new set of design tools. There is noassurance we could do so at all or under terms that are acceptable to us. Anydelay in our design tool development would result in a delay in introducing ourFPOA chips to the marketplace, which would have an adverse effect on ourbusiness, revenue, financial condition and results of operations.

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***We use a third-party contractor to fabricate thesilicon wafers used in our FPOA chips. If our supply of silicon wafers from thecontractor was interrupted, delayed or terminated for any reason, our business,revenue, financial condition and results of operations would be adverselyaffected.***

We are and intend to remain a fabless semiconductorcompany. We do not intend to invest any funds or resources to build, own oroperate a silicon wafer fabrication facility. We anticipate that all of ourchip fabrication needs will be supplied by independent contractors.

Currently, we are working with Taiwan SemiconductorManufacturing Company, or TSMC, in Taiwan to fabricate the silicon wafers usedin our FPOA chips. We have no formalized contract with or supply or allocationcommitment from TSMC. TSMC’s chip production facilities have at any time afixed capacity, the allocation of which is determined by TSMC and over which wehave no control. As a small customer of TSMC, our production runs may not beassigned the priority given to larger customers of TSMC. Our reliance on TSMCto fabricate our FPOA chips also subjects us to reduced control over deliveryschedules, quality assurance and manufacturing yields and costs. A shortage inTSMC’s capacity, or any interruptions or delays in fabricating the siliconwafers used in our FPOA chips, could hinder our ability to meet any demand forour FPOA chips. To help assure the continued supply of our FPOA chips, we mayengage other companies to fabricate the silicon wafers used in our chips.However, there are only a limited number of foundries that have the capabilityto fabricate these silicon wafers. If we engage other vendors, we may encounterstart-up difficulties and delays and incur additional costs. We may not be ableto engage other chip fabrication vendors at all or under terms that areacceptable or favorable to us.

Also, TSMC is located in Taiwan, which is in an areathat is seismically active and where cyclones occur, and there have beentensions between Taiwan and the Peoples Republic of China. Should there be amajor earthquake, a cyclone or a threatened or actual outbreak of hostilitiesin Taiwan in the future, the production of our chips by TSMC could be disruptedor cease. Such a disruption or cessation in the production of our chips wouldlikely result in our inability to ship our FPOA chips in a timely manner,thereby adversely affecting our business, revenue, financial condition andresults of operations.

***The production of silicon wafers is a complex process,and production yields can be adversely affected by many factors over which wehave no control. A shortage or delay in producing the silicon wafers used inour FPOA chips could have an adverse effect on our business, revenue, financialcondition and results of operations.***

If our FPOA chips gain market acceptance, we will increasinglyrely on favorable production yields and timely delivery of silicon wafers fromour third-party contractor, which currently is TSMC. The fabrication of thesilicon wafers used in our FPOA chips is a highly complex and precise process.Wafer production yields depend on a wide variety of factors. Minute impurities,contaminants in the manufacturing environment, difficulties in the fabricationprocess, defects in the masks used to print the circuit designs onto thesilicon wafers, manufacturing equipment failures, wafer breakage and otherfactors could cause a substantial percentage of the wafers to be nonfunctional.Shortages in the supply of or defects in the silicon wafers used in our FPOAchips could cause us to delay producing, testing and shipping our FPOA chips,which could have an adverse effect on our business, revenue, financialcondition and results of operations.

Difficulties in the chip fabrication process can alsooccur if we begin production of a new product or transition to new processes.We expect that the majority of our existing and planned FPOA chips use and willuse increasingly advanced process geometries in order to achieve higherperformance, lower power consumption and lower production costs. Our FPOA chipsare presently fabricated in 130-nanometer process technology, and weexpect our FPOA chips will be fabricated in 90-nanometer or smallerprocess technologies in the future to remain competitive. If we experiencedelays in the redesign of the FPOA chip or the fabrication of the siliconwafers, it would delay the introduction of our chips to the market, cause us tomiss market opportunities and have an adverse effect on our business, revenue,financial condition and results of operations.

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***We rely on a single-source independent contractorfor our packaging. The disruption or termination of our relationship with thiscontractor could result in a material adverse effect on our business, revenue,financial condition and results of operations.***

The packaging of our FPOA chips is performed by asingle supplier—Siliconware Precision Industries Co. Ltd. (SPIL). Because werely on an independent contractor for our packaging services, we cannotdirectly control delivery schedules or quality levels. The disruption ortermination of this source for any reason could result in, at a minimum, atemporary or a long-term adverse effect on our business, revenue financialcondition and results of operations.

***The semiconductor industry is intensely competitive.Most of our competitors have substantially greater resources than we do, andthere can be no assurance that we will be able to successfully compete in theindustry.***

The semiconductor industry is highly competitive andcharacterized by rapid and disruptive technological change, productobsolescence and heightened international competition. Our ability to competesuccessfully in the industry will depend on our ability to develop, manufactureand sell complex semiconductor components and design tools that offer customersgreater value and higher performance than solutions offered by competingvendors.

Significant competitive factors in the semiconductormarket include, among others, product features, performance, price, timing ofmarket introductions, effectiveness of sales channels, emergence of new computingand networking standards, quality, reliability and customer support. Our FPOAchips may be used in applications now served by vendors of FPGAs, ASICs anddigital signal processors, and we will compete against vendors of theseproducts. Most of these competitors, including Xilinx, Inc. and AlteraCorporation, have greater technical, financial and marketing resources,well-established market positions, name recognition, broader product lines andlonger standing customer relationships than we do. There are multiplemanufacturers of communications and digital signal processing semiconductorchips currently planning or offering products that will compete with the FPOAchips we offer and plan to offer. We may not be able to compete with thesevendors in the targeted applications and densities.

Increased competition would likely adversely affectour financial condition and revenue. Competitors with greater financialresources or broader product lines may have a greater ability to withstandsustained price reductions in their primary markets, retain or regain marketshare and offer lower prices and additional products or services that we cannotoffer. These competitors may be in a stronger position to respond more quicklyto new technologies and to undertake more extensive marketing campaigns.Competitive pressures could reduce or slow market acceptance of our FPOA chipsand result in price reductions, lower gross margins and increased expenses thatcould adversely affect our business, revenue, financial condition and resultsof operations.

***Rapid technological change could cause our FPOA chipsand technology to become obsolete or require us to redesign our FPOA chips,which could have a material adverse effect on our business, revenue, financialcondition and results of operations.***

The rapid rate of change in technology across a widevariety of industries will require us to expend substantial resources in aneffort to develop new FPOA chips that will keep pace with or stay ahead ofthese advancements. We may not be able to anticipate and/or respond totechnological changes in a timely manner, and our response may not result insuccessful product development and timely product introductions. If we areunable to anticipate or respond to technological changes, our business,revenue, financial condition and results of operations could be adverselyaffected.

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***Our ability to compete depends on our ability toprotect our intellectual property, which may not be adequately protected.***

Our ability to compete depends upon our ability toprotect our intellectual property. We rely on a combination of United Statespatents, copyrights, trademarks, trade secret law, employee non-disclosureagreements and work-for-hire and non-disclosure agreements with independentcontractors to protect and enforce our intellectual property rights. As of thedate of this filing, we had been granted two United States patents, and we hadsix patent applications on file with the United States Patent and TrademarkOffice. However, filing a patent application does not mean we will be issued apatent or that any patent eventually issued will be as broad as requested inthe patent application or sufficient to protect our technology. In addition,there are a number of factors that could cause our patents to become invalid orunenforceable or that could cause our patent applications to not be granted,including known or unknown prior art, deficiencies in the patent application orthe lack of originality of the technology. Also, any common law protection ofour intellectual property could be compromised by the fact that we do not haveassignment of inventions agreements with our former employees.

We believe that we currently hold common law trademarkrights in our trademarks *MathStar*, *FPOA* and *ARRIX*, andwe have pending federal trademark applications in the United States for thetrademarks *MathStar*, *FPOA* and *ARRIX*.However, filing a trademark application does not mean that our trademarks willbe registered or protected. We do not have any trademarks registered outsidethe United States, nor do we have any trademark applications pending outsidethe United States. Even if federal registrations are granted to us, ourtrademark rights may be challenged. It is also possible our competitors orothers will adopt trademarks similar to ours, thus impeding our ability tobuild brand identity and possibly leading to customer confusion. We could incursubstantial costs in prosecuting or defending trademark infringement suits. Wecurrently hold one domain name relating to our business, *MathStar.com*,which we believe is important to our brand recognition and overall success. Wemay be unable to acquire other relevant domain names in the United States andin other countries where we conduct or may conduct business. If we are not ableto protect our trademarks or domain name, we may experience difficulties inachieving and maintaining brand recognition and customer loyalty, causing us tolose significant market share. If we lose market share, our business, revenue,financial condition and results of operations may be materially adverselyaffected.

Our patents and patent applications and copyrights,trademarks, trade secret law, employee non-disclosure agreements andwork-for-hire and non-disclosure agreements with independent contractors maynot provide meaningful protection from our competitors because the status ofany patent and other intellectual property rights involves complex legal andfactual questions, and the breadth of claims allowed is uncertain. Ourcompetitors may be able to circumvent our patents and other intellectualproperty rights or develop new patentable technologies that displace ourexisting technology. In addition, and despite our efforts to protect ourproprietary rights from unauthorized use or disclosure, third parties,including our employees, former employees or consultants, may attempt todisclose, obtain or use our proprietary information or technologies without ourauthorization. If other companies obtain our proprietary information ortechnologies or develop substantially equivalent information or technologies,they may develop products that successfully compete against our FPOA chips.

***Our technology has no patent protection outside of theUnited States because we have no non-United States patents, and we do notcurrently plan on applying for non-United States patents. This could result inthe appropriation of our technology outside of the United States, which couldhave an adverse effect on our business, revenue, financial condition andresults of operations.***

We have no patents outside of the United States, andwe do not currently plan on applying for non-United States patents. Thus, ourtechnology does not have patent protection outside of the United States. Thiscould result in the appropriation of our technology outside of the UnitedStates, which could have an 

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adverse effect on ourbusiness, revenue, financial condition and results of operations. The laws ofcertain countries in which our FPOA chips are or may be developed, manufacturedor sold may not protect our technology and intellectual property rights to thesame extent as the laws of the United States. Policing the unauthorized use ofour technology is difficult, may result in significant expense to us and coulddivert the efforts of our technical and management personnel. Even if we spendsignificant resources and efforts to protect our intellectual property, therecan be no assurance that we will be able to prevent the appropriation of ourtechnology. The appropriation and use by others of our proprietary intellectualproperty could materially harm our business, revenue, financial condition andresults of operations.

***We are at risk of intellectual property infringementclaims.***

The semiconductor industry is characterized byfrequent litigation regarding patent and other intellectual property rights. Ifwe prosecute infringement claims against third parties who are infringing orillegally using our intellectual property, or if we defend ourselves or ourlicensees against any similar claims brought by others, it could be costly andtime-consuming to us and would divert the attention of management and keypersonnel from business issues, regardless of the claims’ merit. Due to theanticipated costs involved in filing and conducting an infringement action toprotect our technology, we may decide not to file such an action, which couldresult in another party misappropriating our intellectual property. We couldalso incur substantial costs in interference proceedings declared by the UnitedStates Patent and Trademark Office in connection with any patents or patentapplications or opposition proceedings declared by the United States Patent andTrademark Office in connection with our trademarks.

Although we have filed patent applications and havebeen granted two patents in the United States, we have not conducted, and arenot required to conduct, any search or study regarding the existence of anytechnology on which our technology may infringe before filing a patentapplication. We are required to investigate any patented technology of which wehave knowledge on which our technology may infringe. We have no knowledge ofany such patented technology. However, a patent application is confidentialuntil 18 months after its filing date and, for this reason, and due to thecomplexities of such a search, a search may not discern technology subject topatent applications on which our technology may infringe.

A third party claiming infringement may be able toobtain an injunction or other equitable relief against us and the use of ourtechnology by us or others, which could prevent or inhibit the production orsale of our FPOA chips. If another party bringing a claim of infringementagainst us prevailed, we or our licensees, if any, may be required to obtainone or more licenses from or pay royalties to third parties, which could entailsignificant expense. There can be no assurance that we or our vendors orlicensees would be able to obtain from a third party any required license oftechnology at a reasonable cost or at all, or be able to design commerciallyacceptable non-infringing alternatives. Our failure or the failure of ourvendors or licensees to obtain such a license or develop such alternativescould have a material adverse effect on our business, revenue, financialcondition and results of operations.

***We plan on purchasing intellectual property for thenext versions of our FPOA, and we may not be able to obtain the intellectualproperty we need under terms and conditions that are acceptable to us.***

We developed certain intellectual property (primarilyinput/output blocks) for the current production version of our FPOA chip we areselling. We made the decision to purchase this intellectual property in thefuture, as we believe it will allow us to get future FPOA chips to market morequickly and economically. We have signed contracts to acquire the intellectualproperty we believe we need for the next two versions of our FPOA chips. Theintellectual property for which we have signed contracts is based on industrystandards. However, there is no certainty that the intellectual property wewill acquire under the contracts will be sufficient to produce the chips, thatwe will be able to purchase adequate intellectual property for future versionsof the chip, or that we can acquire the intellectual property we need underterms and pricing we find acceptable.

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***The market for semiconductor chips has beencharacterized by periods of significant fluctuations in demand. Our revenue andfinancial performance will depend on demand for semiconductor chips overall andparticularly those with the performance characteristics of our FPOA chip.***

We are focusing our efforts on the design, marketingand sale of our FPOAs for users of semiconductors. The market for semiconductorchips has been characterized since its inception by significant fluctuations indemand. Beginning in early 2000, the semiconductor industry was significantlyaffected by the economic downturn and contraction in the computing andcommunication equipment markets and has only recently begun to emerge from thisdownturn. During this downturn, semiconductor users significantly reduced oreven suspended purchases of semiconductor chips. This cycle of reduced demandfor semiconductor chips resulted in significant reductions in unit demand,excess customer inventories, price erosion and excess production capacity. Ifdemand for semiconductor chips remains low or declines further and does notincrease, our business, revenue, financial condition and results of operationswould be materially adversely affected.

***We currently rely and we may rely in the future oncontracts, relationships and arrangements between our strategic partners andthe United States government, and we may enter into contracts with the UnitedStates government. Contracts with the United States government involve risks inaddition to normal business risks. If our contracts or our strategic partners’contracts with the United States government were altered or terminated for anyreason, our business, revenue, financial condition and results of operationscould be adversely affected.***

Two of the companies with which we have strategicrelationships—Honeywell International, Inc. and Valley Technologies, Inc.—havecontracts, relationships and arrangements with branches of the United Statesgovernment in which they are using or plan to use our FPOA chips. We may enterinto contracts, relationships and arrangements with branches of the UnitedStates government in the future. In addition to normal business risks,companies engaged in supplying military or other equipment to the United Statesgovernment are subject to additional risks, including dependence onCongressional appropriations and administrative allotment of funds, changes ingovernmental procurement legislation and regulations and other policies thatmay reflect military and political developments, significant changes incontract scheduling, complexity of designs and the speed with which they becomeobsolete, necessity for constant design improvements, intense competition forUnited States government business which requires increases in time and investmentfor design and development, difficulty of forecasting costs and schedules whenbidding on developmental and highly sophisticated technical work and otherfactors characteristic of the industry. Changes are customary over the life ofUnited States government contracts, particularly development contracts, andgenerally result in adjustments of contract prices. Such contracts are subjectto termination by the United States government for the convenience of theUnited States government. We and other companies with which we may formstrategic relationships in the future may enter into similar contracts,relationships and arrangements with the United States government, which wouldexpose us and them to the same risks. If these contracts, relationships and arrangementswith the United States government were altered or terminated for any reason,our business, revenue, financial condition and results of operations could beadversely affected.

***Our success depends on the services of our existingmanagement and upon our ability to attract qualified engineers and othertechnical, management, sales, marketing and financial personnel.***

Our success depends to a significant extent upon thecontinued services of our current management and on our ability to attract,retain and motivate qualified critical employees, including design andapplication engineers, of which there are a limited number. In some of ourfields of operations, there are only a limited number of people in the jobmarket who possess the requisite skills. The competition for such employees isvery intense. Even if we identify and hire qualified employees, there can be noassurance that such employees will remain in our employ. We have had difficultyin finding qualified engineers experienced in the design of high-performancedigital chips. In addition, we may not be able to attract and 

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retain engineers locatedin proximity to our design centers. To employ qualified design and applicationengineers, we may have to establish a presence in other localities, which wouldbe expensive.

We do not have employment or noncompetition agreementswith any of our employees, including members of management, although we havenon-disclosure agreements with them. The loss of the services of one or more ofour executive officers or key employees, or our inability to attract qualifiedpersonnel in the future, could restrict our ability to develop new FPOA chipsor enhance existing FPOA chips in a timely manner, sell our FPOA chips to ourcustomers or manage our business effectively, which would have a materialadverse effect on our business, revenue, financial condition and results ofoperations.

***Douglas M. Pihl owned 7.3% of our outstanding sharesof common stock as of December 31, 2006, which allows him to exertsubstantial influence over our business and management.***

Douglas M. Pihl, who is our chairman, president, chiefexecutive officer and a director, owned 1,352,501 shares individually and177,334 shares jointly with his spouse, which is 7.3% of the outstanding sharesof our common stock as of December 31, 2006. He is our single largeststockholder. Accordingly, he is able to exert significant control over ouraffairs including, but not limited to, the election of directors. As of December 31,2006, Mr. Pihl’s spouse owned individually 2,834 shares of our commonstock and warrants to purchase 137,492 shares, of which Mr. Pihldisclaims any beneficial ownership. Mr. Pihl’s spouse disclaims anybeneficial ownership of shares owned individually by Mr. Pihl. Mr. Pihl’sspouse is a registered representative with the underwriter of our initialpublic offering. Mr. Pihl also disclaims beneficial ownership of 8,001shares of our common stock owned by irrevocable trusts for which he is thegrantor.

***We may encounter difficulties in managing our growthand expanding our operations successfully.***

If we successfully introduce our FPOAs to themarketplace, we will need to expand our development, marketing and salescapabilities. If our operations expand, we expect that we will need to manageadditional relationships with various strategic partners, suppliers,manufacturers’ representatives and other third parties. Our ability to manageour operations and any growth will require us to make appropriate changes andupgrades, as necessary, to our operational, financial and management controls,reporting systems and procedures. Our inability to manage growth could delaythe execution of our business plan or disrupt our operations.

***Changes in accounting principles, including changes inemployee stock option accounting rules, may adversely affect our reportedoperating results and our efforts and success in recruiting and retainingemployees.***

Technology companies, including us, have a history ofusing employee stock programs to hire, incentivize and retain employees in acompetitive marketplace. In December 2004, the Financial AccountingStandards Board, or FASB, adopted SFAS No. 123(R), *Share-Based Payment*, which was effectivefor MathStar on January 1, 2006. SFAS No. 123(R) requirescompanies, including MathStar, to record equity-based compensation expense forstock options and any employee stock purchase plan rights granted to employeesbased on the fair value of the equity instrument at the time of grant. We beganto record these expenses on January 1, 2006. MathStar applied the modifiedprospective method and has not restated prior year results. The actual amountof expense that we recognize will depend on the value of our common stock atthe time of any grants of options and other stock awards to employees. Thechange in accounting rules may lead to an increased loss, if we recognizea net loss, or a decrease in reported earnings, if we have earnings. This couldalso adversely affect our ability to use employee stock plans to attract andreward employees and could result in a competitive disadvantage to us in theemployee marketplace. Our financial results could be adversely affected byother changes in accounting principles by FASB, the American Institute ofCertified Public Accountants, the Securities and Exchange Commission, the SEC,or various other bodies formed to promulgate and interpret accountingprinciples which have not yet been announced or adopted.

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***We are incurring increased costs as a result of beinga public company.***

On October 26, 2005, which was the effective dateof our initial public offering, we became a public company. As a publiccompany, we are incurring significant legal, accounting and other expenses thatwe did not incur as a private company. The Sarbanes-Oxley Act of 2002 and new rules subsequentlyimplemented by the SEC and The NASDAQ Global Market have required changes incorporate governance practices of public companies. We expect these new rules andregulations to increase our legal and financial compliance costs significantly andto make some activities more time consuming and costly. For example, we createdadditional board committees and adopted and implemented policies regardinginternal controls and disclosure controls and procedures. We also are incurringadditional costs associated with our public company reporting requirements. Wehave hired additional accounting and financial staff with appropriate publiccompany experience and technical accounting knowledge. These new rules andregulations are making it more difficult and more expensive for us to obtainand maintain director and officer liability insurance, and we will be requiredto accept reduced policy limits and coverage or incur substantially highercosts to obtain and maintain the same or similar coverage. As a result, it willbe more difficult for us to attract and retain qualified persons to serve onour board of directors or as executive officers.

***Our board of directors may issue and fix the terms ofshares of our preferred stock without stockholder approval, which couldadversely affect the voting power of holders of our common stock or any changein control of MathStar.***

Our board of directors is authorized, withoutstockholder action, to establish various classes or series of preferred stockfrom time to time and to determine the rights, preferences and privileges ofany unissued classes or series including, among other matters, any dividendrights, dividend rates, conversion rights, voting rights, terms of redemption,liquidation preferences, sinking fund terms, the number of shares constitutingany such series and the description thereof, and to issue any such shares. Ourboard of directors may, without stockholder approval, issue shares of a classor series of preferred stock with voting and conversion rights that couldadversely affect the voting power of the holders of the common stock and mayhave the effect of delaying, deferring or preventing a change in control of us.

***We will not pay cash dividends on our common stock inthe foreseeable future.***

We intend to retain any earnings or cash flow tofinance the development of our business. Accordingly, we do not anticipate thepayment of cash dividends on our common stock in the foreseeable future. Wehave not paid any dividends in the past, and we may be restricted or preventedfrom paying cash dividends by loan covenants with any lenders or cash dividendson our common stock by the terms of any preferred stock that we issue.

***An active trading market for our common stock may notbe sustained.***

The market for our stock is thinly traded, and a moreactive trading market for our shares may never develop or be sustained.Further, we cannot be certain that the market price of our common stock willnot decline below the current trading ranges or below the amount required tomaintain a listing on The NASDAQ Global Market. Should we fail to meet theminimum standards established by The NASDAQ Global Market, we could bede-listed, meaning stockholders would be subject to limited liquidity.

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***Our stock price will be volatile, meaning purchasersof our common stock could incur substantial losses.***

Our stock pricewill be volatile. The stock market in general and the market for semiconductorand other technology companies in particular have experienced extremevolatility that has often been unrelated to the operating performance ofparticular companies. As a result of this volatility, investors may not be ableto sell their common stock at or above the price at which they purchased it.The market price for our common stock may be influenced by many factors,including:

·       thefailure of our FPOAs to perform as anticipated;

·       thefailure of our FPOAs to be accepted in the marketplace;

·       delaysin the acceptance of our FPOAs in the marketplace;

·       changesin our relationships with our strategic partners;

·       adverseevents with respect to our strategic partners;

·       disputesconcerning patents or other proprietary rights;

·       ourability to design products to commercial or governmental standards;

·       litigation;

·       thecondition of our balance sheet;

·       thedeparture of key personnel and our inability to replace such personnel in atimely manner;

·       futuresales of our common stock, including shares eligible for sale under Rule 144;

·       variationsin our financial results or those of companies that are perceived to be similarto us;

·       changesin accounting principles;

·       ourfailure to maintain adequate internal control over financial reporting ordisclosure controls and procedures;

·       investors’perceptions of us; or

·       generaleconomic, industry and other market conditions.

***If there are substantial sales of our common stock,our stock price could decline.***

If our existing stockholders sell a large number ofshares of our common stock or the public market perceives that existingstockholders may sell shares of common stock, the market price of our commonstock could decline significantly. All shares are freely tradable without restriction or further registration underthe federal securities laws unless purchased by our “affiliates,” as that termis defined in Rule 144 under the Securities Act of 1933. In addition, on May 23,2006, we filed a Form S-8 registration statement to register2,549,456 additional shares of common stock that were authorized for issuanceunder our stock plans. To the extent these shares are subject to outstandingoptions, after any exercise of the options, the shares can be freely sold inthe public market subject to the restrictions imposed on our affiliates by Rule 144.

***The anti-takeover provisions of the Delaware GeneralCorporation Law, or the DGCL, may delay or prevent transactions that arefavorable to our stockholders.***

As a Delaware corporation,we are subject to provisions of the DGCL regarding “business combinations,” asthat term is defined in the DGCL. Our directors’ ability to issue and fix theterms of our undesignated preferred stock without stockholder approval could beused as an anti-takeover measure. We may, in the future, consider adoptingadditional anti-takeover measures. The anti-takeover provisions of 

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theDGCL, as well as any future anti-takeover measures adopted by us, may, incertain circumstances, delay, deter or prevent takeover attempts and otherchanges in control of the company not approved by our board of directors. As aresult, our stockholders may lose opportunities to dispose of their shares atfavorable prices generally available in takeover attempts or that may beavailable under a merger proposal, and the market price, voting and otherrights of the holders of common stock may also be affected. See “Description ofOur Securities.”

**Item 1B.**               UnresolvedStaff Comments

None

**Item 2.**                        Properties

Our headquarters arelocated in Hillsboro, Oregon, near Portland, in approximately 11,900 squarefeet of leased space under a lease expiring on February 28, 2011. Until March 2006,our principal office was located at 5900 Green Oak Drive, Minnetonka, Minnesotain 60,000 square feet of space. The lease for this location expires on April 30,2007, and we have given notice of our intent to vacate this  facility at the end of the initial lease termand move to a yet to be determined location in the Twin Cities area. We alsolease office space in San Jose, California and Dallas, Texas. The San Joseoffice is approximately 357 square feet, and the lease expires in August 31,2007. The Dallas office is approximately 300 square feet, and the lease expireson July 31, 2007. After leaving the Green Oak Drive facility, rents underall of the leases will average approximately $24,000 per month. In March 2006,we relocated our corporate headquarters to the Hillsboro, Oregon facility. Weconsider our leased facilities to be adequate for the foreseeable future.

**Item 3.**                        LegalProceedings

We are currently not aparty to any legal proceedings.

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

No matters were submittedto a vote of our stockholders during the fourth quarter ended December 31,2006.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

(a)   Since October 27,2005, our common stock has been listed on The Nasdaq Global Market under thesymbol “MATH.”  Before October 27, 2005, there was no public marketfor our common stock. The following table shows the high and low sales pricesfor our common stock as reported on The Nasdaq Global Market for the periodsindicated. As of March 9, 2007, there were 20,931,890 shares of our commonstock issued and outstanding. 

| ** **                                        | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------------|------------|----------|------------|---------|------------|
| Year ended  December 31, 2005                |       |     |       |    |       |
| Fourth quarter  (beginning October 27, 2005) |       | $        | 6.12       |    | $          | 5.64 |   |
| Year ended  December 31, 2006                |       |     |       |    |       |
| First quarter (through  March 31, 2006)      |       | $        | 5.75       |    | $          | 4.62 |   |
| Second quarter (through  June 30, 2006)      |       | $        | 6.38       |    | $          | 4.70 |   |
| Third quarter (through  September 30, 2006)  |       | $        | 6.00       |    | $          | 4.37 |   |
| Fourth quarter (through  December 31, 2006)  |       | $        | 4.60       |    | $          | 3.74 |   |

 

We have never declared or paid cash dividends on ourcommon stock. We currently intend to retain our cash for the development of ourbusiness. We do not intend to pay cash dividends to our stockholders in theforeseeable future.

Any future determination relating to our dividendpolicy will be made at the discretion of our board of directors and will dependupon then existing conditions, including our financial condition, results ofoperations, any contractual restrictions on the payment of dividends, capitalrequirements, business prospects and other factors our board of directors maydeem relevant.

The number of stockholders of record at March 9,2007 was approximately 3,000.

(b)          Not applicable.

(c)           Not applicable.

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**Performance Graph**

The following graphcompares the return of MathStar, Inc.’s stock performance compared to theNASDAQ and SOXX indices for the dates of October 27, 2005 (MathStar’sinitial public offering), December 31, 2005 and December 31, 2006.The graph is based on the assumption that you invested $100 in MathStar, Incand each index. The selection of each index is appropriate given MathStar, Incis traded on the NASDAQ exchange and SOXX is the Philadelphia SemiconductorSector Index and therefore represents the performance of competitor companies.

****

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**Item 6.**                        SelectedFinancial Data

Theselected financial data below should be read in conjunction with “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operation” andthe financial statements and notes thereto included elsewhere in this report.

| ** **                                                               | ** ** | **Year ended December 31**                             | ** ** | **Period from   Inception   (April 14, 1997)  to December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2002**                                                              | ** ** | **2003**                                                                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2006** | ** ** |
| ** **                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Statement of Operations Data:**                                        | ** ** | ** **                                                            | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |
| Net revenue                                                              |       | $                                                                     | 17         |                                                                                               | $          | 50 |   | $ | 130 |   | $ | 134 |   | $ | 53 |   |   | $ | 933 |   |   |
| Cost of sales                                                            |       | —                                                                |       | —                                                                                             |       | 53 |   | 52 |   | 126 |   |   | 231 |   |   |
| Gross profit                                                             |       | 17                                                                    |       | 50                                                                                                 |       | 77 |   | 82 |   | (73 | ) |   | 702 |   |   |
| Operating expenses:                                                      |       |                                                                  |       |                                                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                                                 |       | 2,906                                                                 |       | 7,286                                                                                              |       | 4,830 |   | 8,228 |   | 14,090 |   |   | 42,038 |   |   |
| Selling, general and  administrative                                     |       | 3,374                                                                 |       | 3,838                                                                                              |       | 4,053 |   | 6,564 |   | 9,133 |   |   | 30,426 |   |   |
| Total operating expenses                                                 |       | 6,280                                                                 |       | 11,124                                                                                             |       | 8,883 |   | 14,792 |   | 23,223 |   |   | 72,464 |   |   |
| Loss from operations                                                     |       | (6,263                                                                | )          | (11,074                                                                                            | )          | (8,806 | ) | (14,710 | ) | (23,296 | ) |   | (71,762 | ) |   |
| Other income  (expense)(2)                                               |       | 82                                                                    |       | 47                                                                                                 |       | 57 |   | (4,225 | ) | 653 |   |   | (2,501 | ) |   |
| Loss from continuing  operations                                         |       | (6,181                                                                | )          | (11,027                                                                                            | )          | (8,749 | ) | (18,935 | ) | (22,643 | ) |   | (74,263 | ) |   |
| Loss from discontinued  operations(1)                                    |       | (23,528                                                               | )          | —                                                                                             |       | — |   | — |   | — |   |   | (31,874 | ) |   |
| Net loss                                                                 |       | $                                                                     | (29,709    | )                                                                                                  | $          | (11,027 | ) | $ | (8,749 | ) | $ | (18,935 | ) | $ | (22,643 | ) |   | $ | (106,137 | ) |   |
| Basic and diluted loss  per share—continuing operations             |       | $                                                                     | (0.94      | )                                                                                                  | $          | (1.56 | ) | $ | (0.95 | ) | $ | (1.56 | ) | $ | (1.26 | ) |   |   |   |   |
| Basic and diluted loss  per share—discontinued operations           |       | $                                                                     | (3.59      | )                                                                                                  | $          | (— | ) | $ | — |   | $ | — |   | $ | — |   |   |   |   |   |
| Basic and diluted net  loss per share                                    |       | $                                                                     | (4.53      | )                                                                                                  | $          | (1.56 | ) | $ | (0.95 | ) | $ | (1.56 | ) | $ | (1.26 | ) |   |   |   |   |
| Weighted average number  of common shares outstanding, basic and diluted |       | 6,551                                                                 |       | 7,048                                                                                              |       | 9,209 |   | 12,121 |   | 18,001 |   |   |   |   |   |
| ** **                                                               | ** ** | **As of December 31**                                       | ** ** |                                                                                               | ** ** | ** ** |   |
| ** **                                                               | ** ** | **2002**                                                              | ** ** | **2003**                                                                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |   | ** ** | ** ** |   |
| **Balance Sheet Data:**                                                  | ** ** | ** **                                                            | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |
| Cash and cash equivalents                                                |       | $                                                                     | 4,773      |                                                                                               | $          | 2,805 |   | $ | 4,132 |   | $ | 20,149 |   | $ | 12,891 |   |   |   |   |   |
| Working Capital                                                          |       | 4,469                                                                 |       | 1,809                                                                                              |       | 3,904 |   | 19,676 |   | 11,852 |   |   |   |   |   |
| Total assets                                                             |       | 5,846                                                                 |       | 3,244                                                                                              |       | 4,504 |   | 22,202 |   | 15,614 |   |   |   |   |   |
| Total liabilities                                                        |       | 724                                                                   |       | 1,152                                                                                              |       | 487 |   | 2,028 |   | 2,997 |   |   |   |   |   |
| Deficit accumulated  during development stage                            |       | (44,783                                                               | )          | (55,810                                                                                            | )          | (64,559 | ) | (83,494 | ) | (106,137 | ) |   |   |   |   |
| Total stockholders’  equity                                         |       | 5,122                                                                 |       | 2,092                                                                                              |       | 4,017 |   | 20,174 |   | 12,617 |   |   |   |   |   |

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(1)          Our acquisition ofDigital MediaCom, Inc. in August 2001 resulted in a new and separateoperating segment, the physical media device, or PMD, segment. In August 2002,due to events and changes in circumstances, which included a severe downturn inthe market for the acquired in process PMD 

19

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development projects. Wecommitted to a plan to sell the PMD operating segment, which was comprised ofthe acquired Digital MediaCom operations. Accordingly, we tested the PMD assetsfor impairment and recorded a $13,306 goodwill impairment. This amount wasincluded in the $23,528 loss from discontinued operations in 2002. On November 15,2002, we sold or disposed of the assets of our PMD operating segment, includingall of the valuable technology, property and equipment, licensed software andemployees, for $1,752 in cash and the assumption by the buyer of $187 inliabilities. There was no gain or loss on the sale because the assets of thePMD operating segment were written down to their estimated net realizable valuein August 2002.

(2)          Otherexpenses for year 2005 of $4,225 included $4,395 of interest expense associatedwith the convertible notes issued April 2005 (which included theamortization of discount recorded for the value of the beneficial conversionfeature and the warrants issued to the note holders and interest costs). Thisexpense was partially offset by interest income of $170. Other income disclosedin years 2002, 2003, 2004 and 2006 is interest income earned on positive cashbalances.

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**Business Overview**

We are a development stage fabless semiconductor companyengaged in the development, marketing and selling of our high-performance,programmable platform chips and design tools required to program our chips. Wehave sold and shipped a limited quantity of our first production FPOA chip andprovided an early release of our design tools to a limited number of customers.To date, we have recognized only nominal revenue from chip sales, researchservices provided under grants from governmental agencies, engineering servicesand development kits.

We were incorporated in April 1997. In August 2001,we acquired Digital MediaCom, Inc. and began a new and separate operatingsegment, the physical media dependent, or PMD, segment. The primary businessobjective of the PMD segment was to develop in-process technology in high-speedserial interface chips for the 10 gigabit Ethernet market. In August 2002,we decided to cease operations of the PMD segment because of a severe downturnin the market for 10 gigabit Ethernet products. On November 15, 2002, wesold or disposed of the assets of our PMD operating segment, including all ofthe valuable technology, property and equipment, licensed software andemployees, for $1,752,000 in cash and the buyer’s assumption of $187,000 ofliabilities. The results of operations of the PMD segment are reported asdiscontinued operations in the cumulative period from inception (April 14,1997) through December 31, 2006.

In January 2002, wedecided to cease the development of the fixed-function chips that had been thegoal of our research and development efforts until then and to switch to thedevelopment of a family of programmable platform chips. In November 2003,we initiated the fabrication of the first version of our FPOA chip with TaiwanSemiconductor Manufacturing Company, or TSMC, our chip fabrication contractor.In March 2004, TSMC delivered to us the first working silicon of thatchip. Since that time, we have been principally engaged in further developmentsof our FPOA products and in marketing and selling our first FPOA chip to a limitednumber of customers. Although there can be no assurance, we expect broadermarket acceptance of our FPOA chip in 2007 with chip revenue becoming a largerpercentage of our revenue.

**FinancialOperations Overview**

From inception through December 31,2006, we had gross revenues of $933,000, a loss from continuing operations of$74,263,000, and a loss from our discontinued PMD operations of $31,874,000. AtDecember 31, 2006, we had federal and state income tax net operating losscarryforwards of approximately $84,361,000. The operating loss carryforwardswill expire in the calendar years from 2014 to 2026. At 

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December 31,2006, we had federal and state research credit carryforwards of approximately$3,330,000. The research credit carryforwards will expire in the calendar yearsfrom 2014 to 2026. Under the Internal Revenue Code of 1986, the utilization ofthese net operating loss and research credit carryforwards may be limited as aresult of significant changes in our ownership.

***Research and Development***

Research and developmentexpenses represent costs incurred for designing and engineering our FPOA chipand developing design tools and applications to enable customers to more easilyprogram our chip. Research and development expenses consist primarily of salariesand related costs of our engineering organization, fees paid to third partyconsultants and an allocation of facilities and depreciation expenses. Weexpense all research and development costs related to the development of ourFPOA. Development of certain design tools and applications include thedevelopment of software. Such research and development expenses are required tobe expensed until the technological feasibility of the software is established.We determine technological feasibility based upon completion of a working modelof the software. To date, the period between technological feasibility andgeneral release of the software has been short, so virtually all of oursoftware development costs relate to software development during the period beforetechnological feasibility. Accordingly, all such costs have been charged tooperations as incurred. We expect to incur significant additional research anddevelopment costs as we develop more chips using our FPOA technology.

***Selling, General and Administrative Expenses***

Selling, general andadministrative expenses consist primarily of salaries and related costs of oursales and marketing and administrative staff, commissions paid to direct salesstaff and manufacturing representatives, general corporate activities and anallocation of facilities and depreciation expenses. We anticipate that ourselling, general and administrative costs will increase as a result ofincreasing our sales and marketing and administrative staff  and commissions to support sales of FPOAchips in worldwide markets and to support our growth and operation as a publiccompany.

**Critical AccountingPolicies and Significant Judgments and Estimates**

Our management’sdiscussion and analysis of our financial condition and results of operationsare based on our financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States of America.The preparation of these financial statements requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements as well as the reported revenues and expensesduring the reporting periods. On an ongoing basis, we evaluate our judgmentsrelated to accounting estimates. We base our estimates on historical experienceand on various other factors that we believe are reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily apparent fromother sources. Actual results may differ from these estimates under differentassumptions or conditions.

***Revenue Recognition***

We have generated limited revenues since ourinception. Revenue before 2002 resulted from contractual research and developmentservices and was recognized as the services were performed. Customer paymentsreceived in advance of providing services were recorded as customer deposits.Costs related to this revenue consisted primarily of salary and relatedbenefits of certain employees and were included in research and developmentexpenses.

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Revenue during 2002through 2004 resulted primarily from the sale of prototype products, productdevelopment kits and a limited number of evaluation chips. We recognize revenuefor these products when:

·       persuasiveevidence of an arrangement exists;

·       deliveryhas occurred;

·       thesales price is fixed or determinable;

·       collectibilityis reasonably assured; and

·       thereare no post-delivery obligations.

During 2005, revenue also resulted from contractualresearch and development services that was recognized as the services wereperformed. Costs related to these revenues consisted primarily of salary andrelated benefits of certain employees and were included in cost of sales.

During 2004 and 2005, we made marketing supportpayments to one customer. Such payments are reported as a reduction of revenuein accordance with Emerging Issues Task Force, or EITF, Issue 01-09, *Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products).*No suchpayments were made in 2006*.*

During 2006, revenueresulted from the sale of test and evaluation units, design tools and a limitednumber of engineering samples of our production chips. Costs associated withrevenue consisted of the manufacturing costs of the evaluation units and chips,software license expense and a non-cash excess and obsolete inventory reservecharge.

***Accounts Receivable***

Accounts receivable areinitially recorded at invoice value upon the shipment of products or servicesto customers. They are stated net of allowances for uncollectible accounts,which represent estimated losses resulting from the inability of customers tomake the required payments. When determining the allowances for uncollectibleaccounts, we take several factors into consideration, including our priorhistory of accounts receivable write-offs, the type of customer and ourknowledge of specific customers. To date, we have not had any accountwrite-offs, nor have we recorded an allowance for bad debts.

***Inventory***

Inventory is valued at the lower of cost or market andheld as an asset until such time as it is consumed or sold. Inventory isconsumed on a first in, first out basis. On a quarterly basis, managementreviews the inventory balance for inventory that is not forecasted to be usedin the normal course of business. A reserve will be established for any amountdeemed excessive or obsolete. This will result in a non-cash charge to cost ofsales. If and when the inventory is written off, the inventory reduction isoffset against the reserve. If the level of future sales differs significantlyfrom that of the forecast, any future inventory write-off could result inadditional charges to the income statement.

***Stock-Based Compensation***

On January 1, 2006, the Company adopted  SFAS No. 123(R), *Share-based payment*,  using the modified prospective transitionmethod. Under the transition method, compensation costs recognized in 2006include compensation costs for share-based payments granted prior to, but notvested as of January 1, 2006 based on the grant date fair value estimatedin accordance with the provisions of SFAS No. 123, *Accounting for Stock-based Compensation,*andcompensation costs for all share-based payments granted subsequent to January 1,2006 based on the grant date fair value estimated in accordance with SFAS No. 123(R).Prior to the Company’s initial public offering in October 2005 and inaccordance with SFAS 

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No. 123, *Accounting for Stock-Based Compensation*,the Company had elected to account for stock-based compensation to employeesusing the intrinsic value method prescribed in Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations. Accordingly,compensation cost for stock options granted to employees was measured as theexcess, if any, of the fair value of the Company’s stock at the date of thegrant over the amount an employee must pay to acquire the stock.

The Company accounts for restricted stock byamortizing the grant date fair value over the vesting period.

The Company accounts for stock-based compensation tononemployees using the fair value method prescribed by SFAS No. 123.Compensation cost for stock options granted to nonemployees is measured basedon the fair value of the option at the date of grant with the unvested portionrevalued at each balance sheet date. Compensation costs, if any, are amortizedover the underlying option vesting terms.

The application of SFAS No. 123(R) includesthe use of a number of estimates to compute the fair value of options granted.Such estimates include the use of an appropriate valuation model, andassumptions including stock price volatility, expected terms and forfeiturerates. Changes in such assumptions could have a material impact of thefinancial statements.

***Income Taxes***

We account for incometaxes in accordance with SFAS No. 109, *Accountingfor Income Taxes*. The asset and liability approach of SFAS No. 109requires the recognition of deferred tax assets and liabilities for the taxconsequences of temporary differences between the tax bases of assets andliabilities and their carrying amounts for financial reporting purposes usingenacted tax rates in effect for the years in which the differences are expectedto reverse. We have recorded a valuation allowance to offset our net deferredtax assets based upon our history of generating losses and the relateduncertainty about our ability to generate sufficient taxable income to realizethese benefits.

**Recently IssuedAccounting Pronouncements**

See Note 2 of Notes toConsolidated Financial Statements included in Part II, Item 8 of thisAnnual Report on Form 10-K.

**Results ofOperations**

***Years ended December 31, 2005 and 2006***

*Revenueand Cost of Sales.**  *Werecognized revenue for the year ended December 31, 2006 of $53,000compared to $134,000 for the year ended December 31, 2005. Revenue in 2005consisted of $59,000 generated from the sale of development kits and $75,000from non-recurring engineering services. Revenue in 2006 consisted of $43,000from the sale of evaluation units, $5,000 from the sale of product and $5,000in other related sales. Cost of sales was $52,000 and $126,000 for the yearsended December 31, 2005 and 2006 respectively. Cost of sales for 2005consisted of third party software licenses and certain salaries and benefitsdirectly related to the delivery of engineering services. Cost of sales for2006 included the associated costs of the evaluation units, $23,000; productcosts, $1,000; other costs associated with sales, $10,000; and a $92,000noncash charge associated with the excess and obsolete inventory reserve.

*Researchand Development.**  *Researchand development costs increased 71% or $5,862,000 to $14,090,000 for the yearended December 31, 2006 compared to $8,228,000 for the year ended December 31,2005. The $5,862,000 increase was the result of increased payroll costs of$1,592,000 (of which $297,000 were non-cash charges associated with expensingof restricted stock and stock options), contract engineering costs of $760,000,engineering material costs of $1,655,000 associated with the 

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production of the Heracleschip and future generation intellectual property purchases, building rent of$1,046,000, development of internal test boards of $200,000, recruiting fees of$145,000, design software usage of $300,000 and equipment rentals of $65,000.

*Selling,General and Administrative.**  *Selling, general and administrative costs increased39% or $2,569,000 from $6,564,000 for the year ended December 31, 2005 to$9,133,000 for the year ended December 31, 2006. The $2,569,000 increasewas the result of increased compensation costs of $2,659,000, of which$2,366,000 were non-cash expense related to stock options and restricted stockawards, and $862,000 associated with building the selling, general andadministrative infrastructure and increased costs associated with being apublic company. These increased costs include legal fees, independent auditorfees, consultants hired to assist in compliance with the Sarbanes-Oxleycompliance costs, travel, insurance, printing and transfer agent costs. Theseexpenses were partially offset by a $952,000 reduction in rent expense, whichwas allocated to research and development following a change in the primary useof the Minnesota facility.

*Other Income (Expense).**  *Other income for the year ended December 31,2006 of $653,000 consisted of interest income on invested cash balances. Forthe year ended December 31, 2005, other expenses included $4,395,000 ofinterest expense associated with the convertible notes issued in April 2005(which included the amortization of discount recorded for the value of the beneficialconversion feature and the warrants issued to the note holders and interestcosts). This interest expense is partially offset by interest income oninvested cash balances of $170,000.

***Years ended December 31, 2004 and 2005***

*Revenueand Cost of Sales.**  *Werecognized revenue for the year ended December 31, 2005 of $134,000compared to $130,000 for the year ended December 31, 2004. Revenue in 2004consisted of revenues generated from the sale of product development kits.Revenue in 2005 consisted of $59,000 generated from the sale of developmentkits and $75,000 from non-recurring engineering services. Cost of sales was$53,000 and $52,000 for the years ended December 31, 2004 and 2005. Costof sales for both years consisted of the cost of third party software licensesand certain salaries and benefits directly related to the delivery ofengineering services.

*Researchand Development.**  *Researchand development costs increased 70% or $3,398,000 to $8,228,000 for the yearended December 31, 2005 compared to $4,830,000 for the year ended December 31,2004. The $3,398,000 increase was the result of increased payroll costs($960,000), contract engineering costs ($1,890,000) and material costs($548,000). The increase in research and development costs is primarily due toengineering costs associated with the design changes needed to commercializeour FPOA technology.

*Selling,General and Administrative.**  *Selling, general and administrative costs increased62% or $2,511,000 from $4,053,000 for the year ended December 31, 2004 to$6,564,000 for the year ended December 31, 2005. The $2,511,000 increasewas the result of increased compensation costs of $1,534,000, of which $651,000was non-cash expense related to stock options and restricted stock awards, andthe remaining increase was primarily costs associated with building theselling, general and administrative infrastructure and increased costs associatedwith being a public company of $977,000. These increased costs include legalfees, independent auditor fees, travel, insurance, printing and transfer agentcosts.

*Other Income (Expense).**  *For the year ended December 31,2005, other expense of $4,225,000 included $4,395,000 of interest expenseassociated with the convertible notes issued in April 2005 (which includedthe amortization of discount recorded for the value of the beneficial conversionfeature and the warrants issued to the note holders and interest costs). Thisinterest expense is partially offset by interest income on invested cashbalances of $170,000. Other income for the year ended December 31, 2004 of$57,000 consisted of interest income on invested cash balances.

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**Liquidity andCapital Resources**

Since inception on April 14, 1997, we have fundedour cash flow needs principally through sales of our common stock, rights topurchase our common stock and 8% convertible promissory notes. During theperiod from April 14, 1997 to December 31, 2006, we raised netproceeds of $83,012,000 from sales of common stock and common stock warrants,$5,200,000 from sales of 8% convertible promissory notes and common stockwarrants, $3,420,000 from the exercise of warrants, and $81,000 from theexercise of options. During 2005, we received net proceeds of $24,633,000 inour initial public offering, $5,200,000 of net proceeds from the sale of 8%convertible promissory notes that were converted into common stock, and$235,000 from the exercise of 101,358 warrants. During 2006, we received$11,661,000 of net proceeds in a private placement of our common stock andwarrants to purchase common stock, $512,000 from the exercise of 253,967 warrantsand $80,000 from the exercise of 91,065 options.

Our sales and marketing infrastructure as well as theadministrative support to commercialize our FPOA technology are substantiallyin place. We will continue to add additional sales personnel to increase ourpresence in the market. Our first chip for mass production has been qualifiedand is available for sale. Going forward, our results of operations will dependupon how long it takes and how successful we are in achieving market acceptanceof our FPOA technology.

Our future capitalrequirements will depend on many factors, including our sales growth, marketacceptance of our existing and new FPOA chips, the amount and timing of ourresearch and development expenditures, the timing of our introduction of newchips, the expansion of our sales and marketing efforts and working capitalneeds. We believe that our cash on hand, combined with our existing capitalresources, will be sufficient to meet our capital and operating needs for atleast six months. We anticipate seeking additional financing during the firsthalf of 2007. Our long-term financing requirements will depend significantly onour ability to penetrate the market with our FPOA chip technology. Ifadditional funds are raised through the issuance of debt or equity securities,these securities may have rights senior to those associated with our commonstock, and they could contain covenants that would restrict our operations. Ifwe are unable to obtain additional financing or successfully market ourproducts on a timely basis, we would have to slow our product development andmarketing efforts and may be unable to continue our operations.

***Net Cash Used in Operating Activities***

Net cash used in operatingactivities was $9,311,000, $13,740,000 and $18,922,000 for the years endedDecember 31, 2004, 2005 and 2006, respectively. Net cash used foroperating activities for the years ended December 31, 2004 and 2005 was tofund our on-going research and development activities and our selling, generaland administrative costs. Net cash used for operating activities for the yearended December 31, 2006 was to fund on-going research and developmentactivities and restructure and grow the sales, marketing and administrativeorganization in order to begin the commercialization of our FPOA technology andoperate as a publicly-traded company.

***Net Cash Provided (Used) by Investing Activities***

For the years ended December 31,2004, 2005 and 2006, cash used in investing activities was $13,000, $312,000and $519,000 respectively. For years ending December 31, 2004 and 2005,cash used in investing activities was for the purchase of property andequipment, consisting primarily of acquisitions of computers and officeequipment to develop and support our operations. Net cash used in 2006 was usedto continue the development of our infrastructure and lab equipment used toqualify our FPOA chips and for restricted cash. We expect our capitalexpenditures in 2007 to be approximately $1,000,000.

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***Net Cash Provided by Financing Activities***

Net cash provided byfinancing activities was $10,651,000, $30,068,000 and $12,253,000 for the yearsended December 31, 2004, 2005 and 2006. For all of these periods,financing cash flows consist of the proceeds from the issuance of common stockand warrants for the purchase of common stock, the exercise of common stockwarrants and the exercise of stock options. In addition, during the year ended December 31,2005, we issued $5,500,000 of 8% convertible promissory notes (of which$5,416,000 principal and accrued interest were converted to common stock in December 2005)and related common stock warrants.

***Contractual Cash Obligations***

Thefollowing tables show the future payments that we are obligated to make basedon agreements in place as of December 31, 2006 (in thousands): 

| ** **            | ** ** | **Due in the Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2007**                                                             | ** ** | **2008**   | ** ** | **2009**   | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Operating leases      |       | $                                                                    | 632        |       | $          | 267        |       | $ | 275 |   | $ | 283 |   |   | $ | 47 |   |   |   | $ | — |   |   | $ | 1,504 |   |
| Purchase  obligations |       | 4,273                                                                |       | —     |       | —     |       | — |   |   | — |   |   |   | — |   |   | 4,273 |   |
| Total                 |       | $                                                                    | 4,905      |       | $          | 267        |       | $ | 275 |   | $ | 283 |   |   | $ | 47 |   |   |   | $ | — |   |   | $ | 5,777 |   |

 

**Off-Balance SheetArrangements**

We do not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. Inaddition, we do not engage in trading activities involving non exchange tradedcontracts. As such, we are not materially exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in theserelationships.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

Our exposure to marketrisk is confined to our cash equivalents. We have invested in high-qualityfinancial instruments, primarily money market funds, federal agency notes andasset-backed securities, which we believe are subject to limited credit risks.The effective duration of the portfolio is less than three months, and noindividual investment has an effective duration in excess of one year. Wecurrently do not hedge interest rate exposure. Due to the short-term nature ofour investments, we do not believe we have any material exposure to interest raterisk arising from our investments.

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**Item 8.**                        FinancialStatements and Supplementary Data

Unauditedquarterly financial data for each of the eight quarters in the two-year periodended December 31, 2006 is as follows (the numbers in the table may notadd up due to rounding): 

| ** **                                            | ** ** | **Three Months Ended**                                      | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                            | ** ** | **March 31**                                                     | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **2005**                                              | ** ** |                                                                  | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                           |       |                                                                  | $          | 15 |   |   | $ | 25 |   | $ | 15 |   | $ | 79 |   |
| Cost of sales                                         |       |                                                                  | 7          |   |   | 8 |   | — |   | 37 |   |
| Gross profit                                          |       |                                                                  | 8          |   |   | 17 |   | 15 |   | 42 |   |
| Operating expenses:                                   |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Research and development                              |       |                                                                  | 2,448      |   |   | 1,884 |   | 1,693 |   | 2,203 |   |
| Selling, general and administrative                   |       |                                                                  | 1,147      |   |   | 1,557 |   | 1,632 |   | 2,228 |   |
| Total operating expenses                              |       |                                                                  | 3,595      |   |   | 3,441 |   | 3,325 |   | 4,431 |   |
| Loss from  operations                                 |       |                                                                  | (3,587     | ) |   | (3,424 | ) | (3,310 | ) | (4,389 | ) |
| Other income  (expense)                               |       |                                                                  | 7          |   |   | (476 | ) | (893 | ) | (2,863 | ) |
| Net loss                                              |       |                                                                  | $          | (3,580 | ) |   | $ | (3,900 | ) | $ | (4,203 | ) | $ | (7,252 | ) |
| Basic and diluted  net loss per share                 |       |                                                                  | $          | (0.32 | ) |   | $ | (0.35 | ) | $ | (0.37 | ) | $ | (0.49 | ) |
| Weighted average  number of common shares outstanding |       |                                                                  | 11,155     |   |   | 11,192 |   | 11,233 |   | 14,870 |   |
| **2006**                                              | ** ** |                                                                  | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                           |       |                                                                  | $          | 8 |   |   | $ | 10 |   | $ | 28 |   | $ | 7 |   |
| Cost of sales                                         |       |                                                                  | 2          |   |   | 5 |   | 21 |   | 98 |   |
| Gross profit                                          |       |                                                                  | 6          |   |   | 5 |   | 7 |   | (91 | ) |
| Operating expenses:                                   |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Research and development                              |       |                                                                  | 2,826      |   |   | 3,200 |   | 4,267 |   | 3,797 |   |
| Selling, general and  administrative                  |       |                                                                  | 2,202      |   |   | 2,348 |   | 2,581 |   | 2,002 |   |
| Total operating expenses                              |       |                                                                  | 5,028      |   |   | 5,548 |   | 6,848 |   | 5,799 |   |
| Loss from  operations                                 |       |                                                                  | (5,022     | ) |   | (5,543 | ) | (6,841 | ) | (5,890 | ) |
| Other income  (expense)                               |       |                                                                  | 190        |   |   | 160 |   | 112 |   | 191 |   |
| Net loss                                              |       |                                                                  | $          | (4,832 | ) |   | $ | (5,383 | ) | $ | (6,729 | ) | $ | (5,699 | ) |
| Basic and diluted  net loss per share                 |       |                                                                  | $          | (0.28 | ) |   | $ | (0.31 | ) | $ | (0.39 | ) | $ | (0.28 | ) |
| Weighted average number  of common shares outstanding |       |                                                                  | 16,972     |   |   | 17,104 |   | 17,259 |   | 20,678 |   |

 

27

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors and Stockholders of MathStar, Inc.:

We have completed anintegrated audit of MathStar, Inc’s December 31, 2006 consolidatedfinancial statements and of its internal control over financial reporting as ofDecember 31, 2006 and audits of the 2005 and 2004 consolidated financialstatements in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

*Consolidated financial statements*

In our opinion, the accompanying consolidated balancesheets and the related consolidated statements of operations, changes instockholders’ equity and cash flows present fairly, in all material respects,the financial position of MathStar, Inc. (a development stage company) andits subsidiary (the “Company”) at December 31, 2006 and 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2006 and, cumulatively, for the period from April 14,1997 (date of inception) to December 31, 2006 in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

As discussed in note 2 of the financial statements,the Company changed the manner in which it accounts for stock-basedcompensation in 2006.

The accompanying financialstatements have been prepared assuming that the Company will continue as agoing concern. As discussed in Note 1 to the financial statements, the Companyhas incurred recurring losses and negative cash flows from operations and willrequire additional funding to continue its operations. These matters raisesubstantial doubt about the Company’s ability to continue as a going concern.Management’s plans in regard to these matters are also described in Note 1. Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control Over Financial Reportingappearing under Item 9A , that the Company maintained effective internalcontrol over financial reporting as of December 31, 2006 based on criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), is fairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by the COSO. The Company’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting. Ourresponsibility is to express opinions on management’s assessment and on theeffectiveness of the Company’s internal control over financial reporting basedon our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit 

28

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to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. An audit of internal control overfinancial reporting includes obtaining an understanding of internal controlover financial reporting, evaluating management’s assessment, testing andevaluating the design and operating effectiveness of internal control, andperforming such other procedures as we consider necessary in the circumstances.We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

PricewaterhouseCoopers LLPPortland, ORMarch 13, 2007

29

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**MathStar, Inc.(A development stage company)Balance Sheets**
|                                                                                                                                                             | ** ** | **December 31**                                              | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2005**                                                          | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                  | ** ** | **(in thousands, except  per share amounts)** | ** ** |
| **Assets**                                                                                                                                                  |       |                                                              |       |   |   |
| Current assets                                                                                                                                              |       |                                                              |       |   |   |
| Cash and cash equivalents                                                                                                                                   |       | $                                                                 | 20,149     |   | $ | 12,891 |   |
| Restricted cash                                                                                                                                             |       | —                                                            |       | 103 |   |
| Accounts receivable                                                                                                                                         |       | 75                                                                |       | 14 |   |
| Inventory                                                                                                                                                   |       | 336                                                               |       | 610 |   |
| Prepaid expenses and other current assets                                                                                                                   |       | 1,144                                                             |       | 1,231 |   |
| Total current assets                                                                                                                                        |       | 21,704                                                            |       | 14,849 |   |
| Property and  equipment, net                                                                                                                                |       | 347                                                               |       | 621 |   |
| Other assets                                                                                                                                                |       | 151                                                               |       | 144 |   |
| Total assets                                                                                                                                                |       | $                                                                 | 22,202     |   | $ | 15,614 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                              |       |                                                              |       |   |   |
| Current liabilities                                                                                                                                         |       |                                                              |       |   |   |
| Accounts payable                                                                                                                                            |       | $                                                                 | 734        |   | $ | 1,791 |   |
| Accrued expenses                                                                                                                                            |       | 1,294                                                             |       | 1,206 |   |
| Total liabilities                                                                                                                                           |       | 2,028                                                             |       | 2,997 |   |
| Commitments and  contingencies (Note 9)                                                                                                                     |       |                                                              |       |   |   |
| Stockholders’  equity                                                                                                                                  |       |                                                              |       |   |   |
| Preferred stock, $0.01 par value; 10,000 shares  authorized; no shares issued and outstanding                                                          |       | —                                                            |       | — |   |
| Common stock, $0.01 par value; 90,000 shares  authorized; 17,415 and 20,922 shares issued and outstanding at  December 31, 2005 and 2006, respectively |       | 175                                                               |       | 209 |   |
| Additional paid-in capital                                                                                                                                  |       | 105,717                                                           |       | 118,545 |   |
| Unearned compensation                                                                                                                                       |       | (2,224                                                            | )          | — |   |
| Deficit accumulated during the development stage                                                                                                            |       | (83,494                                                           | )          | (106,137 | ) |
| Total stockholders’ equity                                                                                                                             |       | 20,174                                                            |       | 12,617 |   |
| Total liabilities  and stockholders’ equity                                                                                                            |       | $                                                                 | 22,202     |   | $ | 15,614 |   |

 

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

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**MathStar, Inc.(A development stage company)Statements of Operations**
|                                                                    | ** ** | **Year Ended December 31**                             | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)  Through  December 31,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                                                              | ** ** | **2005**                                                                                                              | ** ** | **2006** | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenue                                                            |       | $                                                                     | 130        |                                                                                                                  | $          | 134 |   | $ | 53 |   |   | $ | 933 |   |   |
| Cost of sales                                                      |       | 53                                                                    |       | 52                                                                                                                    |       | 126 |   |   | 231 |   |   |
| Gross margin                                                       |       | 77                                                                    |       | 82                                                                                                                    |       | (73 | ) |   | 702 |   |   |
| Operating expenses                                                 |       |                                                                  |       |                                                                                                                  |       |   |   |   |   |   |   |
| Research and development                                           |       | 4,830                                                                 |       | 8,228                                                                                                                 |       | 14,090 |   |   | 42,038 |   |   |
| Selling, general and administrative                                |       | 4,053                                                                 |       | 6,564                                                                                                                 |       | 9,133 |   |   | 30,426 |   |   |
|                                                               |       | 8,883                                                                 |       | 14,792                                                                                                                |       | 23,223 |   |   | 72,464 |   |   |
| Operating loss                                                     |       | (8,806                                                                | )          | (14,710                                                                                                               | )          | (23,296 | ) |   | (71,762 | ) |   |
| Interest income                                                    |       | 57                                                                    |       | 170                                                                                                                   |       | 653 |   |   | 2,073 |   |   |
| Interest expense                                                   |       | —                                                                |       | (4,395                                                                                                                | )          | — |   |   | (4,591 | ) |   |
| Other income, net                                                  |       | —                                                                |       | —                                                                                                                |       | — |   |   | 17 |   |   |
| Net loss from continuing operations                                |       | (8,749                                                                | )          | (18,935                                                                                                               | )          | (22,643 | ) |   | (74,263 | ) |   |
| Loss from  discontinued operations (Note 4)                        |       | —                                                                |       | —                                                                                                                |       | — |   |   | (31,874 | ) |   |
| Net loss                                                           |       | $                                                                     | (8,749     | )                                                                                                                     | $          | (18,935 | ) | $ | (22,643 | ) |   | $ | (106,137 | ) |   |
| Basic and diluted  loss per share from continuing operations  |       | $                                                                     | (0.95      | )                                                                                                                     | $          | (1.56 | ) | $ | (1.26 | ) |   |   |   |   |
| Weighted average  basic and diluted shares outstanding             |       | 9,209                                                                 |       | 12,121                                                                                                                |       | 18,001 |   |   |   |   |   |

 

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

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**MathStar, Inc (A development stage company) Statements of Changes in Stockholders’ Equity Cumulative for the Period from Inception (April 14, 1997) Through December 31, 2006**

| ** **                                                                                          | ** ** | ** **                                                            | ** ** | **Price**       | ** ** | **Common Stock** | ** ** | **Additional**  | ** ** | ** **            | ** ** | ** **             | ** ** | **Deficit   Accumulated   During the** | ** ** | ** **              | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------|------------|-----------------------|------------|-----------------|------------|-----------------------|------------|------------------------|------------|---------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                          | ** ** | **Date**                                                              | ** ** | **Per   Share** | ** ** | **Shares**            | ** ** | **Par   Value** | ** ** | **Paid-in   Capital** | ** ** | **Notes   Receivable** | ** ** | **Unearned   Compensation**                 | ** ** | **Development   Stage** | ** ** | **Total** | ** ** |
| ** **                                                                                          | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Issuance of common stock to founders for cash and  notes receivable                                 |       | January 1998                                                     |       | $               | 0.045      |                  | 667        |            | $          | 7                     |       | $                      | 23         |                                        |       | $                       | (15        | ) |   |   |   |   |   |   |   |   |   | $ | 15 |   |
| Net income                                                                                          |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | $ | 7 |   |   | 7 |   |
| **Balances at December 31, 1998**                                                              |       |                                                                  |       |            |       | 667                   |       | 7               |       | 23                    |       |                   | (15        | )                                           |       |                    | —     |   |   |   | 7 |   |   | 22 |   |
| Payments on notes receivable                                                                        |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   | 15         |                                        |       |                    |       |   |   |   |   |   |   | 15 |   |
| Net loss                                                                                            |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | (15 | ) |   | (15 | ) |
| **Balances at December 31, 1999**                                                              |       |                                                                  |       |            |       | 667                   |       | 7               |       | 23                    |       |                   | —     |                                        |       |                    | —     |   |   |   | (8 | ) |   | 22 |   |
| Issuance of common stock for notes receivable                                                       |       | April 2000                                                       |       | $               | .11        |                  | 2,100      |            | 21         |                  | 209        |                   |       | (230                                        | )          |                    |       |   |   |   |   |   |   |   | — |   |
| Issuance of common stock for cash                                                                   |       | June 2000                                                        |       | $               | 5.25       |                  | 140        |            | 1          |                  | 735        |                   |       |                                        |       |                    |       |   |   |   |   |   |   |   | 736 |   |
| Payments on notes receivable                                                                        |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   | 230        |                                        |       |                    |       |   |   |   |   |   |   | 230 |   |
| Issuance of common stock for cash, net of  offering costs of $1,908                            |       | July -  November 2000                                       |       | $               | 8.25       |                  | 2,235      |            | 23         |                  | 16,511     |                   |       |                                        |       |                    |       |   |   |   |   |   |   |   | 16,534 |   |
| Net loss                                                                                            |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | (1,437 | ) |   | (1,437 | ) |
| **Balances at December 31, 2000**                                                              |       |                                                                  |       |            |       | 5,142                 |       | 52              |       | 17,478                |       |                   | —     |                                        |       |                    | —     |   |   |   | (1,445 | ) |   | 16,085 |   |
| Issuance of common stock in connection with the  acquisition of Digital Mediacom, Inc.         |       | August 2001                                                      |       | $               | 8.25       |                  | 1,603      |            | 16         |                  | 13,210     |                   |       |                                        |       |                    |       |   |   |   |   |   |   |   | 13,226 |   |
| Issuance of options and warrants in connection with  the acquisition of Digital Mediacom, Inc. |       |                                                                  |       |            |       |                  |       |            |       | 5,158                 |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 5,158 |   |
| Stock-based employee compensation                                                                   |       |                                                                  |       |            |       |                  |       |            |       | 148                   |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 148 |   |
| Stock-based nonemployee compensation                                                                |       |                                                                  |       |            |       |                  |       |            |       | 116                   |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 116 |   |
| Repurchase of common stock                                                                          |       |                                                                  |       |            |       | (667                  | )          | (7              | )          | (243                  | )          |                   |       |                                        |       |                    |       |   |   |   |   |   |   | (250 | ) |
| Net loss                                                                                            |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | (13,629 | ) |   | (13,629 | ) |
| **Balances at December 31, 2001**                                                              |       |                                                                  |       |            |       | 6,078                 |       | 61              |       | 35,867                |       |                   | —     |                                        |       |                    | —     |   |   |   | (15,074 | ) |   | 20,854 |   |
| Issuance of common stock for cash, net of  offering costs of $1,645                            |       | April -  August 2002                                        |       | $               | 10.50      |                  | 1,458      |            | 14         |                  | 13,644     |                   |       |                                        |       |                    |       |   |   |   |   |   |   |   | 13,658 |   |
| Exercise of stock options                                                                           |       |                                                                  |       |            |       | 9                     |       |            |       | 47                    |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 47 |   |
| Stock-based employee compensation                                                                   |       |                                                                  |       |            |       |                  |       |            |       | 528                   |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 528 |   |
| Repurchase of common stock                                                                          |       |                                                                  |       |            |       | (500                  | )          | (5              | )          | (252                  | )          |                   |       |                                        |       |                    |       |   |   |   |   |   |   | (257 | ) |
| Net loss                                                                                            |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | (29,709 | ) |   | (29,709 | ) |
| **Balances at December 31, 2002**                                                              |       |                                                                  |       |            |       | 7,045                 |       | 70              |       | 49,834                |       |                   | —     |                                        |       |                    | —     |   |   |   | (44,783 | ) |   | 5,121 |   |
| Issuance of warrants to purchase common stock for  cash, net of offering costs of $697              |       | April -  August 2003                                        |       |            |       |                  |       |            |       | 5,304                 |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 5,304 |   |
| Issuance of common stock for cash, net of  offering costs of $316                              |       | December 2003                                                    |       | $               | 4.80       |                  | 585        |            | 6          |                  | 2,487      |                   |       |                                        |       |                    |       |   |   |   |   |   |   |   | 2,493 |   |
| Exercise of warrants for subscription receivable                                                    |       |                                                                  |       |            |       | 18                    |       |            |       | 27                    |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 27 |   |
| Stock-based employee compensation                                                                   |       |                                                                  |       |            |       |                  |       |            |       | 148                   |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 148 |   |
| Stock-based nonemployee compensation—options                                                   |       |                                                                  |       |            |       |                  |       |            |       | 26                    |       |                   |       |                                        |       |                    |       |   |   |   |   |   |   | 26 |   |
| Net loss                                                                                            |       |                                                                  |       |            |       |                  |       |            |       |                  |       |                   |       |                                        |       |                    |       |   |   |   | (11,027 | ) |   | (11,027 | ) |
| **Balances  at December 31, 2003**                                                             |       |                                                                  |       |            |       | 7,648                 |       | 76              |       | 57,826                |       |                   | —     |                                        |       |                    | —     |   |   |   | (55,810 | ) |   | 2,092 |   |
|                                                                                                     |            |                                                                       |            |                 |            |                       |            |                 |            |                       |            |                        |            |                                             |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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**MathStar, Inc (A development stage company) Statements of Changes in Stockholders’ Equity (Continued) Cumulative for the Period from Inception (April 14, 1997) Through December 31, 2006**

 

| Issuance of common stock for cash, net of  offering costs of $970        |   | January -  August 2004 |   | $      | 4.80   |   | 1,864  |   | 19     |   | 7,959  |    |   |   |   |   |   |   |   |   |    |   |   |    | 7,978    |   |
|-------------------------------------------------------------------------------|--------|----------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|---------|----------|--------|
| Exercise of warrants for cash, net of warrant call  costs of $279             |   |                             |   |   |   | 1,627  |   | 16     |   | 2,629  |   |    |   |   |   |   |   |   |   |   |    |   |   | 2,645   |     |
| Exercise of stock options                                                     |   |                             |   |   |   | 1      |   |   |   | 1      |   |    |   |   |   |   |   |   |   |   |    |   |   | 1       |     |
| Vesting of warrants issued to nonemployees                                    |   |                             |   |   |   |   |   |   |   | 50     |   |    |   |   |   |   |   |   |   |   |    |   |   | 50      |     |
| Net loss                                                                      |   |                             |   |   |   |   |   |   |   |   |   |    |   |   |   |   |   |   |   |   | (8,749  | )      |   | (8,749  | )        |
| **Balances at December 31, 2004**                                        |   |                             |   |   |   | 11,140 |   | 111    |   | 68,465 |   |    | — |   |   |   | — |   |   |   | (64,559 | )      |   | 4,017   |     |
| Exercise of warrants for cash                                                 |   |                             |   |   |   | 101    |   | 2      |   | 233    |   |    |   |   |   |   |   |   |   |   |    |   |   | 235     |     |
| Warrants issued in connection with convertible bridge  notes                  |   |                             |   |   |   | — |   |   |   | 1,126  |   |    |   |   |   |   |   |   |   |   |    |   |   | 1,126   |     |
| Discount on convertible bridge notes—beneficial  conversion rate         |   |                             |   |   |   | — |   |   |   | 2,502  |   |    |   |   |   |   |   |   |   |   |    |   |   | 2,502   |     |
| Vesting of warrants issued to nonemployees                                    |   |                             |   |   |   | — |   |   |   | 515    |   |    |   |   |   |   |   |   |   |   |    |   |   | 515     |     |
| Issuance of common stock in public offering, net of  offering costs of $2,967 |   | Oct./Dec. 2005              |   | $      | 6.00   |   | 4,600  |   | 46     |   | 24,587 |    |   |   |   |   |   |   |   |   |    |   |   |    | 24,633   |   |
| Restricted common stock issued to employees                                   |   |                             |   |   |   | 457    |   | 5      |   | 2,736  |   |    |   |   |   |   | (2,741 | )      |   |   |    |   |   |    |     |
| Forfeitures of restricted stock                                               |   |                             |   |   |   | (11    | )      |   |   | (70    | )      |    |   |   |   |   | 70     |   |   |   |    |   |   |    |     |
| Bridge note conversion                                                        |   | Dec. 2005                   |   | $      | 4.80   |   | 1,128  |   | 11     |   | 5,419  |    |   |   |   |   |   | — |   |   |    |   |   |    | 5,430    |   |
| Stock-based employee compensation—restricted stock                       |   |                             |   |   |   | — |   |   |   |   |   |    |   |   |   |   | 447    |   |   |   |    |   |   | 447     |     |
| Stock-based employee compensation—options                                |   |                             |   |   |   | — |   |   |   | 204    |   |    |   |   |   |   |   |   |   |   |    |   |   | 204     |     |
| Net loss                                                                      |   |                             |   |   |   | — |   |   |   |   |   |    |   |   |   |   |   |   |   |   | (18,935 | )      |   | (18,935 | )        |
| **Balances at December 31, 2005**                                        |   |                             |   |   |   | 17,415 |   | $      | 175    |   | $      | 105,717 |   |   | — |   |   |   | $      | (2,224 | )       |   |   | $       | (83,494  | )      |   | $ | 20,174 |   |
| Exercise of warrants for stock                                                |   |                             |   |   |   | 253    |   | 2      |   | 510    |   |    |   |   |   |   |   |   |   |   |    |   |   | 512     |     |
| Stock option exercises                                                        |   |                             |   |   |   | 91     |   | 1      |   | 79     |   |    |   |   |   |   |   |   |   |   |    |   |   | 80      |     |
| Issuance of common stock in PIPE offering, net of  offering costs of $910     |   | Oct. 2006                   |   | $      | 4.00   |   | 3,142  |   | 31     |   | 11,630 |    |   |   |   |   |   |   |   |   |    |   |   |    | 11,661   |   |
| Restricted stock issued to employees, net                                     |   |                             |   |   |   | 21     |   |   |   |   |   |    |   |   |   |   |   |   |   |   |    |   |   | —  |     |
| Reclassify Unearned Compensation expense on adoption  of FAS 123(R)           |   |                             |   |   |   |   |   |   |   | (2,224 | )      |    |   |   |   |   | 2,224  |   |   |   |    |   |   | —  |     |
| Contractor Warrant Expense                                                    |   |                             |   |   |   |   |   |   |   | 169    |   |    |   |   |   |   |   |   |   |   |    |   |   | 169     |     |
| Stock-based employee compensation—                                       |   |                             |   |   |   | — |   | — |   | 2,664  |   |    |   |   |   |   | — |   |   |   | —  |   |   | 2,664   |     |
| Net loss                                                                      |   |                             |   |   |   | — |   | — |   | — |   |    |   |   |   |   | — |   |   |   | (22,643 | )      |   | (22,643 | )        |
| **Balances  at December 31, 2006**                                       |   |                             |   |   |   | 20,922 |   | $      | 209    |   | $      | 118,545 |   |   | — |   |   |   | $      |   |    |   |   | $       | (106,137 | )      |   | $ | 12,617 |   |

 

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

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**MathStar, Inc(A development stage company)**Statements of Cash Flows 

| ** **                                                                                                              | ** ** | **Year Ended   December 31,** | ** ** | **Cumulative   for the Period   from Inception   (April 14, 1997)  Through   December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2004**                                     | ** ** | **2005**                                                                                                                                      | ** ** | **2006** | ** ** | **2006** | ** ** |
| ** **                                                                                                              | ** ** | **(In thousands)**                      | ** ** |
| **Cash flows from operating activities**                                                                                | ** ** | ** **                                   | ** ** | ** **                                                                                                                                    | ** ** | ** ** | ** ** | ** ** |   |
| Net loss                                                                                                                |       | $                                            | (8,749     | )                                                                                                                                             | $          | (18,935 | ) | $ | (22,643 | ) | $ | (106,137 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities                                             |       |                                         |       |                                                                                                                                          |       |   |   |   |   |
| Depreciation                                                                                                            |       | 183                                          |       | 74                                                                                                                                            |       | 140 |   | 1,673 |   |
| Amortization of beneficial conversion feature on  convertible notes and value of warrants issued with convertible notes |       | —                                       |       | 3,628                                                                                                                                         |       | — |   | 3,628 |   |
| Interest expense settled with common stock                                                                              |       | —                                       |       | 230                                                                                                                                           |       | — |   | 230 |   |
| Amortization of discount on held-to-maturity  securities                                                                |       | —                                       |       | —                                                                                                                                        |       | — |   | (233 | ) |
| Acquired in-process research and development                                                                            |       | —                                       |       | —                                                                                                                                        |       | — |   | 4,300 |   |
| Stock-based compensation                                                                                                |       | 50                                           |       | 1,166                                                                                                                                         |       | 2,833 |   | 5,073 |   |
| Loss on disposal of asset                                                                                               |       |                                         |       |                                                                                                                                          |       | 4 |   | 4 |   |
| Goodwill impairment                                                                                                     |       | —                                       |       | —                                                                                                                                        |       | — |   | 13,306 |   |
| Change in  operating assets and liabilities, net of effects of acquisition                                         |       |                                         |       |                                                                                                                                          |       |   |   |   |   |
| Accounts receivable                                                                                                     |       | (29                                          | )          | (46                                                                                                                                           | )          | 61 |   | 131 |   |
| Inventory                                                                                                               |       | —                                       |       | (336                                                                                                                                          | )          | (274 | ) | (610 | ) |
| Prepaid expenses and other assets                                                                                       |       | (101                                         | )          | (560                                                                                                                                          | )          | (81 | ) | (736 | ) |
| Accounts payable                                                                                                        |       | (188                                         | )          | 178                                                                                                                                           |       | 1,057 |   | 1,338 |   |
| Accrued expenses                                                                                                        |       | (477                                         | )          | 862                                                                                                                                           |       | (89 | ) | 977 |   |
| Net cash used in operating activities                                                                                   |       | (9,311                                       | )          | (13,740                                                                                                                                       | )          | (18,992 | ) | (77,056 | ) |
| **Cash flows from investing  activities**                                                                               | ** ** | ** **                                   | ** ** | ** **                                                                                                                                    | ** ** | ** ** | ** ** | ** ** |   |
| Cash used in  acquisition, net of cash acquired                                                                         |       | —                                       |       | —                                                                                                                                        |       | — |   | (791 | ) |
| Purchase of  property and equipment                                                                                     |       | (13                                          | )          | (312                                                                                                                                          | )          | (416 | ) | (2,136 | ) |
| Proceeds from sale  of discontinued operations                                                                          |       | —                                       |       | —                                                                                                                                        |       | — |   | 1,752 |   |
| Purchases of  held-to-maturity securities                                                                               |       | —                                       |       | —                                                                                                                                        |       | — |   | (10,000 | ) |
| Sales of  held-to-maturity securities                                                                                   |       | —                                       |       | —                                                                                                                                        |       | — |   | 10,233 |   |
| Restricted cash                                                                                                         |       | —                                       |       | —                                                                                                                                        |       | (103 | ) | (103 | ) |
| Net cash used in investing activities                                                                                   |       | (13                                          | )          | (312                                                                                                                                          | )          | (519 | ) | (1,045 | ) |
| **Cash flows from financing  activities**                                                                               | ** ** | ** **                                   | ** ** | ** **                                                                                                                                    | ** ** | ** ** | ** ** | ** ** |   |
| Proceeds from  issuance of common stock, net of offering costs                                                          |       | 7,978                                        |       | 24,633                                                                                                                                        |       | 11,661 |   | 77,708 |   |
| Proceeds from  issuance of convertible notes                                                                            |       | —                                       |       | 5,500                                                                                                                                         |       | — |   | 5,500 |   |
| Payments on  convertible notes                                                                                          |       | —                                       |       | (300                                                                                                                                          | )          | — |   | (300 | ) |
| Proceeds from  issuance of warrants to purchase common stock, net of offering costs                                     |       | —                                       |       | —                                                                                                                                        |       | — |   | 5,304 |   |
| Proceeds from  exercise of warrants, net of costs                                                                       |       | 2,645                                        |       | 235                                                                                                                                           |       | 512 |   | 3,420 |   |
| Collection of  subscription receivable                                                                                  |       | 27                                           |       | —                                                                                                                                        |       | — |   | 27 |   |
| Proceeds from  exercise of stock options                                                                                |       | 1                                            |       | —                                                                                                                                        |       | 80 |   | 81 |   |
| Principal payments  on notes receivable from stockholders                                                               |       | —                                       |       | —                                                                                                                                        |       | — |   | 245 |   |
| Principal payments  on notes payable to stockholders                                                                    |       | —                                       |       | —                                                                                                                                        |       | — |   | (250 | ) |
| Repurchase of  common stock                                                                                             |       | —                                       |       | —                                                                                                                                        |       | — |   | (257 | ) |
| Payments on  capital lease obligations                                                                                  |       | —                                       |       | —                                                                                                                                        |       | — |   | (486 | ) |
| Net cash provided by financing activities                                                                               |       | 10,651                                       |       | 30,068                                                                                                                                        |       | 12,253 |   | 90,992 |   |
| Net (decrease) increase in cash and cash equivalents                                                                    |       | 1,327                                        |       | 16,017                                                                                                                                        |       | (7,258 | ) | 12,891 |   |
| **Cash and cash equivalents**                                                                                           | ** ** | ** **                                   | ** ** | ** **                                                                                                                                    | ** ** | ** ** | ** ** | ** ** |   |
| Beginning of  period                                                                                                    |       | 2,805                                        |       | 4,132                                                                                                                                         |       | 20,149 |   | — |   |
| End of period                                                                                                           |       | $                                            | 4,132      |                                                                                                                                          | $          | 20,149 |   | $ | 12,891 |   | $ | 12,891 |   |
| **Cash  paid during period for interest**                                                                               |       | $                                            | —     |                                                                                                                                          | $          | — |   | $ | — |   | $ | 26 |   |
| **Significant noncash  transactions**                                                                                   | ** ** | ** **                                   | ** ** | ** **                                                                                                                                    | ** ** | ** ** | ** ** | ** ** |   |
| Common stock,  options and warrants issued in connection with Digital Mediacom, Inc.  acquisition                  |       | $                                            | —     |                                                                                                                                          | $          | — |   | $ | — |   | $ | 18,384 |   |
| Conversion of notes  payable and $230 of accrued interest into common stock                                             |       |                                         |       | 5,430                                                                                                                                         |       |   |   | 5,430 |   |

 

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

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**MathStar, Inc.(A development stage company)Notes to the Financial Statements(in thousands, except per share data)**

**1.**                 Natureof the Business and Going Concern

MathStar, Inc. (the “Company”) was incorporatedas a Minnesota corporation in April 1997 and reincorporated under Delawarelaw in June 2005. The Company is a fabless semiconductor companyaddressing the reconfigurable logic markets with a new class of platform chipsdesigned to be high performance, reconfigurable integrated circuits based onthe Company’s proprietary silicon object technology. Since its inception, theCompany has devoted substantially all of its efforts to business planning,research and development, recruitment of management and technical staff,acquiring operating assets and raising capital. The Company has generated onlynominal revenues from the sale of development kits that support customerdevelopment of applications for one of the Company’s products, the sale ofproduct prototypes, contractual research and development services and samplesof production product. Accordingly, the Company is considered to be in thedevelopment stage as defined by Statement of Financial Accounting Standards (“SFAS”)No. 7, *Accounting and Reporting byDevelopment Stage Enterprises*.

In November 2005, the Company closed on itsinitial public offering of 4,000 shares of its common stock at $6.00 per share,and in December 2005, the Company closed on the underwriter’soverallotment option of 600 shares of the Company’s common stock at $6.00 pershare, resulting in net proceeds to the Company of $24,633.

In October 2006, the company sold 3,142 shares at$4.00 per share in a private placement with net proceeds after expenses of$11,661.

The accompanying financialstatements have been prepared on a basis which assumes that the Company willcontinue as a going concern and which contemplates the realization of assetsand the satisfaction of liabilities and commitments in the normal course ofbusiness. The Company has a limited operating history and has incurred lossesand negative cash flows from operations since inception. The Company expects toincur additional losses and will require additional funding to continue itsoperations. These circumstances raise substantial doubt about the Company’s abilityto continue as a going concern. Management intends to seek additional financingduring 2007. However, there can be no assurance that such additional fundingwill be available on terms acceptable to the Company or at all.

**2.**                 Summaryof Significant Accounting Policies

**Use of Estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

**Cash and CashEquivalents**

The Company considers allhighly liquid investments with an original maturity of three months or less atthe date of purchase to be cash equivalents.

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**Fair Value ofFinancial Instruments**

The carrying amounts ofthe Company’s financial instruments, which include cash equivalents, accountsreceivable, accounts payable and other accrued expenses, approximate their fairvalues due to their short maturities and/or market-consistent interest rates.

***Inventory***

Inventory is valued at thelower of cost or market and held as an asset until such time as it is consumedor sold. Inventory is consumed on a first in, first out basis. On a quarterlybasis, management reviews the inventory balance for inventory that is notforecasted to be used in the normal course of business. A reserve will beestablished for any amount deemed excessive or obsolete. This will result in anon-cash charge to cost of  sales. If andwhen the inventory is written off, the inventory reduction is offset againstthe reserve, with no resulting income statement impact.

**Property andEquipment**

Property and equipment arerecorded at cost and depreciated over their estimated useful lives, generallythree to five years, using the straight-line method. Upon retirement or sale,the cost of assets disposed of and the related accumulated depreciation areremoved from the accounts, and any resulting gain or loss is included inoperating results. Repairs and maintenance costs are expensed as incurred.

**Patents**

The Company has filedapplications for patents with the U.S. Patent and Trademark Office. The legalfees and application costs associated with obtaining patents from the U.S.Patent and Trademark Offices are expensed as incurred.

**Long-Lived Assets**

The recoverability oflong-lived assets is assessed periodically or whenever adverse events orchanges in circumstances or business climate indicate that the expected cashflows previously anticipated warrant a reassessment. When such reassessmentsindicate the potential of impairment, all business factors are considered and,if the carrying value of such assets is not likely to be recovered from futureundiscounted operating cash flows, they will be written down for financialreporting purposes. See Note 4 regarding assessment of the carrying value ofgoodwill.

**Research andDevelopment**

Research and developmentexpenses represent costs incurred for designing and engineering of the Company’sproducts, including the costs of developing design tools and applications toenable customers to more easily utilize the Company’s products. The Companyexpenses all research and development costs related to development of itsproducts. Development of certain tools and applications include the developmentof software. Such research and development expenses are required to be expenseduntil the point that technological feasibility of the software is established.The Company determines technological feasibility based upon completion of aworking model of the software. To date, the period between technologicalfeasibility and general release of the software has been short, such thatvirtually all of the Company’s software development costs relate to softwaredevelopment during the period prior to technological feasibility. Accordingly,all such costs have been charged to operations as incurred.

**Revenue Recognition**

The Company recognizesrevenue for products when persuasive evidence of an arrangement exists,delivery has occurred, the sales price is fixed or determinable, collection isreasonably assured and there 

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are no post-deliveryobligations. Costs associated with product revenue consist of the manufacturingcosts of the evaluation units and chips and software license fees and capturedin cost of sales. During 2004 and 2005, marketing support was paid to acustomer of the Company. Such payments are reported as a reduction of revenuein accordance with Emerging Issues Task Force Issue 01-09, *Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products)*. TheCompany will recognize revenue from contractual research and developmentservices as the services are performed. Costs related to these revenuesconsisted primarily of salary and related benefits of certain employees andincluded in cost of sales. During 2006, MathStar recognized a non-cash cost ofsales expense resulting from an excess and obsolete reserve charge.

**Stock-BasedCompensation**

On January 1, 2006, the Company adopted  SFAS No. 123(R), *Share-based payment*,  using the modified prospective transitionmethod. Under the transition method, compensation costs recognized in 2006include compensation costs for share-based payments granted prior to, but notvested as of January 1, 2006 based on the grant date fair value estimatedin accordance with the provisions of SFAS No. 123, *Accounting for Stock-based Compensation,*andcompensation costs for all share-based payments granted subsequent to January 1,2006 based on the grant date fair value estimated in accordance with SFAS No. 123(R).Prior to the Company’s initial public offering in October 2005 and inaccordance with SFAS No. 123, *Accountingfor Stock-Based Compensation*, the Company had elected to account forstock-based compensation to employees using the intrinsic value methodprescribed in Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations. Accordingly, compensation cost for stock optionsgranted to employees was measured as the excess, if any, of the fair value ofthe Company’s stock at the date of the grant over the amount an employee mustpay to acquire the stock.

The Company accounts for restricted stock byamortizing the grant date fair value over the vesting period.

The Company accounts forstock-based compensation to nonemployees using the fair value method prescribedby SFAS No. 123. Compensation cost for stock options granted tononemployees is measured based on the fair value of the option at the date ofgrant with the unvested portion revalued at each balance sheet date.Compensation costs, if any, are amortized over the underlying option vestingterms.

**Income Taxes**

The Company accounts forincome taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*. The asset and liabilityapproach of SFAS No. 109 requires the recognition of deferred tax assetsand liabilities for the tax consequences of temporary differences between thetax bases of assets and liabilities and their carrying amounts for financialreporting purposes using enacted tax rates in effect for the years in which thedifferences are expected to reverse. Valuation allowances are provided if,based upon the weight of available evidence, it is more likely than not thatsome or all of the deferred tax assets will not be realized.

**Concentration ofCredit Risk**

Financial instruments,which potentially subject the Company to concentrations of credit risk, consistprimarily of cash and cash equivalents. The Company places its cash and cashequivalents primarily in checking and money market accounts with one financialinstitution that management considers creditworthy. However, the FederalDeposit Insurance Corporation does not insure most of these accounts.

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**Comprehensive Loss**

Comprehensive loss, asdefined in SFAS No. 130, *ReportingComprehensive Income*, includes all changes in equity during a periodfrom non-owner sources. The Company has not had any changes in stockholders’equity from non-owner sources other than a net loss.

**Earnings Per Share**

Basic earnings per shareare computed by dividing the net loss available to common stockholders by theweighted average number of common shares outstanding during the period. Dilutedearnings per share gives effect to all dilutive potential common sharesoutstanding during the period, including stock options, warrants andconvertible notes payable, using the treasury stock method. Options andwarrants to purchase 2,611, 4,021 and 5,268 shares of common stock wereoutstanding at December 31, 2004, 2005 and 2006, respectively, but werenot included in the computation of net loss per share as their effect wasanti-dilutive. Common shares issuable upon exercise of the convertible notespayable and related accrued interest and shares of the Company’s contingentlyissuable restricted stock also were not included in the computation of net lossper share as their effect was anti-dilutive (see Note 6).

**New AccountingPronouncements**

In July 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes* (“FIN 48”), which is an interpretation of SFAS No. 109,*Accounting for Income Taxes*. FIN48 clarifies the accounting for uncertainty in income taxes recognized inaccordance with SFAS No. 109 and prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Guidance isalso provided on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure and transition. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. The Company does notexpect the impact of adopting FIN 48 to have a material effect on itsconsolidated financial position and results of operations.

In September 2006, the FASB issued FAS No.158, *Employers Accounting for DefinedBenefit Pension and Other Post Retirement Plans.*SFAS No. 158is effective for the years ending December 15, 2006 and therefore requirescompanies to recognize prospectively adjustments to assets, liabilities andshareholders’ equity (through accumulated other comprehensive income) for thedifference between the fair value of the plan’s assets and the benefitobligation of pension and post retirement health care plans. Since the Companyhas no defined benefit pension or other post retirement plans, the Companybelieves it has no expected impact.

In September 2006, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*”(“SAB No. 108”). SAB No. 108 provides guidance on how the effects of thecarryover or reversal of prior year financial statement misstatements should beconsidered in quantifying a current year misstatement. The adoption of SAB No. 108did not  have any impact on our financialstatements for the year ended December 31, 2006.

In February 2007, theFASB issued SFAS No. 159, “*The fair valueoption for Financial Assets and Liabilities—including Amendment of FAS**No. 115”.*SFASNo. 159 gives companies the option of recording certain financial assetsand liabilities at fair value. SFAS No. 159 is effective for the Company asof December 31, 2007. The Company is still evaluating the potential impactof the standard.

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**3.**                 SelectedBalance Sheet Information

**Restricted Cash**

The Company has pledged$100,000 plus accrued interest to a bank as collateral to secure the balanceson Company issued credit cards. The Company cannot use the restricted cash inthe normal course of business until the credit cards are cancelled or the bankreleases the funds. The credit cards are issued to certain Company employeesfor the purpose of travel and Company related purchases.

**Inventory**

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Raw Material                                     |       | $                     | 26         |   | $ | 49 |   |
| Finished Goods                                   |       | 336                   |       | 662 |   |
|                                             |       | $                     | 362        |   | $ | 711 |   |
| Less: Reserve for  Excess and Obsolete Inventory |       | (26                   | )          | (101 | ) |
| Total Inventory, net                             |       | $                     | 336        |   | $ | 610 |   |

 

The increase in the valuation reserve was charged tocost of sales.

**Prepaid and Other Current Assets**

| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2006** | ** ** |
| EDA Licenses                            |       | 775                   |       | 695 |   |
| Prepaid insurance                       |       | 165                   |       | 239 |   |
| Prepaid rent                            |       | 89                    |       | 111 |   |
| Other                                   |       | 115                   |       | 186 |   |
| Total prepaid and other  current assets |       | $                     | 1,144      |   | $ | 1,231 |   |
|                                         |            |                       |            |  |  |  |  |

 

**Property andEquipment**

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Computer equipment                 |       | $                     | 1,003      |   | $ | 1,003 |   |
| Purchased  software                |       | 425                   |       | 533 |   |
| Equipment                          |       | —                |       | 106 |   |
| Furniture and  fixtures            |       | 370                   |       | 499 |   |
|                               |       | $                     | 1,798      |   | $ | 2,141 |   |
| Less: Accumulated  depreciation    |       | (1,451                | )          | (1,520 | ) |
| Total property and  equipment, net |       | $                     | 347        |   | $ | 621 |   |

 

Depreciation expense was$183, $74 and $140 for the years ended December 31, 2004, 2005 and 2006and $1,673 cumulative for the period from inception (April 14, 1997)through December 31, 2006.

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**Accrued Expenses**

| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Accrued rent               |       | $                     | 117        |   | $ | 77 |   |
| Accrued  compensation      |       | 417                   |       | 480 |   |
| Accrued  professional fees |       | 320                   |       | 226 |   |
| Other                      |       | 440                   |       | 423 |   |
| Total accrued expenses     |       | $                     | 1,294      |   | $ | 1,206 |   |

 

**4.**                 Acquisitionand Disposition of Digital Mediacom, Inc.

**Acquisition**

On August 31, 2001,the Company completed its acquisition of Digital Mediacom, Inc. (“DMC”), aprovider of design and engineering services and a developer of physical mediadevice technology. In connection with the merger transaction, the Companyacquired all outstanding shares of DMC common stock in exchange for cash of$950 and 1,603 shares of the Company’s common stock. In addition, options andwarrants to purchase shares of DMC common stock outstanding immediately priorto the consummation of the merger were assumed by the Company and converted intooptions and warrants to purchase 781 shares of the Company’s common stock. Thetotal purchase price, including the fair value of converted options andwarrants and direct acquisition costs, was $19,402. The purchase price wasallocated to the assets acquired and liabilities assumed based upon their fairvalues. The most significant asset was $4,300 of acquired, in process researchand development (see discussion below). The excess of the purchase price overthe fair value of the net assets acquired of $14,589 was recorded as goodwill.

**In-Process Researchand Development**

At the time ofacquisition, DMC had certain in process development projects. Managementestimated that $4,300 of the purchase price represented the fair value ofpurchased in process research and development relating to these developmentprojects which had not yet reached technological feasibility and had noalternative future uses. The Company estimated the fair value of the in-processresearch and development using an income approach, which estimates fair valueby discounting the cash flows expected to arise from the development of thein-process projects and future sale of the resulting products.

**Goodwill Impairmentand Discontinued Operations**

In August 2002, due to events and changes in circumstanceswhich included a severe downturn in the market for the acquired in processdevelopment projects, management and the Board of Directors committed to a planto sell the physical media device (“PMD”) operating segment which was comprisedof the acquired DMC operations. Accordingly, the Company tested the PMD assetsfor impairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,and SFAS No. 142, *Goodwill and OtherIntangible Assets*, and recorded a $13,306 goodwill impairmentcharge.

On November 15, 2002, the Company closed on thesale of its PMD operating segment for $1,752 in cash. In connection with thesale, the buyer assumed $187 in liabilities, and the Company sold or disposedof all of the valuable technology, property and equipment, licensed softwareand employees. There was no gain or loss on the sale because the assets of thePMD operating segment were written down to their estimated net realizable valuein August 2002.

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Theoperating results from the discontinued PMD operating segment included in theaccompanying financial statements were as follows:

| ** **                                     | ** ** | **Cumulative for   the Period from   August 31,   2001 Through   December 31,   2002** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Operating  expenses                            |       |                                                                                                                                          | $          | 14,268 |   |   |
| Purchased  in-process research and development |       |                                                                                                                                          | 4,300      |   |   |
| Goodwill  impairment                           |       |                                                                                                                                          | 13,306     |   |   |
| Loss from discontinued  operations             |       |                                                                                                                                          | $          | 31,874 |   |   |

 

**5.**                 StockBased Compensation

Under SFAS No. 123(R), the Company has elected touse the modified prospective transition method, which requires the Company torecord compensation expense in accordance with the provisions of SFAS No. 123(R) onlyfor options issued after January 1, 2006. As a result of adopting themodified prospective method of adoption, prior periods have not been restated.The impact of adopting SFAS No. 123(R) on the results of operationsfor the year ended December 31, 2006 was to record additional expensesof  $274 which increased the net loss pershare by $0.02 for the year ended December 31, 2006 . Of this amount, $104was charged to research and development and $170 was charged to selling,general and administrative expense for the year ended December 31, 2006. Includingthe charges for restricted stock and cheap stock, the total stock compensationexpense for the year ended December 31, 2006 was $2,664.

The Company has chosen to use the Black-Scholesoption-pricing model to determine the fair value of options. The Black-Scholesmodel variables are stock price volatility, average option life, risk freeinterest rate and dividend rate. The Company has developed an index based onfive comparable companies within the semiconductor industry to use as avolatility index due to the short period of time it has been public. Averageoption life has been calculated using the “safe harbor” method prescribed inSEC Staff Accounting Bulletin 107. The Company anticipates using this averagelife through 2007 or until it has enough history to calculate a meaningfullife. The Company uses the treasury bill rate corresponding with the averagelife as its risk free interest rate. The dividend rate used is zero, as theCompany does not in the near future have any plans to pay dividends. SFAS No. 123(R) requiresthe Company to estimate forfeitures in calculating the expense relating to stock-basedcompensation as opposed to recognizing these forfeitures and the correspondingreduction in expense as they occur.

Thefollowing table summarizes the weighted average assumptions used by the Companyin the Black-Scholes option-pricing model: 

| ** **                  | ** ** | **Twelve Months Ended  December 31, 2006** | ** **  |
|-----------------------------|------------|----------------------------------------------------------------|-------------|
| Expected option  term       |       | 6.25                                                           |  Years |   |
| Expected  volatility factor |       | 71.2                                                           | %           |   |   |
| Expected dividend  yield    |       | 0                                                              | %           |   |   |
| Risk free interest rate     |       | 4.62                                                           | %           |   |   |

 

**Stock Option Plan**

In January 2002, the Company and its stockholdersadopted the 2002 Combined Incentive and Nonstatutory Stock Option Plan (the “2002Plan”). In April 2000, the Company and its stockholders adopted the 2000Combined Incentive and Nonstatutory Stock Option Plan (the “2000 Plan”). Underthe 2002 Plan and the 2000 Plan, 1,000 and 333 shares of the Company’s commonstock were reserved for 

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issuance of incentive andnonqualified stock options to directors, officers and employees of and advisersto the Company at exercise prices as determined by the Board of Directors onthe date of grant, respectively. These options have exercise prices and vestingterms established by a committee of the Board of Directors at the time of eachgrant. Vesting terms of outstanding options are generally four years. In noevent are the options exercisable more than ten years after the date of grant.These plans were terminated by the Board of Directors effective in May 2006and options to purchase 199 shares were no longer available for grant under theplan.

In October 2004, the Company adopted and in June 2005its stockholders approved the 2004 Amended and Restated Long-Term IncentivePlan (the “2004 Plan”). Under the 2004 Plan, 1,334 shares of the Company’scommon stock were reserved for the issuance of restricted stock and incentiveand nonqualified stock options to directors, officers and employees of andadvisors to the Company at exercise prices as determined by the Board ofDirectors on the date of grants. With the approval of the stockholders at the2006 annual meeting, 300 additional shares were reserved.

Inconnection with the acquisition of DMC (Note 4), the Company assumed DMC’sstock option plan, and 744 shares of the Company’s common stock have beenreserved for issuance under the assumed plan. The related options are includedin the following table, which summarizes stock option plan activity:

| ** **                                      | ** ** | **Shares    Available    for Grant** | ** ** | **Number of    Options** | ** ** | **Weighted-    Average    Exercise    Price** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------|------------|--------------------------------------------------------------|------------|
| Outstanding at beginning  of period (inception) |       |                                                |       |                               |       |                                                         |       |   |   |   |   |   |   |
| Shares reserved                                 |       |                                                | 333        |                               |       |                                                         | —     |   |   |   |   |   |   |
| Options granted  in 2000                        |       |                                                | (187       | )                                  |       |                                                         | 187        |   |   |   | $ | 6.80 |   |   |
| Outstanding at  December 31, 2000          |       |                                                | 146        |                               |       |                                                         | 187        |   |   |   | $ | 6.80 |   |   |
| Shares reserved for DMC assumed options         |       |                                                | 744        |                               |       |                                                         | —     |   |   |   |   |   |   |
| Options assumed  from DMC acquisition           |       |                                                | (744       | )                                  |       |                                                         | 744        |   |   |   | $ | 1.54 |   |   |
| Options granted                                 |       |                                                | (95        | )                                  |       |                                                         | 95         |   |   |   | $ | 8.25 |   |   |
| Options cancelled                               |       |                                                | 5          |                               |       |                                                         | (5         | ) |   |   | $ | 8.25 |   |   |
| Outstanding at  December 31, 2001          |       |                                                | 56         |                               |       |                                                         | 1,021      |   |   |   | $ | 3.10 |   |   |
| Shares reserved                                 |       |                                                | 1,000      |                               |       |                                                         | —     |   |   |   |   |   |   |
| Options granted                                 |       |                                                | (796       | )                                  |       |                                                         | 796        |   |   |   | $ | 7.98 |   |   |
| Options cancelled                               |       |                                                | 358        |                               |       |                                                         | (712       | ) |   |   | $ | 4.76 |   |   |
| Options exercised                               |       |                                                | —     |                               |       |                                                         | (12        | ) |   |   | $ | 7.01 |   |   |
| Outstanding at December 31, 2002           |       |                                                | 618        |                               |       |                                                         | 1,093      |   |   |   | $ | 5.50 |   |   |
| Options granted                                 |       |                                                | (174       | )                                  |       |                                                         | 174        |   |   |   | $ | 4.89 |   |   |
| Options cancelled                               |       |                                                | 130        |                               |       |                                                         | (183       | ) |   |   | $ | 6.38 |   |   |
| Outstanding at  December 31, 2003          |       |                                                | 574        |                               |       |                                                         | 1,084      |   |   |   | $ | 5.26 |   |   |
| Shares reserved                                 |       |                                                | 334        |                               |       |                                                         | —     |   |   |   |   |   |   |
| Options granted                                 |       |                                                | (276       | )                                  |       |                                                         | 276        |   |   |   | $ | 4.80 |   |   |
| Options cancelled                               |       |                                                | 128        |                               |       |                                                         | (206       | ) |   |   | $ | 4.63 |   |   |
| Options exercised                               |       |                                                | —     |                               |       |                                                         | (1         | ) |   |   | $ | 0.87 |   |   |
| Restricted stock  issued                        |       |                                                | (84        | )                                  |       |                                                         | —     |   |   |   |   |   |   |
| Outstanding at  December 31, 2004          |       |                                                | 676        |                               |       |                                                         | 1,153      |   |   |   | $ | 5.79 |   |   |

42

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| Shares reserved                        |   |   | 1,000  |   |   |   | — |   |   |   |   |   |   |
|----------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Options granted                        |   |   | (1,203 | )      |   |   | 1,203  |   |   |   | $      | 5.75   |   |   |
| Options cancelled                      |   |   | 319    |   |   |   | (319   | )      |   |   | $      | 6.84   |   |   |
| Restricted stock  issued               |   |   | (408   | )      |   |   | — |   |   |   |   |   |   |
| Restricted stock  cancelled            |   |   | 47     |   |   |   | — |   |   |   |   |   |   |
| Outstanding at  December 31, 2005 |   |   | 431    |   |   |   | 2,037  |   |   |   | $      | 5.60   |   |   |
| Shares reserved, net                   |   |   | 101    |   |   |   | — |   |   |   |   |   |   |
| Options granted                        |   |   | (555   | )      |   |   | 555    |   |   |   | $      | 5.09   |   |   |
| Options cancelled                      |   |   | 323    |   |   |   | (323   | )      |   |   | $      | 6.21   |   |   |
| Restricted stock  issued               |   |   | (60    | )      |   |   | — |   |   |   |   |   |   |
| Restricted stock  cancelled            |   |   | 40     |   |   |   | — |   |   |   |   |   |   |
| Exercised                              |   |   | — |   |   |   | (91    | )      |   |   | $      | 0.87   |   |   |
| Outstanding at  December 31, 2006 |   |   | 280    |   |   |   | 2,178  |   |   |   | $      | 5.46   |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2006: 

| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted-**                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | ** **                   | ** ** | **Outstanding**              | ** ** | **Life** | ** ** | **Price** | ** ** | **Outstanding** | ** ** | **Price** | ** ** |
| $0.87                    |       |                         | 27         |                         |       |   | 2.97 |   |   |   | $ | 0.87 |   |   |   | 27 |   |   |   | $ | 0.87 |   |   |
| $3.45-$4.89              |       |                         | 1,035      |                         |       |   | 6.81 |   |   |   | $ | 4.67 |   |   |   | 463 |   |   |   | $ | 4.61 |   |   |
| $5.00-$5.33              |       |                         | 164        |                         |       |   | 8.76 |   |   |   | $ | 5.12 |   |   |   | 18 |   |   |   | $ | 5.25 |   |   |
| $5.70-$6.30              |       |                         | 806        |                         |       |   | 8.72 |   |   |   | $ | 6.12 |   |   |   | 214 |   |   |   | $ | 6.24 |   |   |
| $8.25                    |       |                         | 127        |                         |       |   | 4.18 |   |   |   | $ | 8.25 |   |   |   | 127 |   |   |   | $ | 8.25 |   |   |
| $10.50                   |       |                         | 19         |                         |       |   | 2.99 |   |   |   | $ | 10.50 |   |   |   | 19 |   |   |   | $ | 10.50 |   |   |
|                     |       |                         | 2,178      |                         |       |   | 7.43 7 |   |   |   | $ | 5.46 |   |   |   | 868 |   |   |   | $ | 5.58 |   |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Options outstanding at December 31, 2006 had anaggregate intrinsic value of $169, and options exercisable at December 31,2006 had a weighted average contractual term of 5.45 years and an aggregateintrinsic value of $154.

The weighted-average grant-date fair value of optionsgranted during the year ended December 31, 2006 was $3.49. The totalintrinsic value of options exercised during the year ended  December 31, 2006 was $350.

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Thefollowing table shows the status of the Company’s unvested shares as of December 31,2006 and changes during the year then ended: 

| **Unvested Options**           | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted Average   Grant Dated Fair   Value** | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|--------------------------------------------------------------------------|------------|
| Unvested at  December 31, 2005 |       |       | 1,321      |       |       |                                                                     | $          | 1.69 |   |   |
| Granted                             |       |       | 555        |       |       |                                                                     | 3.49       |   |   |
| Vested                              |       |       | (377       | )          |       |                                                                     | 1.79       |   |   |
| Forfeited                           |       |       | (189       | )          |       |                                                                     | 2.42       |   |   |
| Unvested at  December 31, 2006 |       |       | 1,310      |       |       |                                                                     | $          | 2.32 |   |   |

 

Stock options outstandingat December 31, 2006 include options to purchase 262 shares that weregranted to non-employees and options to purchase 1,916 shares that were grantedto employees. Compensation expense related to employee stock options that willbe amortized into future operating expenses was $2,010 at December 31,2006. That cost is expected to be recognized over a weighted-average period of3.14 years. The total fair value of shares vested during the year ended December 31,2006 was $615.

**6.**                 Stockholders’Equity

**Authorized Shares**

The Company’s authorizedcapital consists of 100,000 shares of capital stock, of which 90,000 shareshave been designated as common stock ($0.01 per share par value), and 10,000shares have been designated as preferred stock ($0.01 per share par value). Inaddition, as of December 31, 2006, 2,518 of the 90,000 shares of commonstock had been reserved for issuance under the Company’s 2000 Plan, 2002 Plan,2004 Plan and DMC plan. Each share of common stock entitles the holder to onevote.

**Stock Split**

The Company’s Board ofDirectors and stockholders declared a three-for-one reverse stock split,effective June 10, 2005. The accompanying financial statements and relatednotes give retroactive effect to this reverse stock split.

**Warrants**

In October 2006, in connection with its private placement,the Company issued warrants  to purchase1,367 common shares at an exercise price of $6.00 per share and with anexpiration date of October 2011. Of these warrants, 1,257 were issued topurchasers of the shares and 110 to the selling agent.

During 2006, the Company received net proceeds of $512from the exercise of 253 warrants with an average exercise price of $2.25.

In November  2005 in connection with its initialpublic offering, the Company issued warrants to purchase 400 common shares tothe selling agent at an exercise price of $7.20 per share expiring in October 2010.

In connection with the convertible notes issued in April 2005(see “Convertible Notes” below), the Company issued warrants to purchase 367common shares at an exercise price of $4.80 per share.

In March 2005, the Company granted fully vestedwarrants to purchase 33 common shares at an exercise price of $6.00 per shareto a consultant of the Company. In August 2005, the Company grantedwarrants to purchase 80 common shares at an exercise price of $6.00 per shareto a consultant of the Company. These warrants vest ratably over three yearsbeginning retroactively to October 2004. In 

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October and December 2004,the Company granted warrants to purchase 253 shares of the Company’s commonstock at a price of $6.00 per share to consultants of the Company. Of thesewarrants, warrants to purchase 170 shares vest over three years and have aten-year term. The remaining warrants to purchase 83 shares vest based ondesign wins and have a five-year term.

Total stock-based compensation expense related tothese warrants during the years ended December 31, 2004, 2005 and 2006 andcumulative for the period from inception (April 14, 1997) through December 31,2006 was $50, $515, $169 and $734, respectively. The fair value of thesewarrants was measured as they were earned using the Black-Scholes optionpricing model and the following assumptions at December 31, 2006: term—10years; volatility—71.2%; risk-free interest rate—4.70%; and expected dividendyield of zero.

In connection with the issuance of common stock by theCompany from January 2004 to August 2004, the Company issued warrantsto the selling agent to purchase 244 shares of common stock at an exerciseprice of $4.80. Of these warrants, warrants to purchase 200 shares expire on March 24,2009, and the remaining warrants to purchase 44 shares expire on August 15,2009.

In the period between April 1, 2003 and July 31,2003, the Company received proceeds of $5,304, net of $697 of offering costs,in exchange for three-year warrants to purchase 2,000 shares of the Company’scommon stock. These warrants, which expire if not exercised three years afterissuance, consisted of 1,000 Part A Warrants with an exercise price of$1.50 and 1,000 Part B Warrants with an exercise price of $2.25.

The warrants areredeemable at the Company’s option upon at least 30 days’ notice at aredemption price of $0.01 per warrant under any of the following circumstances:

·       Part Aand B Warrants are redeemable by the Company when any one of the followingtransactions closes: i) the sale, lease, exchange or other transfer,directly or indirectly, of all or substantially all of the assets of theCompany, ii) the approval by the Company’s stockholders of any plan or proposalfor the liquidation or dissolution of the Company, iii) any person or entitybecomes the beneficial owner, directly or indirectly, of more than 50% ofcombined voting power of the outstanding securities of the Company, or iv) amerger or consolidation to which the Company’s stockholders represent less than50% of the surviving company’s combined voting power of outstanding securities.

·       Part AWarrants were redeemable by the Company when the Company gave notice that ithad fabricated and successfully tested and demonstrated the functionality ofits FPOA and also received commitments from at least two customers that willuse the chip in at least one of each customer’s design programs.

·       Part BWarrants are redeemable by the Company when the Company gives notice that ithas i) closed on a strategic investment from a company with significantfinancial resources (as defined) that is a participant in the semiconductorindustry or a related industry, or ii) recognized total aggregate cumulativerevenue from the sale or license of its FPOA chips of at least $2,500.

During 2004, the Company gave notice that it hadachieved the milestones required to permit the Company to redeem thePart A warrants. In December 2004, the Company called for redemptionof all Part A warrants. Proceeds from the exercise of Part A warrantsto purchase 981 shares and Part B warrants to purchase 646 shares, whoseholders voluntarily elected to exercise, were $2,645 net of offering costs of$279. The remaining Part A warrants to purchase 19 shares were exercisedin December 2003 and January 2005.

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Thefollowing table summarizes warrant activity: 

| ** **                                               | ** ** | **Warrants   Outstanding** | ** ** | **Price Range   Per Share** | ** ** |
|----------------------------------------------------------|------------|---------------------------------|------------|--------------------------------------------|------------|
| Warrants outstanding at  beginning of period (inception) |       |                            |       |                                       |       |   |   |
| Warrants issued in 2000                                  |       |                            | 224        |                                       |       | $ | 8.25 |   |
| Outstanding at December 31, 2000                    |       |                            | 224        |                                       |       | $ | 8.25 |   |
| Warrants issued                                          |       |                            | 36         |                                       |       | $ | 7.77 |   |
| Outstanding at December 31, 2001                    |       |                            | 260        |                                       |       | $ | 7.77 - $8.25 |   |
| Warrants issued                                          |       |                            | 146        |                                       |       | $ | 10.50 |   |
| Outstanding at December 31, 2002                    |       |                            | 406        |                                       |       | $ | 7.77 -$1.50 |   |
| Warrants sold                                            |       |                            | 2,000      |                                       |       | $ | 1.50 - $2.25 |   |
| Warrants issued                                          |       |                            | 200        |                                       |       | $ | 4.89 |   |
| Warrants  exercised                                      |       |                            | (18        | )                                          |       | $ | 1.50 |   |
| Outstanding at December 31, 2003                    |       |                            | 2,588      |                                       |       | $ | 1.5 -$10.50 |   |
| Warrants issued                                          |       |                            | 497        |                                       |       | $ | 4.8 - $6.00 |   |
| Warrants  exercised                                      |       |                            | (1,627     | )                                          |       | $ | 1.0 - $2.25 |   |
| Outstanding at December 31, 2004                    |       |                            | 1,458      |                                       |       | $ | 1.50 - 10.50 |   |
| Warrants issued                                          |       |                            | 880        |                                       |       | $ | 4.8 - $7.20 |   |
| Warrants  exercised                                      |       |                            | (101       | )                                          |       | $ | 1.0 - $2.25 |   |
| Warrants expired                                         |       |                            | (253       | )                                          |       | $ | 7.77 - $8.25 |   |
| Outstanding at December 31, 2005                    |       |                            | 1,984      |                                       |       | $ | 1.5 -$10.50 |   |
| Warrants issued                                          |       |                            | 1,367      |                                       |       | $ | 6.00 |   |
| Warrants  exercised                                      |       |                            | (253       | )                                          |       | $ | 2.25 |   |
| Warrants expired                                         |       |                            | (8         | )                                          |       | $ | 2.25-$7.76 |   |
| Outstanding at  December 31, 2006                   |       |                            | 3,090      |                                       |       | $ | 4.8 -$10.50 |   |

 

**Restricted Stock**

In 2005, the Companyissued 84 and 408 shares of restricted common stock to certain employees of theCompany which vested on October 26, 2006. The Company recognizedcompensation expense equal to the grant date fair value of the common shares($2,741) pro rata over the one-year vesting period. During 2005, the Companyrecognized $447 of compensation expense related to these restricted shares, netof the reversal of $70 compensation expense recorded for 47 restrictedshares cancelled before vesting. During 2006, the Company issued 60 shares ofrestricted stock to certain employees of the Company with a fair value of $342.Fifty percent of these shares will vest after one year, and fifty percent atthe end of the second year. The Company is recognizing the expense over thetwo-year vesting period. In addition, during 2006, 405 shares of previouslyissued restricted stock vested and 39 shares were forfeited. The remainingestimated compensation expense of $175 will be recognized over the remainingvesting period of one year.

**Convertible Notes**

In April 2005, the Company issued 8% convertiblenotes totaling $5,500. The notes, which were due on April 28, 2006, boreinterest at the rate of 8% per year and were convertible into shares of theCompany’s common stock at a price per share equal to 80% of the issuance priceof the Company’s stock 

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in an initial publicoffering, if any. If an initial public offering did not occur on or before April 28,2006 or any extended maturity date of the notes, the notes would have beenconvertible into shares of the Company’s common stock at a price of $4.80 pershare. The Company could have elected to extend the maturity of the notes forup to six months if an initial public offering had not closed on or before April 28,2006. However, the notes were payable in full 30 days after the closing date ofan initial public offering.

In connection with the issuance of the convertiblenotes, the Company issued to the note holders warrants to purchase up to 367shares of the Company’s common stock. The warrants, which have a five-yearterm, are exercisable at a price per share equal to 80% of the issuance priceof the Company’s stock in an initial public offering ($4.80). If an initialpublic offering had not occurred on or before April 28, 2006 or anyextended maturity date of the notes, the warrants would have become exercisableat a price of $4.80 per share.

The allocated fair value of the warrants of $1,126 andthe value attributable to the beneficial price for conversion of the notes of$2,502 were accounted for as a discount on the convertible notes. The Companywas amortizing this discount to interest expense over the original term of thenotes. However, following completion of the Company’s initial public offeringduring the fourth quarter of 2005, the note holders elected to convert $5,430of the notes and accrued interest into 1,128 shares of common stock, and theremaining $330 of notes and accrued interest was repaid on December 1,2005 in accordance with the terms of the notes. The remaining unamortizeddiscount on these notes was charged to interest expense during the quarterended December 31, 2005. Interest expense recorded during the year ended December 31,2005 related to amortization of the discount was $3,628.

The fair value of thewarrants was determined using the Black-Scholes option pricing model and thefollowing assumptions at the date of issuance:  term—five years;volatility—68%; risk-free interest rate—3.79%; and expected dividend yield ofzero. The value of the conversion feature was determined using the mostbeneficial conversion price of the notes at the time of issuance ($4.80 pershare) and taking into account the additional discount attributable to theallocated value of the warrants. This approach resulted in a per shareconversion price for accounting purposes of approximately $3.81. When comparedto the estimated fair value of the Company’s common stock at the time of theissuance of the notes ($6.00 per share), this accounting conversion priceprovides approximately a $2.19 conversion benefit to the note holders for eachof the 1,146 shares into which the notes were convertible.

**7.**                 IncomeTaxes

The Company has not recorded any income tax benefitfor losses recorded since inception.

Thecomponents of deferred income taxes are as follows: 

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Net operating  loss carryforwards                  |       | $                     | 25,461     |   | $ | 34,555 |   |
| Research and experimentation  credit carryforwards |       | 2,669                 |       | 3,070 |   |
| Accrued expenses  and stock options                |       | 822                   |       | 679 |   |
| Total deferred  tax assets                         |       | 28,952                |       | 38,304 |   |
| Valuation  allowance                               |       | (28,952               | )          | (38,304 | ) |
| Net deferred tax asset                             |       | $                     | —     |   | $ | — |   |

 

The Company has established valuation allowances tofully offset its deferred tax assets due to uncertainty about the Company’sability to generate the future taxable income necessary to realize thesedeferred tax assets, particularly in light of the Company’s recent history ofsignificant operating losses. The valuation allowance increased by $3,877,$6,745 and $9,352 for the years 2004, 2005 and 2006, respectively. Future utilization of available net operating losscarryforwards may be limited under Internal Revenue 

47

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Code Section 382 as aresult of significant changes in ownership. These limitations could result inexpiration of these net operating loss carryforwards before they are utilized.

For the years ended December 31, 2004, 2005 and2006, and cumulative for the period from inception (April 14, 1997)through December 31, 2006, the Company has generated federal net operatingloss carryforwards of approximately $8,650, $14,037, $21,710 and $84,361,respectively.

The Company’s federal net operating loss carryforwardsand state net operating loss carryforwards expire in various calendar yearsfrom 2014 through 2026. Available research and development credit carryforwardsat December 31, 2006, include federal and state amounts of $2,588 and$742, respectively, with expiration dates in calendar years 2020 through 2026.

TheCompany’s effective income tax rate differs from the U.S. Federal income taxrate as shown below: 

| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Tax expense  (benefit) at the federal statutory rate          |       | (35.00                | )%         | (35.00 | )% | (35.00 | )% |
| State income tax  (benefit), net of federal income tax effect |       | (5.00                 | )%         | (5.70 | )% | (5.96 | )% |
| Permanent  differences                                        | ** ** | ** **            |       | 7.84 | % | 1.80 | % |
| Other                                                         |       | (4.83                 | )%         | (2.78 | )% | (2.14 | )% |
| Increase in  valuation allowance                              |       | 44.83                 | %          | 35.62 | % | 41.30 | % |
| Effective tax rate                                            |       | 0.00                  | %          | 0.00 | % | 0.00 | % |

 

**8.**                 401(k) SavingsPlan

During 2000, the Companyestablished a defined contribution savings plan under Section 401(k) ofthe Internal Revenue Code. This plan covers substantially all employees whomeet minimum age and service requirements and allows participants to defer aportion of their annual compensation on a pre-tax basis. The Company may makecontributions to the plan at the discretion of the Board of Directors. TheCompany has made no contributions to the plan.

**9.**                 Commitments

**Operating Leases**

The Company leases its office and research facilitiesand certain office equipment under noncancellable operating leases. Total rentexpense under these operating leases was $859, $1,074 and $1,163 for the yearsended December 31, 2004, 2005 and 2006, respectively, and $5,265cumulative for the period from inception (April 14, 1997) through December 31,2006.

Futureminimum lease payments under non-cancelable operating leases at December 31,2006 are as follows: 

| **Year  Ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2007                               |       | $          | 632        |   |
| 2008                               |       | 267        |       |
| 2009                               |       | 275        |       |
| 2010                               |       | 283        |       |
| 2011                               |       | 47         |       |
| 2012 and  thereafter               |       | —     |       |
|                               |       | $          | 1,504      |   |

 

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**Item9.**                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosure

Notapplicable.

**Item9A.**                Controls andProcedures

**Evaluation of Disclosure Controls and Procedures**

Wemaintain disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended)that are designed to reasonably ensure that information required to bedisclosed by us in the reports we file or submit under the Securities ExchangeAct of 1934, as amended, is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, or persons performing similar functions, as appropriate to allowtimely decisions regarding required disclosure.

Our management hasevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of the Company’s disclosure controls andprocedures as of the end of the period covered in this Annual Report on Form 10-K.Based on this evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that the Company’s disclosure controls and procedureswere effective as of December 31, 2006.

**Management’s Report on Internal Control Over FinancialReporting**

Management of the Companyis responsible for establishing and maintaining adequate internal control overfinancial reporting. The Company’s internal control over financial reporting isa process designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles in theUnited States of America. The Company’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of the financial statements in accordance with generally acceptedaccounting principles in the United States of America, and that receipts andexpenditures of the Company are being made only in accordance withauthorizations of management and directors of the Company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the Company’s assets that could have amaterial effect on the financial statements.

Internal control overfinancial reporting cannot provide absolute assurance of achieving financialreporting objectives because of its inherent limitations. Internal control overfinancial reporting is a process that involves human diligence and is subjectto lapses in judgment or breakdowns resulting from human failures. Internalcontrol over financial reporting also can be circumvented by collusion orimproper management override. Because of such limitations, there is a risk thatmaterial misstatements may not be prevented or detected on a timely basis byinternal control over financial reporting. However, these inherent limitationsare known features of the financial reporting process. Therefore, it ispossible to design into the process safeguards to reduce, though not eliminate,this risk.

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

Management assessed theeffectiveness of the Company’s internal control over financial reporting as of December 31,2006. In making this assessment, management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in “*Internal Control—*

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*Integrated Framework*”. Based on this assessment,management has concluded that the Company’s internal control over financialreporting was effective as of December 31, 2006.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2006 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report whichis included in this Form 10-K.

**Changes in Internal Control Over Financial Reporting**

As of December 31,2004 and 2005, the Company reported a material weakness in its internal controlover financial reporting related to management’s conclusion that (i) itdid not have a sufficient number of financial personnel with adequate trainingand experience in accounting and financial reporting and that (ii) theCompany’s controls were not designed and operating effectively to ensure thatoperating expenses and stock based compensation transactions were identifiedand recorded accurately and in the appropriate accounting period. A materialweakness is a control deficiency, or combination of control deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected. Thetwo aforementioned control deficiencies, in combination, constituted a materialweakness in the Company’s internal control over financial reporting as of December 31,2005. In addition, the combination of these two control deficiencies could haveresulted in a misstatement of the presentation and disclosure of the Company’sfinancial statements that would result in a material misstatement in annual orinterim financial statements that would not be prevented or detected.

As of December 31,2006, the Company has remediated the previously reported material weakness inits internal control over financial reporting. The following remedial actionshave been undertaken and completed:

·       InJune 2005, the Company hired a Chief Financial Officer and in July 2005,the Company hired a Controller. Both are certified accountants;

·       InDecember 2005, a nonexempt employee was hired to process transaction-basedactivity, including Accounts Receivable and Accounts Payable transactions whichimpact the reporting of operating expenses;

·       InFebruary 2006, another certified public accountant was added to theCompany’s staff;

·       Foreach reporting period in 2006, all accounts were timely reconciled andreviewed;

·       Asof January 1, 2006, the Company implemented the Great Plains GeneralLedger System. The system is functional in a network environment that enablessystem constraints to ensure segregation of duties and traceability ofactivity; and

·       TheCompany established new policies and procedures surrounding the processing ofoperating expense and stock based compensation transactions and relatedfinancial reporting. Key policies were established and implemented in the firstquarter of 2006 with final implementation of the new operating expense andstock based compensation reporting procedures during the third quarter of 2006.

In the third and fourthquarters of 2006, the Company has undertaken and completed, as appropriate, itstesting to validate compliance with the enhanced financial reporting policies,procedures and controls. The Company has undertaken testing over the design andoperating effectiveness of these enhanced financial reporting controls so as tobe able to demonstrate operating effectiveness over a period of time that issufficient to support its conclusion that the Company has remediated thepreviously reported material weakness in its internal control over financialreporting as of December 31, 2006.

**Item9B.**               Other Information

Not applicable.

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**PART III**

**Items 10 through 14 of this AnnualReport on Form 10-K are omitted because we will file before April 30,2007 a definitive Proxy Statement (the “Proxy Statement”) conforming toSchedule 14A involving the election of directors. The information required byItems 10, 11, 12, 13 and 14 of Part III of the Form 10-K arehereby incorporated by reference to the information set forth in such ProxyStatement under the headings “Proposal No. 1—Election of Directors, “Meetingsand Committees of the Board of Directors,” “Code of Business Conduct andEthics,” “Director Compensation,” “Security Ownership of Certain BeneficialOwners and Management,” “Executive Officers,” “Executive Compensation,” “RelatedParty Transaction,” “Compensation Committee Interlocks and InsiderParticipation in Compensation Decisions,” “Proposal No. 2—Ratification ofAppointment of Independent Registered Public Accounting Firm” and “Section 16(a) BeneficialOwnership Reporting Compliance.”**

**PART IV**

**Item 15. Exhibitsand Financial Statement Schedules**

**FinancialStatements and Schedules**

(a)(1)    The Financial Statements, together with thereport thereon of our independent registered public accounting firm, areincluded on the pages indicated below: 

|                                                                                                                                                                    | ** ** | **Page** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm                                                                                                           |       |     | 27         |   |   |
| Balance Sheets as  of December 31, 2005 and 2006                                                                                                              |       |     | 30         |   |   |
| Statements of  Operations for the years ended December 31, 2004, 2005 and 2006 and  cumulative from inception (April 14, 1997) to December 31, 2006 |       |     | 31         |   |   |
| Statements of Changes  in Stockholders’ Equity from inception (April 14, 1997) to  December 31, 2006                                                |       |     | 32         |   |   |
| Statements of  Cash Flows for the years ended December 31, 2004, 2005 and 2006 and  cumulative from inception (April 14, 1997) to December 31, 2006 |       |     | 34         |   |   |
| Notes to Consolidated  Financial Statements                                                                                                                        |       |     | 35         |   |   |

 

(2)   There areno schedules required to be filed herewith.

(3)   The following exhibits are filed herewith orincorporated herein by reference, as indicated, and this list is intended toconstitute the exhibit index. 

| Exhibit No. | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **Page** |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| 2.1              |       | Agreement and Plan of Merger dated June 10,  2005 by and between MathStar, Inc. (Minnesota Corporation) and  MathStar, Inc. (Delaware Corporation) (incorporated by reference to  Exhibit 2.1 to the Registration Statement on Form S-1 filed  by MathStar, Inc. with the Securities Exchange Commission (“SEC”) on  August 3, 2005, Registration No. 333-127164 (“Registration  Statement”)). |       |     |
| 2.2              |       | Articles of Merger dated June 10, 2005 by and  between MathStar, Inc. (Minnesota Corporation) and MathStar, Inc.  (Delaware Corporation) as filed with the Delaware and Minnesota Secretaries  of State on June 14, 2005 (incorporated by reference to Exhibit 2.2  to the Registration Statement).                                                                                                                               |       |     |
| 3.1              |       | Certificate of Incorporation of MathStar, Inc.  (incorporated by reference to Exhibit 31 to the Registration Statement).                                                                                                                                                                                                                                                                                                                         |       |     |

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| 3.2   |   | By-laws of MathStar, Inc. (incorporated by  reference to Exhibit 32 to the Registration Statement).                                                                                                                                                                                                     |   |   |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| 4.1   |   | Form of common stock certificate of  MathStar, Inc. (incorporated by reference to Exhibit 41 to the  Registration Statement).                                                                                                                                                                      |   |   |
| 10.1  |   | MathStar, Inc. 2004 Amended and Restated  Long-Term Incentive Plan and related forms of agreements (incorporated by  reference to Exhibit 10.4 to the Registration Statement).*                                                                                                                         |   |   |
| 10.2  |   | MathStar, Inc. 2005 Variable Compensation Plan  (incorporated by reference to Exhibit 10.5 to the Registration  Statement).*                                                                                                                                                                            |   |   |
| 10.3  |   | First Amendment to the Standard Commercial Lease  dated as of July 22, 2005 by and between Parkway Point Joint Venture and  MathStar, Inc. (incorporated by reference to Exhibit 1011 to the  Registration Statement).                                                                             |   |   |
| 10.4  |   | Office Lease Agreement dated June 1, 2005 by  and between Mark Tanasbourne, LLC and MathStar, Inc. (incorporated by  reference to Exhibit 1012 to the Registration Statement).                                                                                                                     |   |   |
| 10.5  |   | Executive Suite Rental Agreement dated  June 16, 2005 by and between Jet Center Property Services, LLC and  MathStar, Inc. (incorporated by reference to Exhibit 1013 to the  Registration Statement).                                                                                        |   |   |
| 10.6  |   | Form of Non-Statutory Stock Option Agreement  evidencing options granted and to be granted to the non-employee directors of  MathStar, Inc. (incorporated by reference to Exhibit 10.3 to the  Quarterly Report on Form 10-Q filed by the Company with the SEC on  November 22, 2005).*  |   |   |
| 10.7  |   | Form of Restated Bridge Loan and Subscription  Agreement for April 2005 note and warrant financing of  MathStar, Inc. (incorporated by reference to Exhibit 1017 to the  Registration Statement).                                                                                             |   |   |
| 10.8  |   | Form of Bridge Note for April 2005 note  and warrant financing of MathStar, Inc. (incorporated by reference to  Exhibit 1018 to the Registration Statement).                                                                                                                                  |   |   |
| 10.9  |   | Form of Bridge Warrant for April 2005 note  and warrant financing of MathStar, Inc. (incorporated by reference to  Exhibit 1019 to the Registration Statement).                                                                                                                               |   |   |
| 10.10 |   | Strategic Partnership Agreement dated as of  October 8, 2004 by and among Valley Technologies, Inc., Gerald  Petrole and MathStar, Inc. (incorporated by reference to Exhibit 10.7  to the Registration Statement).**                                                                         |   |   |
| 10.11 |   | Amendment No. 1 to Strategic Partnership  Agreement dated August 11, 2005 by and between MathStar, Inc. and  Valley Technologies, Inc. (incorporated by reference to  Exhibit 1020 to the Registration Statement).                                                                       |   |   |
| 10.12 |   | Amendment No. 2 to Strategic Partnership  Agreement dated December 5, 2005 by and between MathStar, Inc. and  Valley Technologies, Inc. (incorporated by reference to  Exhibit 10.1 to the Current Report on Form 8-K filed by the  Company with the SEC on December 5, 2005). |   |   |
| 10.13 |   | Honeywell/MathStar Strategic Agreement dated as of  December 13, 2004 by and between Honeywell International, Inc. and  MathStar, Inc. (incorporated by reference to Exhibit 10.7 to the  Registration Statement).**                                                                          |   |   |

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| 10.14 |   | Schedule of Executive Officer and Director  Compensation for 2007 (filed electronically herewith).*                                                                                                |   |   |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| 23.1  |   | Consent of Independent Registered Public Accounting  Firm.                                                                                                                                         |   |   |
| 31.01 |   | Certification of the Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  (Rules 13a-14 and 15d-14 of the Exchange Act) (filed  electronically herewith). |   |   |
| 31.02 |   | Certification of the Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  (Rules 13a-14 and 15d-14 of the Exchange Act) (filed  electronically herewith). |   |   |
| 32.01 |   | Certification of the Chief Executive Officer  pursuant Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.  Section 1350) (filed electronically herewith).                          |   |   |
| 32.02 |   | Certification of the Chief Financial Officer  pursuant Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.  Section 1350) (filed electronically herewith).                          |   |   |

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*                    Indicates amanagement contract or compensatory plan or arrangement.

**             Portions of suchexhibit are treated as confidential pursuant to an Order Granting ConfidentialTreatment under the Securities Act of 1933 dated October 26, 2005 issuedby the SEC. Such portions of the exhibit have been redacted, and the redactedportions were separately filed with the SEC.

***      Portions of such exhibit aretreated as confidential pursuant to a request for that confidential treatmentfiled with the SEC by MathStar, Inc. Such portions of the exhibit havebeen redacted, and the redacted portions have been separately filed with theSEC.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized. 
| Date  March 13, 2007 | MATHSTAR, INC.                     |
|---------------------------|-----------------------------------------|
|                      | /s/ DOUGLAS M. PIHL                     |
|                      | Douglas M. Pihl                         |
|                      | *President and Chief Executive Officer* |
|                      | *(Principal Executive Officer)*         |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities indicated on March 31, 2006: 
|                                        | **Signature** | ** **                                                                              | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------------------|---------------|-----------------------------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ DOUGLAS  M. PIHL              |          | President, Chief  Executive Officer and                                                 |       | March 13,  2007 |
| Douglas  M. Pihl                       |          | Chairman of the Board of  Directors  (Principal Executive Officer)                      |       |                 |
| /s/ JAMES W. CRUCKSHANK |          | Vice President of  Administration and                                                   |       | March 13,  2007 |
| James  W. Cruckshank                   |          | Chief Financial Officer  (Principal Financial Officer and Principal Accounting Officer) |       |                 |
| /s/ BENNO  G. SAND                |          | Director                                                                                |       | March 13,  2007 |
| Benno  G. Sand                         |          |                                                                                    |       |                 |
| /s/ MERRILL A.  MCPEAK                 |          | Director                                                                                |       | March 13,  2007 |
| Merrill  A. McPeak                     |          |                                                                                    |       |                 |
| /s/ MORRIS  GOODWIN, JR.          |          | Director                                                                                |       | March 13,  2007 |
| Morris  Goodwin, Jr.              |          |                                                                                    |       |                 |
| /s/ MICHAEL O.  MAERZ                  |          | Director                                                                                |       | March 13,  2007 |
| Michael O. Maerz                       |          |                                                                                    |       |                 |

 

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