**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

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**FORM 10-K**

**(Mark One)**
| x | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** | ** ** |
|---|------------|-----------------------------------------------------------------------------------------------------|------------|

 

**For the fiscal yearended December 31, 2005**

**OR**
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** | ** ** |
|-------|------------|---------------------------------------------------------------------------------------------------------|------------|

 

**For the transitionperiod from                         to                         **

**Commission file number: **000-51560

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**MathStar, Inc.**

(Exact name 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’s telephone number, including area code)

**5900 Green Oak Drive, Minnetonka, Minnesota 55343**

(Former name, former address and former fiscal year, ifchanged since last report)

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

|                     | **Title of each class** | ** ** | ** ** | **Name of each exchange on which registered** | ** ** |
|---------------------|-------------------------|------------|------------|-----------------------------------------------|------------|
| **Not applicable.** | **Not applicable.**     |

 

Securities registered pursuant to Section 12(g) ofthe Act:   Common stock, $0.01 per share par value

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

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.   Yes o   No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.   Yes x   No o

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

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).   Yes o   No x

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

State the aggregate market value of the voting andnon-voting common equity held by non-affiliates computed by reference to theprice at which the common equity was last sold, or the average bid and askedprice of such common equity, as of the last business day of the registrant’smost recently completed second fiscal quarter.

Not applicable. The registrant’s common equity was notpublicly traded on The Nasdaq National Market on June 30, 2005, which wasthe last day of the registrant’s most recently completed second fiscal quarter.The registrant’s common equity began trading on The Nasdaq National Market on October 27,2005.

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

|                                          | **Class**         | ** ** | ** ** | **Outstanding at March 17, 2006** | ** ** |
|------------------------------------------|-------------------|------------|------------|----------------------------------------|------------|
| Common Stock,  $0.01 par value per share | 17,447,691 shares |

 

 

 

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**DOCUMENTSINCORPORATED BY REFERENCE**

| Document                                                                                                                       | ** ** | ** **    | ** ** | **Parts Into Which Incorporated** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------------------------------|
| Certain portions of the Proxy Statement for the  Annual Meeting of Stockholders to be held May 18, 2006 (Proxy Statement) |       | Part III |

 

 

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**MathStar, Inc.2005 ANNUAL REPORT ON FORM 10-K**

**TABLEOF CONTENTS**

|                   | ** ** | ** **                                                                                                         | ** ** | **Page**   | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **PART I**   | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |   |
| Item 1.           |       | Business                                                                                                           |       |       | 1          | ** ** |   |
| Item  1A.         |       | Risk Factors                                                                                                       |       |       | 16         | ** ** |   |
| Item 2.           |       | Properties                                                                                                         |       |       | 28         | ** ** |   |
| Item  3.          |       | Legal Proceedings                                                                                                  |       |       | 28         | ** ** |   |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                |       |       | 28         | ** ** |   |
| **PART II**  | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |   |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |       | 29         | ** ** |   |
| Item 6.           |       | Selected  Financial Data                                                                                           |       |       | 30         | ** ** |   |
| Item 7.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                   |       |       | 31         | ** ** |   |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       |       | 37         | ** ** |   |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                        |       |       | 38         | ** ** |   |
| Item 9.           |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       |       | 61         | ** ** |   |
| Item 9A.          |       | Controls and Procedures                                                                                            |       |       | 61         | ** ** |   |
| Item 9B.          |       | Other Information                                                                                                  |       |       | 62         | ** ** |   |
| **PART III** | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |   |
| Item 10.          |       | Directors and Executive Officers of the Registrant                                                                 |       |       | 62         | ** ** |   |
| Item 11.          |       | Executive Compensation                                                                                             |       |       | 62         | ** ** |   |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       |       | 62         | ** ** |   |
| Item 13.          |       | Certain Relationships and Related Transactions                                                                     |       |       | 62         | ** ** |   |
| Item 14.          |       | Principal Accountant Fees and Services                                                                             |       |       | 62         | ** ** |   |
| **PART IV**  | ** ** | ** **                                                                                                         | ** ** |       | ** ** | ** ** |   |
| Item 15.          |       | Exhibits and  Financial Statement Schedules                                                                        |       |       | 63         | ** ** |   |
| Signatures        |       |                                                                                                               | 66         | ** ** |       |

 

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**PART I**

**Item 1. Business**

**Overview**

Today’s modern electronic devices and systems offerbetter functionality, better performance, smaller size, lower power and lowerprice than ever before. These advantages are largely derived from theincreasing capabilities of silicon integrated circuits, or chips. It is theavailability of these integrated circuit chips that fuels improvements in awide range of system solutions, which, in turn, creates increased demand foreven higher performance chips. System-level designs in many modernapplications, such as image and media processing, require hundreds of billionsof computations per second of digital processing performance in order tocompete in today’s markets. To achieve these computational rates, many of theseapplications currently use special-purpose application specific integratedcircuits, or ASICs, tailored to one specific product application. The primaryadvantages of using ASIC technology are low per unit cost and high performance.The principal challenges associated with developing applications using ASICsare increasing development costs and the inability to change the chips’function as applications and algorithms evolve. Development costs have becomehigh enough that ASICs tend to be used for only higher volume applicationsbecause high development costs can be amortized over a large unit volume. Thesechallenges have caused system designers to seek alternative solutions. One ofthe alternative solutions available to designers is field programmable gatearrays, or FPGAs. Because FPGAs are reprogrammable, they can accommodatechanges in the chip as applications and algorithms evolve. However, by theirnature, FPGAs have lower performance and higher per unit cost than ASICs. Webelieve that these disadvantages limit the applications that can be effectivelyserved by the FPGA architecture. We have introduced a new chip architecturethat combines the cost and performance advantages of ASICs with theprogrammability of FPGAs.

We design, develop and market a new class of logicplatform chips we call field programmable object arrays, or FPOAs. FPOAs arehigh performance, reprogrammable integrated circuits based on our proprietarysilicon object technology. FPOAs provide a new way of implementing highperformance functions in silicon integrated circuits. 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. Each of our silicon objects can execute its function ata rate of up to one billion times per second, which is up to four times fasterthan commercially available programmable logic devices. Our first FPOA contains400 silicon objects, and each of these can operate simultaneously, creating achip capable of executing 400 billion computational operations per second.

We believe an additional advantage of the FPOA isderived from the programming architecture of the chip. The process ofprogramming FPGAs and FPOAs begins in a similar manner. The applicationdesigner creates a functional diagram of the application that shows the variouscomputational stages of the algorithm and the flow of data through thefunctional diagram. A simple example of a functional block within this diagramwould be a comparator block that determines which of two numbers is thelargest. After the application is diagrammed in this manner, the engineer needsto implement the particular functions required. It is at this point that theprogramming process for FPOAs and FPGAs diverges.

Traditional FPGAs require programming at the gatelevel. Gates are the most basic building blocks of digital systems and, bythemselves, implement only very rudimentary functions. Because the hardware ofan FPGA is comprised of only basic logic gates, a function such as thecomparator example described above does not exist within an un-programmed FPGA.The application designer must create such a function by programming the logicfor a comparator using the gates of the FPGA. Creating all of the functionsrequired for a typical application can be a time-consuming process.

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In contrast, silicon objects are programmed at theobject level to implement higher level functions, which involves designinghundreds of objects rather than millions of gates. Using the comparatorexample, a function to compare two numbers is one of the many logical functionsalready built into the architecture of the arithmetic logic unit, or ALU, whichis one of the silicon objects on our chip. Comparing two numbers in an FPOA isa simple matter of specifying the right command for the ALU to execute on aparticular instruction cycle. The ALU then indicates that either x is largerthan y, y is larger than x, or x and y are equal. The application designer doesnot need to be concerned about the details of how two numbers are compared.This means the design team can focus more on the chip’s system levelfunctionality and less on detailed implementation issues. We believe this willreduce development time and cost and improve overall system performance ascompared to other methods of chip design.

We believe the only significant advantages ofhigh-performance FPGAs over our FPOAs in our target markets are applications inwhich the data is less than 16 bits, as our FPOA chip is designed to operate on16-bit data values. In that case, our FPOA could implement theapplication but may be less efficient in the use of silicon area. If the datawere more than 16 bits, we would need additional ALU objects to implement thefunction. To date, most of the applications we have addressed have fit well inour 16-bit architecture.

FPOAs combine the low development cost, rapidtime-to-market and extended time-in-market advantages of existing programmablelogic devices while delivering the low per unit cost and high performanceadvantages of ASICs. We believe that FPOAs are ideally suited to implement highperformance algorithmic functions across a wide spectrum of digitalapplications. We are introducing the FPOA into markets that will benefit fromour chip’s high performance. Initial target markets for our FPOA include highperformance video and image processing, machine vision, such as automatedinspection systems, and military/aerospace applications.

Examples ofapplications where FPOAs appear to offer a superior solution based ondiscussions with existing and potential customers include:

·       Amachine vision system manufacturer needs to design a high-performance imagingboard to process the image data from multiple high-resolution, high-frame ratecamera inputs in real time.

·       Ahigh-performance spectrum analyzer designer wants a flexible signal samplingdesign that can process 16 bit resolution data at billions of samples persecond.

·       Ahigh-performance display manufacturer wants to design a board that can be programmedin the field to handle individual high definition MPEG 4 video streams ormultiple TV-quality MPEG 4 video streams.

·       Anengineer designing a computer tomography, or CT, scanner wants to migrate itsimage processing sub-system from a 16 slice image mode to a 32 slice image modewithout requiring its customers to upgrade their hardware.

·       Amilitary/defense contractor wants to perform image processing in multiplewavelengths, such as visible and infrared, and execute complex patterndetection algorithms in real time.

We will sell the FPOA chips in a blank state asstandard off-the-shelf products. Our chips can be programmed forapplication-specific functionality by using a combination of industry-standarddesign tools, our physical-layer software design tools and our library ofpre-programmed algorithms. Although the programming process is very similar tohow FPGAs are programmed, we believe programming at the object level will proveto be more efficient than programming at the gate level. We currently have alimited supply of our first 400 object FPOA chips available for sale along withthe development boards and software design tools used to program the FPOA.

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Part of the proceedsof our October 2005 initial public offering are being used to fund an ongoingengineering project to analyze the current design of the FPOA. With suchproceeds, we expect to resolve material design issues in the current chip andexpect to produce, in the first half of 2006, a chip that is expected to befully functional at the intended one GHz clock speed, although there is noassurance we can do so. There are three major differences in the currentversion of our chip and the chip that will be introduced in the first half of2006. First, all of the defects in the current version will be fixed so we canship the new chip to customers in high volume without incurring the extensivetesting and sorting time required with the current version of the chip. Second,we are adding more input/output bandwidth to accommodate the needs of some ofour customers. Third, we are adding more internal memory, which will allowapplication designers to hold more data in the chip while performing variouscomputing steps, which should improve the performance of our chip.

**Industry Overview**

The digital integratedcircuits used in most electronic systems can be broadly categorized into threeclassifications:

·       processors,which are used for control and computing tasks;

·       memorydevices, which are used for storing program instructions and data; and

·       logic devices, either fixedor programmable, which are used for managing the interchange and manipulationof digital signals within a system—logic devices contain interconnectedgroupings of simple logical “and” and “or” and other logic functions, known asgates, to create more complex functions, and these complex combinations ofindividual gates are required to implement specialized logic functions requiredfor a system

***ASIC and FPGA Technologies***

Currently, two of the most common methodologies usedto design logic devices are the application specific integrated circuit, orASIC, and the programmable logic device, or PLD. The principal sub-category ofPLDs against which our FPOA chip will compete is field programmable gatearrays, or FPGAs. These design methods compete against each other because theymay be used in the same types of applications in electronic systems. Each ofthe design methods places a different emphasis on the trade-off between designcomplexity and design cost versus the performance and per unit cost that can beachieved. System designers must consider the often conflicting requirements oflife-cycle costs, time-to-market and relative performance when making decisionson which design methodology to use.

The functionality of an ASIC is fixed during thedesign process and typically is intended for a single application. ASICs arecustom designed specifically for the needs of one customer. ASICs’ design costsand development schedules have increased dramatically as semiconductorfabrication technologies have advanced, allowing more functionality in asmaller chip but significantly increasing design complexity. In recent years,fabrication process technologies called process geometries, which are measuredin nanometers, or nm, have progressed from 130 nm to 90 nm to 65 nm. Thisprogression is expected to continue to even smaller geometries or greaterdensities. The total design costs for an ASIC application at the 130 nmgeometry, including design, mask set creation and prototype fabrication, can beas much as $20 million. However, the per unit manufacturing cost of ASICs islower than FPGAs due, in part, to the smaller chip size possible with ASICs,enabling more chips per silicon wafer processed. Although the use of ASICs canresult in optimized chip performance, due to their high design costs and longdevelopment schedule, they are generally viewed as cost effective only forlarge-volume applications.

FPGAs are purchased in blank states and are configuredor programmed by the customer into combinations of specific logic oralgorithmic functions. The system designer may choose already existing 

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intellectual propertycores, which are pre-verified building blocks, to implement standardsystem-level functions. The system designer then programs the FPGA chip withthe specific functionality required for the end product, a design process thattakes less development time than for an ASIC. Although FPGAs have lower upfrontsilicon design costs than ASICs, their per unit manufacturing cost is usuallyhigher than an ASIC that can perform the same system function primarily becausethe FPGA requires a larger chip size.

Application specific standard products, or ASSPs, arebasically the same as ASICs except that ASSPs are sold as standardoff-the-shelf products to fit the needs of a broader range of customers. Inaddition, ASSPs usually require system design changes to accommodate the ASSPchip rather than the chip being designed for the specific requirements of thesystem.

Another prevailingtechnology is called the digital signal processor, or DSP. DSP chips fall intothe category of processors. They are fully programmable devices much like astandard microprocessor found in a typical computer but have additionalfeatures that make them better suited to computing the types of mathematicalalgorithms found in signal processing systems. Cell phone manufacturers are thebiggest consumers of DSP chips by volume, although there are many otherapplications.

***The Growth of Programmable Logic***

Manufacturers of electronic systems are increasinglyattracted to solutions that can reduce product development time and cost andshorten time-to-market. The typical ASIC design time to first silicon is about18 months, while the design time for a corresponding FPGA is about 12 months.The shorter development cycle of programmable logic is a direct result of thedevelopment process steps the designer must go through to complete a design.The development process for an ASIC involves the complex task of using basiclogic elements such as “and” and “or” gates to construct complex functions andalgorithms. These blocks of logic are then expressed as transistor circuitsthat are physically implemented in a form that can be built as a silicon chip.The FPGA development process typically involves the same initial steps.However, instead of reducing the logic blocks to physical circuits, the logicfunctions are programmed into pre-designed blocks of logic, thus reducing thetime-to-market for FPGAs as compared to ASICs. The FPGA vendors offer a range ofproducts that contain differing numbers of blocks of logic targeting a range ofdifferent applications. The number of new programmable logic designs initiatedby customers of ASIC and FPGA vendors indicates the industry’s growing interestin programmable logic devices. According to publicly-available information fromGartner Dataquest, the number of new ASIC design starts began to decline fromapproximately 10,000 new designs in 1998 to less than 4,000 in 2004. During thesame period, the capabilities of FPGAs as measured by the number of logic cellswas being increased to the point that high performance FPGAs were suitable forthe implementation of much larger portions of a system design, thusrepresenting a viable alternative to ASICs.

Manufacturers of electronicsystems may prefer programmable logic, rather than fixed-function ASICs, forthe following reasons:

·       Programmablelogic offers much more flexibility during the design cycle because designiterations are simply a matter of changing the programming file, and theresults of design changes can be seen immediately.

·       Programmablelogic does not require long lead times for prototypes or production parts—theblank chips can be available immediately from distributor inventory,eliminating costly inventory shortages and potential obsolete inventory.

·       Programmablelogic does not require the high engineering expenses associated with designingchips and the purchase of expensive mask sets because the chips arepre-designed and available off-the-shelf.

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·       FPGAscan be reprogrammed even after a piece of equipment is shipped to a customer,providing the ability to upgrade the equipment with new features and functionsafter they are deployed in the field.

·       Thecost of implementing a given function using an FPGA chip is decreasing asmanufacturers adopt smaller process geometries, reducing the per unit costadvantage of ASICs.

·       The smaller processgeometries of ASIC design continue to increase the mask costs and developmentschedules for these custom chips.

**Our FPOA Chip**

Our FPOA chip is a proprietary reprogrammableintegrated circuit chip that provides a new way of implementinghigh-performance digital algorithms and logic. Our FPOA chip will compete inthe marketplace principally with FPGAs but also with ASICs, ASSPs and DSPs. Webelieve market forces that are causing more designers to use programmable logicwill cause many customers to consider FPOAs, and that some of these customersmay select our FPOA products due to their superior performance.

Our highly integrated FPOA chips consist of a set ofcustom-designed high-level objects, each optimized to perform a set ofmathematical and/or logic functions. The user implements complex solutions byprogramming and interconnecting the silicon objects rather than designing withtraditional low-level logic gates. This method is expected to reduce designtime and expense and improve overall system performance. Our first FPOAcontains an array of 400 objects and is fabricated using an industry-standard,130 nm complementary metal oxide silicon, or CMOS, process technology. The setof objects in this initial array are designed to be useful in a wide range ofapplications.

We believe FPOAintegrated circuits have significant competitive advantages over thetraditional ASIC and FPGA chips in applications requiring high performance,rapid time-to-market and lower manufacturing cost for the following reasons:

·       Eachobject in the FPOA operates at a speed of up to one GHz, which is up to fourtimes the speed of FPGAs.

·       Inhigh-performance applications, our FPOAs have a per unit manufacturing costadvantage over FPGAs. In many cases, the FPOA architecture will realizesolutions that have a higher functional density than typical FPGAs, reducingthe amount of silicon required for a given design.

·       Thesize and performance advantages of FPOAs will often result in systemimplementations that use fewer total chips. Reducing the number of chips meanssmaller, lower-power solutions.

·       OurFPOA architecture simplifies the silicon design process. ASIC and FPGA devicesrequire the designer to perform the complex task of implementing algorithmsusing millions of individual logic gates. FPOA designers implement thesealgorithms by programming a few hundred interconnected silicon objects, reducingdesign costs and improving overall system performance and time-to-market.

Key technicalcharacteristics of our initial FPOA chip include the following:

·       EachFPOA contains a diverse set of 400 objects that operate at a speed of up to oneGHz per object to address a wide range of application requirements.

·       Eachobject is programmed and executes independently, providing up to 400 billionoperations per second of total chip performance.

·       Eachobject can be easily connected to any other object in a deterministic manner.

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·       EachFPOA is scalable in performance and power, delivering up to 10 billionoperations per second per watt of power.

·       EachFPOA provides a variety of flexible, high-performance input/output, simplifyingoverall system design.

·       EachFPOA can be reprogrammed in the field to prolong the useful life of the system.

An FPOA chip consists of silicon objects, memory andinput/output, which are arranged in a grid pattern and programmed to executeunique customer applications. The array is surrounded by blocks of high-speedlocal memory and high-speed input/output for communicating with external memoryand other system devices. The objects, interconnects and input/output can beprogrammed to create a completely customized chip.

We are developing a library of different siliconobject types that can be inserted in the array in any pattern. Our object typesinclude an arithmetic logic unit, a truth table, a register file and amultiply/accumulate unit. We are designing additional object types, includingcontent addressable memory and cyclical redundancy check. Each of these objecttypes can be programmed to perform a number of different functions, thusenabling this relatively small number of object types to satisfy a wide rangeof applications. Each of the object types shares a common interface to theinterconnect system. This interface allows us to quickly and easily add objecttypes into the array and rearrange the objects within the array to create newchips optimized for particular applications and algorithms. We plan to enhancethe existing set of object types and develop new object types to expand ourmarket opportunities.

The interconnect system is an important element of theFPOA architecture. This system is configured in the programming process in amanner similar to the programming of the objects. The interconnect providesboth the communication between objects, allowing them to work together, and inisolation, enabling each object to operate independently up to a speed of oneGHz. The architecture consists of nearest neighbor connections and party lineconnections. The nearest neighbor connections are local connections amonggroups of adjacent objects, allowing local clusters of objects to cooperatevery efficiently. The party line connections provide the means for any objectanywhere in the array to communicate with any other object. We believe thecombination of nearest neighbor and party line connections enable the FPOA toachieve unique versatility and performance.

We offer a customer development kit consisting of anFPOA chip, a prototype board and software design tools. This kit enables ourcustomers to create an FPOA design, simulate the functionality and performanceof the design, program the FPOA and test the chip using a standard personalcomputer.

We have fabricated a limited quantity of our firstchip that we believe will be sufficient to meet the needs of our currentcustomers and those we plan to engage before the next version of our FPOA chipis available. Although there can be no assurance, we expect the next version ofthe FPOA chip to be available in the first half of 2006. For the purpose ofprototype application development, the two versions are similar enough toenable customers to develop their application and test the functionality of thechip in their application. We do not expect any current or planned customers toenter full-scale production with the current version of the chip.

We are developing, andplan to provide our customers access to, a library of application programs forour FPOA. To date, we have implemented and offer different applicationalgorithms, including fast fourier transforms, digital filters and digitalencoders. These applications are fully tested and documented, allowing ourcustomers to use them as is or to easily modify them for their specific needs.We plan to continue to develop applications to support our target markets andto locate the entire library on our website for easy access by designers. Webelieve this specialized customer support will help speed adoption of the FPOA.We and our strategic partners continue to develop algorithms, which will beplaced on our website when they are sufficiently developed.

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**Application Design Tools**

Our strategy is to form strategic relationships withelectronic design automation companies to jointly develop design tools to beoffered for sale by us and also directly by those companies.

In November 2003, we entered into a strategicrelationship with Summit Design, Inc. under a business developmentagreement that was amended in January 2006. This relationship resulted inthe integration of our FPOA-specific design tools into the Summit Design VisualElite tool suite, which is an electronic system-level tool. An electronicsystem-level tool enables the system designer to work at the system levelrather than at the component level using higher-level languages to design andsimulate the functionality and performance of an entire system in a softwareenvironment rather than as hardware prototypes. Visual Elite is an integrateddesign environment based on the industry-standard language, SystemC, thatenables system designers to progress through different levels of system designuntil they produce working implementations of a system. These design toolsprovide an integrated environment in which to design, simulate and programFPOAs. The design tools run on a standard personal computer.

Our amended agreement with Summit Design contemplatescertain joint development activities between us and Summit Design to developsoftware (the “Product”) to be used to define, refine, simulate and analyze thefunctional logic design intended for rendering in our FPOA and used to generatecode for output to our physical-layer design tools called COAST that areintegrated into the tool environment. Under the agreement, we have a license touse Summit Design’s products and technology incorporated into the design toolsfor our internal use and for developing design application examples. SummitDesign has the right to incorporate our library of SystemC models and theassociated graphic symbols into the Product and to grant sublicenses of thelibrary to end users. We will distribute the Product to end users combined withother products we produce. Summit Design will provide us with a block ofone-year Product licenses at no charge to us to be used by third-party FPOAapplication developers managed by us while developing preprogrammed FPOAsoftware. In addition, under the agreement, Summit Design will provide us witha block of 90-day evaluation licenses at no charge to us to be used by usto provide prospective customers an opportunity to evaluate the Product. Theagreement provides that we must purchase from Summit Design a minimum number ofone-year licenses for an agreed-upon price and that we have the right to purchaseadditional one-year licenses for distribution to end users. The agreement hasan 18-month term beginning on December 28, 2005, unless earlierterminated in accordance with its terms. Upon expiration of its term, theagreement may be renewed for one or more terms of 12 months upon mutualagreement of the parties.

In addition to the Summit FPOA design tools, wedeveloped our COAST tools that are used to program objects and configurenearest neighbor and party line connections to implement a specific algorithmor logic design. The first generation of the COAST program assigns the softwarecode to particular objects in the array and configures nearest neighbor andparty line connections to perform the necessary functions. We plan to continueto enhance the automated COAST program to allow the system designer to focus ondesigning the algorithm and logic and not on programming the FPOA. We plan toexpand FPOA technology to other electronic design automation tool environmentsusing industry-standard technologies and interfaces.

Custom FPOA applicationsare created by programming a customer’s new and existing algorithms directly tothe FPOAs using our COAST design tools at the physical level and Summit designtools at the functional level. We train customers and prospective customers inthe use of our design environment to enable them to design systems with FPOAs,taking full advantage of the FPOA’s advanced object capabilities and theirreprogrammability.

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**Competitive Position**

We believe thatimportant competitive factors in the logic industry include:

·       productpricing;

·       time-to-market;

·       productperformance, reliability, power consumption and density;

·       fieldreprogrammability;

·       adaptabilityof products to specific applications;

·       easeof use and functionality of software design tools;

·       functionalityof predefined cores of logic;

·       accessto leading-edge process technology; and

·       abilityto provide timely customer service and support.

Competition among semiconductor companies is mostintense during the design win phase of a customer’s design. A design win is acustomer’s selection of a particular vendor’s chip for use in the customer’selectronic system. When a customer has decided to use FPGAs instead of ASICs orASSPs, and after a particular FPGA vendor is selected, customers tend not toswitch FPGA vendors because of the high cost to switch FPGAs after anelectronic system has been designed and prototyped. It is also due to thefamiliarity of the customer’s engineering staff with the FPGA vendor, itsproducts and its design tools. We believe that a potential customer’sfamiliarity with FPGA products and design tools as opposed to FPOA products anddesign tools will be one of the biggest challenges we face in any givencustomer opportunity.

We have identified a range of diverse semiconductorcompanies that are participating in the reprogrammable or reconfigurablemarkets, including the leading FPGA companies. We expect to compete primarilywith the high-performance FPGA products marketed by Xilinx, Inc., whichmarkets the VirtexTM line, and Altera Corporation, which markets the StratixTMline. We believe that compared to FPGAs, our FPOA has substantial competitiveadvantages, especially in the areas of higher performance, fastertime-to-market and lower manufacturing cost. However, there is not an officialbenchmark established for measuring the performance difference between an FPGAand an FPOA. Because the programming methodology for each technology is sodifferent, there is not a simple measure of how each would perform in a givenapplication. In addition, because the FPOA is new, there are not enoughexamples of the same algorithm implemented in an FPGA and in an FPOA forcustomers to have a good independent measure of the advantages or disadvantagesof FPGAs as compared to FPOAs.

We have also identifiedseveral smaller startup companies developing chips that seem to be directedtoward the same goals as our FPOA. It is our belief that an FPOA-likearchitecture will become increasingly attractive to system designers, and thatnew companies with FPOA-like architectures will enter the market while we areactively marketing our FPOA products. We believe the performance of our FPOA,combined with our early entry to the market, will positively differentiate usfrom other startups.

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**Target EndMarkets and Applications**

To address theinevitable market adoption risks faced by any new technology, we intend to seekthose market segments that will benefit the most from the capabilities of theFPOA architecture. We expect that these initial target market segments willhave the following characteristics:

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

·       applicationsthat demand the reprogrammability of FPGAs but cannot justify the high per unitproduction cost of FPGAs;

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

·       applicationswhere reprogrammability is a requirement, thus deterring the designer fromusing an ASIC.

We believe thefollowing end user markets have these characteristics and are ideally suited totake early advantage of the FPOA architecture:

·       machinevision;

·       testand measurement;

·       highdefinition video (such as MPEG 4 and H.264);

·       medicalimaging;

·       highperformance imaging (such as JPEG 2000);

·       military/defenseand aerospace digital signal processing; and

·       cellularwireless base stations (3G and WiMAX).

Most of our early customers are in themilitary/defense and aerospace markets, and we are now targeting the commercialmachine vision, test and measurement, professional video and medical imagingmarkets. We believe some segments of these markets desire the high-performance processingand reprogrammability that the FPOA architecture offers.

Machine vision is the application of computer visionto factory automation. Just as human inspectors working on assembly linesvisually inspect parts to judge the quality of workmanship and adherence todimensional tolerances, machine vision systems use digital cameras and imageprocessing software to perform similar inspections. A machine vision system isan electronic system that makes decisions based on the analysis of digitalimages. In its report, *Machine Vision Markets2004 Results and Forecasts to 2009*, the Automated ImagingAssociation states that the worldwide machine vision market was $8.1 billion in2004 and will grow to $15.7 billion in 2009.

Test and measurement includes both general purposesystems, such as oscilloscopes and logic analyzers, and automated testequipment for various industries, including semiconductor test andmanufacturing. According to Frost & Sullivan’s reports, *World General Purpose Test & Measurement Equipments Market(2005)* and *Semiconductor ATE TestEquipment (May 2005)*, the combined market for this equipmentwas $7.5 billion in 2004. The amount spent for FPGA components in 2004 was $204million, according to publicly-available information from Gartner Dataquest.

Professional video includes both analog and digitalvideo capture, production, editing, post-production, broadcasting, control anddisplay of television content. Digital video products include everything fromcamcorders used by consumers to large non-linear video editors used byproduction 

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studios. This market iscurrently under a transformation from analog to digital video content and fromstandard definition to high definition television. In its report, *U.S. Broadcast and Professional Video Marketplace 2005*, theSalford Centre for Research and Innovation (SCRI) states that the professionalvideo market in the United States was $9.4 billion in 2005.

Medical imaging includessystems used in x-ray, ultrasound, computer tomography (CT), magnetic resonanceimaging (MRI), positron emission technology (PET) and three dimensional imagingin the medical industry. The conversion of the medical industry from analog todigital will be transforming the medical industry for many years to come.According to Frost & Sullivan’s report, *StrategicAnalysis of Semiconductors in the Global Medical Imaging Market*,there are many opportunities for semiconductor companies to participate in thistransition. It reported that the semiconductor opportunity in the medicalimaging market was $1.2 billion in 2004 and will grow to $1.9 billion in 2008and that $118 million of the $1.2 billion market in 2004 was spent on FPGAs.

**Business Strategy**

Our initial goal is to introduce FPOA technology intothose market applications that prioritize high performance because the FPOAoffers performance advantages over competing technologies. Most of our earlycustomers were in the military/aerospace markets. We are now targetingcommercial applications in machine vision, test and measurement, professionalvideo and medical imaging. We expect to continue to expand our efforts inadditional target markets as we expand our capabilities. We expect demand forour FPOA chips will be driven by the end users’ needs to lower their per unitcosts and for programmability in a low-priced, high-performance logic device.

Our business strategy is to focus our sales andmarketing efforts on commercial applications that can reach volume shipments inthe range of 1,000 to 500,000 units. At the high end of this range, the highper unit cost of FPGAs becomes a deterrent to their use, and at the low end ofthis range, the development cost of ASICs is an equally strong deterrent.

In order to accelerate our initial market penetration,we anticipate that we will offer FPOAs at the same cost to customers thanexisting FPGAs. We believe we can do so without sacrificing gross marginbecause the silicon area of an FPOA is smaller than a high performance FPGAwhen using the same process geometries, giving us a comparative cost advantage.In silicon fabrication, cost and size are directly related. The larger siliconarea required to implement the architecture of FPGAs results in higherfabrication costs than our FPOA. We intend to follow the same fabricationmigration as FPGAs to smaller process geometries, such as 90 nm and 65 nm.

We anticipate that the challenges of adopting a newtechnology will cause some markets to be slower to use our FPOA architecture.We believe the customers that require the high performance the FPOA provideswill more readily adopt our architecture. If a customer feels it can achieve anew performance level and competitive advantage for its system, we expect thecustomer will have a greater incentive to pursue our new technology and tobecome proficient in our design methodology. Once we have worked through aninitial design with a given customer, we expect the customer should be familiarenough with our chips and design tools to award additional design wins to us.

Our initial FPOA chipprovides the basis for a family of FPOA chips that will serve as targeted chipplatforms for the implementation of a range of customer-specific algorithms. Weanticipate that future chips will contain different numbers of object types andwill be optimized either for low power consumption, high performance, low priceor customized intellectual property programming. The size of an FPOA chip isdirectly related to the number of silicon objects. A smaller chip means lesssilicon area, which results in lower per unit costs. The one GHz speed of oursilicon objects can be maintained regardless of the number of silicon objects.

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**Sales and Marketing**

The goal of our sales and marketing organization is toachieve rapid adoption of the FPOA in commercial applications. We haveimplemented a manufacturer’s representative model for selling FPOAs in NorthAmerica and Europe. We expect to have North America covered by June 2006.We will supplement this model with field application engineers, or FAEs, toprovide technical support and with area sales managers, or ASMs, to manage themanufacturer’s representatives and help close design wins. As ofDecember 31, 2005, we had achieved 12 design wins with early adoptercustomers, generating a nominal amount of revenue. Our current focus is onwinning designs in our targeted commercial markets.

***Direct Sales Force***

Our direct sales force iscurrently composed of our Vice President of Sales and two area sales managers,one located in Chicago, Illinois and one located in Philadelphia, Pennsylvania.The sales force collaborates with our field application engineering staff topresent our best solutions to customers and potential customers. Our fieldapplication engineers demonstrate the performance and field programmability ofthe FPOA and work with the customers’ development engineers to resolve theirdesign implementation issues. Because our FPOA chips and design tools are new,if customers request the support, the application engineers may also programthe customers’ applications to the FPOA chips for an additional fee.

***Strategic Relationships***

A key component of our market penetration strategy isto form strategic relationships with companies that implicitly endorse ourtechnology, assist us in engaging customers and help to establish the FPOA inthe marketplace. Our key objectives in creating strategic relationships are toaccelerate market adoption of the FPOA, make FPOAs available at a higher levelof integration and generate revenues.

*HoneywellInternational, Inc.*   Honeywell International, Inc.is a diversified technology and manufacturing company. Our December 13,2004 strategic agreement with Honeywell enables us to introduce our FPOAtechnology to the aerospace market. It is intended to result in the developmentof new radiation-hardened, high-performance, low-risk, reconfigurable signalprocessing chips. We expect the availability of these high-performancesolutions will accelerate the adoption of our FPOA in the signal processingmarket, especially with key defense industry contractors. Our FPOA technologyintroduces a new level of performance for the high-speed signal processingsystems in military systems.

Honeywell has selected our FPOA technology for use indigital signal processing systems it is designing for space-based applications.Honeywell is a major supplier of satellite communications systems forintelligence gathering, surveillance and reconnaissance. The use of our FPOAtechnology in Honeywell’s space applications is highly dependent upon fundingfrom the United States government. We anticipate that it will take two to threeyears before Honeywell is fabricating a significant number of chips using ourFPOA technology. However, there can be no assurance that Honeywell willfabricate any chips using our FPOA technology.

Our December 13,2004 strategic agreement with Honeywell provides:

·        OurFPOA technology is licensed to Honeywell, allowing Honeywell to fabricate ourFPOAs for design into satellites and other space-borne applications. CombiningHoneywell’s 150 nm radiation-hardened process technology with our FPOA’sreprogrammability features will provide greater time savings in the developmentprocess of pre-designed arrays.

·        Honeywellwill use its engineering, technology and experience in space-based computing todesign radiation-hardened FPOAs under the terms of the strategic agreement.Radiation 

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hardened chips providehigher reliability in space satellite and other systems operating in harshenvironments. We expect radiation-hardened FPOAs to be directly applicable tothe challenging onboard computing needs required by new planned military spacecommunications and signal processing programs.

·        Honeywellwill pay to us either a prepaid fee per program in which our FPOA technology isused or a fee per FPOA part fabricated under the agreement or as otherwiseagreed to by the parties. To date, the only amounts that Honeywell has paid tous under the agreement are non-recurring engineering expenses to study theengineering issues associated with a redesign of the FPOA architecture inHoneywell’s radiation-hardened process.

·        Theagreement has an initial term of 36 months but can be terminated earlier undercertain defined conditions or extended by mutual consent.

*ValleyTechnologies, Inc.*   Valley Technologies, Inc.designs, produces and sells system-level processing boards to the defenseindustry. Valley Technologies is developing next-generation reconfigurablecomputer systems optimized for identifying and processing data that is criticalto navigation, weather forecasting and defense applications. Our strategicrelationship with Valley Technologies enables it to incorporate our FPOAs intoits system-level processor boards. In June 2004, Valley Technologies wasawarded a prime contract from the United States Space and Naval Warfare SystemsCommand, or SPAWAR, for the development of a signal processing system. ValleyTechnologies has been informed that the contract will be extended through July 2006.Valley Technologies selected our FPOA technology to implement this system. Thefirst version of the processor board using our FPOA chips is functional and hasbeen tested and demonstrated to potential customers. The use of our FPOAtechnology by SPAWAR is highly dependent upon funding from the United Statesgovernment. We anticipate that it will take two to three years before SPAWAR ispurchasing a significant number of our FPOA chips. However, there can be noassurance that SPAWAR will fabricate any chips using our FPOA technology.

As amended on December 5,2005, our October 8, 2004 strategic alliance agreement with ValleyTechnologies provides:

·        Bothcompanies have the right to market the Valley Technologies system-level boardspopulated with our FPOAs.

·        Wewill receive revenues on FPOAs we sell to Valley Technologies plus a royalty onboards that Valley Technologies sells to its customers. Through October 2005,we paid to Valley Technologies a $13,000 monthly fee for its services andreimbursed it for its reasonable out-of-pocket costs. These services consistedof sales and marketing services, including introducing and presenting theprocessor boards using our FPOA chips to potential customers in the defense andaerospace industries.

·        Wehave issued to the president and chief executive officer of Valley Technologieswarrants to purchase a total of 83,334 shares of our common stock with anexercise price of $6.00 per share. These warrants will vest as to 16,667 sharesupon Valley Technologies obtaining a design win and as to 8,334 shares upon thereceipt and delivery by Valley Technologies to MathStar of any of up to eightcontracts or purchase orders for each algorithm ported to MathStar’s FPOA thatgenerates non-recurring engineering revenue to MathStar of at least $50,000. Inaddition, these warrants will become vested as to all shares upon confirmationsatisfactory to MathStar that the funding required for the radiation hardeningof the FPOA by Honeywell has been received. None of these warrants have vested.

·        Wehave also issued additional warrants to purchase up to 250,000 shares of ourcommon stock to employees of Valley Technologies designated by ValleyTechnologies. Of these warrants, 

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warrants to purchase170,000 shares have an exercise price of $6.00 per share and warrants topurchase 80,000 shares have an exercise price of $6.30 per share. Thesewarrants will vest as to one-third of the shares subject to the warrants oneach of the first, second and third anniversary dates of the date of grant. Asof December 31, 2005, warrants to purchase 83,333 shares at an exerciseprice of $6.00 per share had vested.

*SummitDesign, Inc.*   Under our November 30,2003 business development agreement with Summit Design, Inc., we completedthe incorporation of COAST, our physical-layer design tools, into the SummitDesign Visual Elite tool suite. Visual Elite enables designers to progressthrough different levels of system design until they produce workingimplementations of a system.

We amended ouragreement with Summit Design in December 2005. Our amended agreement withSummit Design contemplates certain joint development activities between us andSummit Design to develop software (the “Product”) to be used to define, refine,simulate and analyze the functional logic design intended for rendering in ourFPOA and used to generate code for output to our COAST software. Our amendedagreement with Summit Design provides:

·        Wehave a license to use Summit Design’s products and technology incorporated intothe design tool for our internal use and for the development of designapplication examples.

·        TheProduct will be sold through the coordinated actions of ours and Summit Design’sdirect sales staffs. We will distribute the Product to end users under SummitDesign’s end user license agreement as a combined product with other productswe produce.

·        SummitDesign will provide us with a block of one-year Product licenses at no chargeto us to be used by third-party FPOA application developers managed by us whiledeveloping preprogrammed FPOA software.

·        SummitDesign will provide us with a block of 90-day evaluation licenses at nocharge to us to be used by us to provide prospective customers an opportunityto evaluate the Product.

·        Wemust purchase from Summit Design a minimum number of one-year licenses for anagreed-upon price and have the right to purchase additional one-year licensesfor distribution to end users.

·        The agreement has an 18-monthterm beginning on December 28, 2005, unless earlier terminated inaccordance with its terms. Upon expiration of its term, the agreement may renewfor one or more terms of 12 months upon mutual agreement of the parties.

**Research and Development**

We believe our products are differentiated from ourcompetition because of our intellectual property-based innovations in thedesign of the silicon object array, including the performance and flexibilityof the objects and the highly efficient and deterministic objectinterconnections. Creating and bringing to market these innovations requires usto invest research and development resources in programmable object and logicdesign, object programming tools, high-performance semiconductor circuit designand application development.

Our hardware engineering team is divided into twogroups. One group does the logic design and the validation and testing of theobjects, memory and input/output functions. This group custom designs thesilicon objects and defines the FPOA programming model. The second group doesthe physical design of the chip, including custom high-performance circuits andcells. The combined efforts of these groups enable the one GHz operation andthe functional density of our FPOA.

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Our software tools team builds the design tools usedby us and our customers to design, simulate and test applications for the FPOA.This team developed the COAST design tool and partners with Summit Design toproduce an integrated design, simulation and programming environment. Havingour own design tool development team assures that our design tools andprogramming techniques keep pace with the evolution of new silicon objects andthe overall FPOA architecture. We believe that as the number of customers forFPOAs increases, the electronic design automation tools industry willincreasingly support FPOA products.

Our software applicationsgroup is responsible for developing and testing applications and applicationsexamples that customers can use as is or modify to meet their specific needs.This group works closely with our field applications engineers to assure thatcustomers take full advantage of our pre-developed application library to helpcustomers reduce their design costs and shorten their time-to-market.

**Manufacturing**

We do not own or operate any semiconductor fabricationfacility. Instead, our FPOA chips are fabricated by an independent semiconductorfoundry and then packaged and tested by an independent packaging company thatprovide these services to the general fabless semiconductor industry. Thisenables us to take advantage of a foundry’s high-volume economies of scale,have direct and timely access to advanced process and packaging technology andfocus our internal resources on product and market development.

The manufacturingor fabrication process for our FPOA and other silicon chips generally consistsof the following process steps:

·       Followingcompletion of the design of one of our chips, we supply an electronic designfile to our fabrication partner, Taiwan Semiconductor Manufacturing Company, orTSMC.

·       TSMCtranslates our design file into a set of lithography masks TSMC will use in thefabrication process.

·       TSMCfabricates our chip on silicon wafers, typically either eight or 12 inches indiameter. Each wafer contains several hundred copies of our chip. The number ofwafers that TSMC produces depends on the number of chips that we order.

·       Followingthe completion of the fabrication process, which involves many individualprocess steps, TSMC performs a parametric and wafer-level test on the wafersproduced. Parametric testing verifies that the processing conformed to theirinternal quality standards. Wafer-level testing provides a first levelscreening of known good die but does not guarantee the functionality of ourchip.

·       Followingsuccessful completion of the parametric testing, the wafers are passed to thepackaging subcontractor that completes the following steps:

·        cuttingwafers into the individual chips in a process called “dicing”; and

·        placingeach individual chip into a package that provides physical protection for thefragile chips and also provides a means of interconnecting the finished chiponto a printed circuit board.

·       Afterpackaging, the chips are tested for functionality and performance. We currentlyare doing this testing internally but plan to outsource this function to atesting subcontractor as our volume increases. Outsourcing this function willrequire us to develop a series of functional and performance tests we willprovide to the testing subcontractor.

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We are currently usingeSilicon, Inc. to coordinate these fabrication steps and to providemanufacturing program management and chip test development. We have negotiatedthe price we pay to eSilicon for packaged and tested FPOA chips. In the future,we may provide this manufacturing support internally.

**Patents and Intellectual Property**

We rely on a combination of United States patents,trademarks, copyrights, trade secret law, employee non disclosure agreementsand work-for-hire and non-disclosure agreements with independent contractors toprotect and enforce our intellectual property rights. We also obtained patentassignments from each inventor named in our patent and patent applications.However, we do not have general assignment of inventions agreements with ourformer employees who are not named as inventors in our patent and patentapplications, which could compromise the common law protection of ourintellectual property.

On November 9, 2004, we were granted UnitedStates Patent No. 6816562 entitled “Silicon Object Array withUnidirectional Segmented Bus Architecture.” This patent covers our interconnectsystem consisting of nearest neighbor and party line connections that allowobjects in our FPOA chip to communicate with other objects in the chip and towork together or independently. We believe that this patent is important to ourcompetitive position because the technology protected by it is key to us beingable to produce an FPOA chip that can achieve a one GHz clock speed. The patentexpires on April 28, 2023.

In addition, wehave filed or are in the process of filing United States patent applications forthe following aspects of our technology:

·       IntegratedCircuit Layout Having Rectilinear Structure of Objects—application filed in January 2005;

·       BooleanLogic Tree Reduction Circuit—application filed in January 2004;

·       Shiftand Recode Multiplier—application filed in April 2004;

·       LeadingZero Counter for Binary Data Alignment—application filed in July 2004;

·       ReconfigurableState Machine—application filed in September 2004; and

·       SystemCSignoff of Reconfigurable Signal Processing Platform Using Hardware-Cycle-AccurateModel—application filed in September 2004.

We currently hold common law trademark rights in thetrademarks *MathStar* and *FPOA*, and we have pending federaltrademark applications in the United States for the *MathStar* and *FPOA*trademarks. We do not have any trademarks registered outside the United States,nor do we have any trademark applications pending outside the United States. Wealso currently hold one domain name relating to our business, *MathStar.com*, which we believe isimportant to our brand recognition and overall success.

We believe our successwill not be based solely on the protection of our intellectual property butmore importantly on our ability to design, market and sell chips that meet thedemand for new technologies and better performance. We plan to continue todevelop new technology, and the methods we use to protect such technologieswill depend on our evaluation of the relative benefits of obtaining suchprotection.

**Employees**

As of February 28,2006, we had 52 full-time employees, consisting of three in management, five inadministration, two in information systems, 30 in research and development, onein operations and 11 in 

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salesand marketing. None of our employees are subject to a collective bargainingagreement. We have not experienced any work stoppages and believe ourrelationships with our employees to be good.

**Item 1A.**                RiskFactors

**Risks Relating to Our Business**

***Our operations andbusiness are subject to the risks of a development stage company with little orno revenue and a history of operating losses. The report of our independentregistered public accounting firm included in this Annual Report on Form 10-Kcontains an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern. We have incurred losses sinceinception, 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 and for the years ended December 31,2003, 2004 and 2005 and cumulatively for the period from April 14, 1997,date of inception, to December 31, 2005 contains an explanatory paragraphexpressing substantial doubt about our ability to continue as a going concern.

Since inception, we havehad only nominal revenue from the sale or licensing of our FPOAs, and we havehad losses. We had net losses of $11,027,000, $8,749,000 and $18,936,000 forthe years ended December 31, 2003, 2004 and 2005. As of December 31,2005, we had an accumulated deficit of $83,494,000. We expect to increase ourspending significantly as we continue to expand our infrastructure. We areusing and will use the proceeds from our initial public offering to expand oursales and marketing efforts and continue research and development. In addition,we will need significant revenue and/or to raise additional capital to financeour business. We do not know whether or when we will become profitable becauseof the significant uncertainties regarding our ability to generate revenues.

***We will needadditional financing in the future, which may not be available to us onfavorable terms or at all. If we do not obtain additional financing when weneed it or on terms that are favorable to us, our business would be adverselyand materially affected.***

We will 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;

·       thecost of or delays in producing our chips;

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

·       thecosts of preparing, filing, prosecuting, maintaining and enforcing patentclaims and other patent-related costs;

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

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

Additional financing maynot be available to us when we need it or on terms that are favorable to us. Ifwe cannot obtain adequate financing on a timely basis or under terms that arefavorable to us, we may be forced to delay or limit aspects of our businessplan, which could have a material adverse effect on our business, revenue,financial condition and results of operations. In addition, we may be requiredto seek funds from sources that will place limits on our operations andmanagement or that require rights that are superior to those possessed by theholders of our common stock. If we raise additional funds by issuing equitysecurities, the new equity securities may dilute the average per share price orownership interests of our stockholders, and the rights of the holders of theequity securities may be more favorable than those of the holders of our commonstock.

***If we do notproduce our new version of our FPOA chip and begin selling it to customers inthe first half of 2006, our business, revenue, financial condition and resultsof operations could be adversely affected and the market price of our stockcould decrease.***

In the first half of 2006,we expect to produce a new version of our FPOA chip and begin selling the chipto customers. However, there can be no assurance that we can do so. Theproduction and sale of the new version of our FPOA chip could be delayed beyondthe first half of 2006 for many reasons, including delays in developing,testing and producing the chip, the lack of qualified personnel to work on thedevelopment of the chip, and the reluctance of customers and potentialcustomers to accept a new technology. If the production or sale of the newversion of the FPOA chip was delayed beyond the first half of 2006, ourbusiness, revenue, financial condition and results of operations could beadversely affected and the market price of our stock could decrease.

***Because our currentand planned FPOA chips are highly complex, they may contain defects or errorsthat are detected only after deployment in commercial applications, which wouldharm our reputation and result 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 performance internally.Our testing may reveal some problems before the chips are delivered to ourcustomers that would result in significant delays and costs to us. Because ourchips are programmable in the field, they can be fully tested only whendeployed 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.

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***Our FPOA chips arenew and have not yet achieved commercial acceptance. Our success depends oneffectively introducing our FPOA chips to the market and have them gain marketacceptance. The failure of our FPOA chips to achieve commercial acceptancewould have a material adverse effect on our business, revenue, financialcondition 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 markets. However, our FPOA chip is new and has not been used in aproduct or in an electronic system that has been commercially distributed. Fromthe time a customer selects our FPOA chips for its electronic system, it may bea considerable period of time before the customer starts volume production ofits system and purchasing chips in volume, if at all. There can be no assurancethat design wins will result in any production commitments that generaterevenue growth for a number of reasons, including the decision of the customerto terminate the development or production of the electronic system for whichthe FPOA chip was selected.

The targeted markets intowhich we are introducing and will introduce our FPOA chips may not accept them.Users may not accept our FPOA chips as preferable to existing semiconductorchips, including ASICs and FPGAs, or new products in our targeted applicationsand densities. Electronic equipment manufacturers and other potential customersfor our FPOA chips often have a preferred and established supplier ofsemiconductor chips. It will be difficult for us to overcome this preferenceand convince our targeted customers to use our FPOA chips rather than chipsfrom their preferred vendors. The acceptance and deployment of our FPOA chipsin the market will depend on many factors, including the availability andeffectiveness of our FPOA chips and competing products from our competitors,the willingness of targeted customers to expend resources to test and use ournew FPOA chips, the effectiveness of our marketing and sales personnel and thepricing for our FPOA chips. All of the foregoing factors, among others, couldlimit market acceptance of our FPOA chips. Our failure to effectively introduceour FPOA chips to the market or the market’s failure to accept our chips wouldhave a material adverse effect on our business, revenue, financial conditionand results of operations.

***Our future successwill depend on our ability to develop new FPOA chips, introduce them to themarket and have them gain market acceptance. There is no assurance that we cando so successfully or on a timely basis. Our failure to do so would have amaterial adverse effect on our business, revenue, financial condition andresults 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 timely introductionof new FPOA chips or enhancements to existing chips. Successful chipdevelopment and introduction depends on a number of factors including, but notlimited to:

·       accuratechip definition and specification;

·       timelycompletion of the chip design;

·       establishingsuccessful production arrangements with third party semiconductor foundries;

·       establishingsuccessful relationships with strategic partners;

·       establishingsuccessful arrangements with third party packaging companies;

·       timelyand quality chip fabrication;

·       effectivepost-fabrication testing;

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·       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.

Due to the complexity andprecision of our planned FPOA chips and the many variables involved in theirdesign, we may not be able to successfully develop and introduce our existingand planned FPOA chips to the marketplace on a timely basis or at all. Weanticipate that we will need to continually invest in semiconductor designengineering talent, state-of-the-art engineering tools and related testequipment. Our failure to develop and introduce new FPOA chips successfullywould materially and adversely affect our business, revenue, financialcondition and results of operations.

***Our success dependson our ability to develop effective FPOA design tools, either alone or inalliances with independent electronic design automation companies, and to havethe design tools gain market acceptance. Our failure to do so would delay orprevent the commercialization of our FPOA chips, which would materially harmour business, revenue, financial condition and results of operations.***

As part of the developmentprocess for our FPOA chips, our customers must have design tools so they canprogram, or map, their intellectual property applications, or algorithms, toour FPOA chips. Working with Summit Design, Inc., we have developed asuite of FPOA-specific design tools. To be successful, we must introduce thesedesign tools to the market and have them accepted by customers, or developother design tools that will be accepted in the marketplace either alone, withSummit Design or with other electronic design automation companies. Developingnew FPOA design tools is a complex process, and we will likely experiencedelays in developing and introducing them. Successful product development andintroduction depends on a number of factors including, but not limited to,accurate tool definition, user documentation and specification, timelycompletion of the design tools and acceptance of our FPOA design tools by ourtarget customers. In many cases, our target customers will have strongpreferences to work with industry leading tool design companies. We mustovercome this preference to have our design tools accepted and used by thesecustomers. In addition, the FPOA-specific design tools run only on Windows®operating systems and software, which may delay or prevent their acceptance byour target customers. We may not be able to successfully develop and introduceFPOA design tools to the market on a timely basis or at all. Our failure todevelop and introduce new design tools successfully would materially andadversely affect our business, revenue, financial condition and results ofoperations.

***We presently relyon Summit Design, Inc. for the design tools that are used to map ourcustomers’ algorithms to our FPOAs. If Summit Design could not or would notprovide these design tools and related support services for any reason, furtherdesign tool development would be delayed, which would delay the introduction ofour FPOAs to the marketplace.***

Our current strategy fordeveloping the FPOA design tools used to program our customers’ intellectualproperty applications to our FPOA chips is to form strategic relationships withelectronic design automation companies, such as Summit Design, Inc., tojointly develop these design tools. Thus, our success will depend on formingand successfully maintaining these relationships. Summit Design is the onlycurrent source for an integrated design tool software suite that includes ourFPOA-specific design tools. If Summit Design was unable or unwilling to providethese design tools and related support services for any reason, any furtherdesign tool development would be delayed. In addition, our ability to fix anyproblems that arise with respect to the design tools would be limited. Weprobably would have to identify and enter into a strategic relationship withanother electronic design automation company to develop a new set of designtools. There is no assurance we could do so at all or under terms that areacceptable to us. Any delay in our design tool development would result in adelay in introducing our FPOA chips to the 

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marketplace,which would have an adverse effect on our business, revenue, financialcondition and results of operations.

***We use athird-party contractor to fabricate the silicon wafers used in our FPOA chips.If our supply of silicon wafers from the contractor was interrupted, delayed orterminated for any reason, our business, revenue, financial condition andresults of operations would be adversely affected.***

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 TSMC tofabricate 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 inTaiwan, which is in an area that is seismically active and where cyclonesoccur, and there have been tensions between Taiwan and the Peoples Republic ofChina. Should there be a major earthquake, a cyclone or a threatened or actualoutbreak of hostilities in Taiwan in the future, the production of our chips byTSMC could be disrupted or cease. Such a disruption or cessation in theproduction of our chips would likely result in our inability to ship our FPOAchips in a timely manner, thereby adversely affecting our business, revenue,financial condition and results of operations.

***The production ofsilicon wafers is a complex process, and production yields can be adverselyaffected by many factors over which we have no control. A shortage or delay inproducing the silicon wafers used in our FPOA chips could have an adverseeffect on our business, revenue, financial condition 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 chipfabrication process can also occur if we begin production of a new product ortransition to new processes. We expect that the majority of our existing andplanned FPOA chips use and will use increasingly advanced process geometries inorder to achieve higher performance, lower power consumption and lowerproduction costs. Our FPOA chips are presently fabricated in 130 nanometerprocess technology, and we expect our FPOA chips will be fabricated in 90nanometer or smaller process 

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technologiesin the future to remain competitive. If we experience delays in the redesign ofthe FPOA chip or the fabrication of the silicon wafers, it would delay theintroduction of our chips to the market, cause us to miss market opportunitiesand have an adverse effect on our business, revenue, financial condition andresults of operations.

***We rely on a singlesource independent contractor for our packaging. The disruption or terminationof our relationship with this contractor could result in a material adverseeffect on our business, revenue, financial condition and results of operations.***

The packaging of our FPOAchips is performed by a single supplier—Advanced Semiconductor Engineering, Inc.Because we rely on an independent contractor for our packaging services, wecannot directly 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 semiconductorindustry is intensely competitive. Most of our competitors have substantiallygreater resources than we do, and there can be no assurance that we will beable to successfully compete in the industry.***

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 newcomputing and networking standards, quality, reliability and customer support.Our FPOA chips may be used in applications now served by vendors of FPGAs,ASICs and digital signal processors, and we will compete against vendors ofthese products. Most of these competitors, including Xilinx, Inc. andAltera Corporation, 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 competitionwould likely adversely affect our financial condition and revenue. Competitorswith greater financial resources or broader product lines may have a greaterability to withstand sustained price reductions in their primary markets,retain or regain market share and offer lower prices and additional products orservices that we cannot offer. These competitors may be in a stronger positionto respond more quickly to new technologies and to undertake more extensivemarketing campaigns. Competitive pressures could reduce or slow marketacceptance of our FPOA chips and result in price reductions, lower grossmargins and increased expenses that could adversely affect our business,revenue, financial condition and results of operations.

***Rapid technologicalchange could cause our FPOA chips and technology to become obsolete or requireus to redesign our FPOA chips, which could have a material adverse effect onour business, revenue, financial condition and results of operations.***

The rapid rate of changein technology across a wide variety of industries will require us to expendsubstantial resources in an effort to develop new FPOA chips that will keeppace with or stay ahead of these advancements. We may not be able to anticipateand/or respond to technological changes in a timely manner, and our responsemay not result in successful product development and timely product 

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introductions.If we are unable to anticipate or respond to technological changes, ourbusiness, revenue, financial condition and results of operations could beadversely affected.

***Our ability tocompete depends on our ability to protect our intellectual property, which maynot 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. We weregranted one United States patent, and we have filed six patent applicationswith the United States Patent and Trademark Office. However, filing a patentapplication does not mean we will be issued a patent or that any patenteventually issued will be as broad as requested in the patent application orsufficient to protect our technology. In addition, there are a number offactors that could cause our patents to become invalid or unenforceable or thatcould cause our patent applications to not be granted, including known orunknown prior art, deficiencies in the patent application or the lack oforiginality of the technology. Also, any common law protection of ourintellectual 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*and *FPOA*, and we have pendingfederal trademark applications in the United States for the trademarks *MathStar* and *FPOA*. However, filing a trademark application does not meanthat our trademarks will be registered or protected. We do not have anytrademarks registered outside the United States, nor do we have any trademarkapplications pending outside the United States. Even if federal registrationsare granted to us, our trademark rights may be challenged. It is also possibleour competitors or others will adopt trademarks similar to ours, thus impedingour ability to build brand identity and possibly leading to customer confusion.We could incur substantial costs in prosecuting or defending trademarkinfringement suits. We currently hold one domain name relating to our business,*MathStar.com*, which we believe isimportant to our brand recognition and overall success. We may be unable toacquire other relevant domain names in the United States and in other countrieswhere we conduct or may conduct business. If we are not able to protect ourtrademarks or domain name, we may experience difficulties in achieving andmaintaining brand recognition and customer loyalty, causing us to losesignificant market share. If we lose market share, our business, revenue,financial condition and results of operations may be materially adversely affected.

Our patents and patentapplications and copyrights, trademarks, trade secret law, employeenon-disclosure agreements and work-for-hire and non-disclosure agreements withindependent contractors may not provide meaningful protection from our competitorsbecause the status of any patent and other intellectual property rightsinvolves complex legal and factual questions, and the breadth of claims allowedis uncertain. Our competitors may be able to circumvent our patents and otherintellectual property rights or develop new patentable technologies thatdisplace our existing technology. In addition, and despite our efforts toprotect our proprietary rights from unauthorized use or disclosure, thirdparties, including our employees, former employees or consultants, may attemptto disclose, obtain or use our proprietary information or technologies withoutour authorization. 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.

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***Our technology hasno patent protection outside of the United States because we have no non-UnitedStates patents. This could result in the appropriation of our technologyoutside of the United States, which could have an adverse effect on ourbusiness, revenue, financial condition and results of operations.***

We have no patents outsideof the United States, and we do not currently plan on applying for non-UnitedStates patents. Thus, our technology does not have patent protection outside ofthe United States. This could result in the appropriation of our technologyoutside of the United States, which could have an 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 ofintellectual property infringement claims.***

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 a patent in the United States, we have not conducted, and are notrequired 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 claiminginfringement may be able to obtain an injunction or other equitable reliefagainst us and the use of our technology by us or others, which could preventor inhibit the production or sale of our FPOA chips. If another party bringinga claim of infringement against us prevailed, we or our licensees, if any, maybe required to obtain one or more licenses from or pay royalties to thirdparties, which could entail significant expense. There can be no assurance thatwe or our vendors or licensees would be able to obtain from a third party anyrequired license of technology at a reasonable cost or at all, or be able todesign commercially acceptable non-infringing alternatives. Our failure or thefailure of our vendors or licensees to obtain such a license or develop suchalternatives could have a material adverse effect on our business, revenue,financial condition and results of operations.

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***The market forsemiconductor chips has been characterized by periods of significant fluctuationsin demand. Our revenue and financial performance will depend on demand forsemiconductor chips overall and particularly those with the performancecharacteristics of our FPOA chip.***

We are focusing ourefforts on the design, marketing and sale of our FPOAs for users ofsemiconductors. The market for semiconductor chips has been characterized sinceits inception by significant fluctuations in demand. Beginning in early 2000,the semiconductor industry was significantly affected by the economic downturn andcontraction in the computing and communication equipment markets and has onlyrecently begun to emerge from this downturn. During this downturn,semiconductor users significantly reduced or even suspended purchases ofsemiconductor chips. This cycle of reduced demand for semiconductor chipsresulted in significant reductions in unit demand, excess customer inventories,price erosion and excess production capacity. If demand for semiconductor chipsremains low or declines further and does not increase, our business, revenue,financial condition and results of operations would be materially adverselyaffected.

***We currently relyand we may rely in the future on contracts, relationships and arrangementsbetween our strategic partners and the United States government, and we mayenter into contracts with the United States government. Contracts with theUnited States government involve risks in addition to normal business risks. Ifour contracts or our strategic partners’ contracts with the United Statesgovernment were altered or terminated for any reason, our business, revenue,financial condition and results of operations could be adversely affected.***

Two of the companies withwhich we have strategic relationships—Honeywell International, Inc. andValley Technologies, Inc.—have contracts, relationships and arrangementswith branches of the United States government in which they are using or planto use our FPOA chips. We may enter into contracts, relationships andarrangements with branches of the United States government in the future. Inaddition to normal business risks, companies engaged in supplying military orother equipment to the United States government are subject to additionalrisks, including dependence on Congressional appropriations and administrativeallotment of funds, changes in governmental procurement legislation andregulations and other policies that may reflect military and politicaldevelopments, significant changes in contract scheduling, complexity of designsand the speed with which they become obsolete, necessity for constant designimprovements, intense competition for United States government business whichrequires increases in time and investment for design and development,difficulty of forecasting costs and schedules when bidding on developmental andhighly sophisticated technical work and other factors characteristic of theindustry. Changes are customary over the life of United States governmentcontracts, particularly development contracts, and generally result inadjustments of contract prices. Such contracts are subject to termination bythe United States government for the convenience of the United Statesgovernment. We and other companies with which we may form strategicrelationships in the future may enter into similar contracts, relationships andarrangements with the United States government, which would expose us and themto the same risks. If these contracts, relationships and arrangements with theUnited States government were altered or terminated for any reason, our business,revenue, financial condition and results of operations could be adverselyaffected.

***Our success dependson the services of our existing management and upon our ability to attractqualified engineers and other technical, management, sales, marketing andfinancial 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 is a limited number. In some of ourfields of operations, there is 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 

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experienced in the designof high-performance digital chips. In addition, we may not be able to attractand retain engineers located in proximity to our design centers. To employqualified design and application engineers, we may have to establish a presencein other localities, which would be expensive.

We do not have employmentor noncompetition agreements with any of our employees, including members ofmanagement, although we have non-disclosure agreements with them. The loss ofthe services of one or more of our executive officers or key employees, or ourinability to attract qualified personnel in the future, could restrict ourability to develop new FPOA chips or enhance existing FPOA chips in a timelymanner, sell our FPOA chips to our customers or manage our businesseffectively, which would have a material adverse effect on our business,revenue, financial condition and results of operations.

***Douglas M. Pihlowned 8.7% of our outstanding shares of common stock as of February 28,2006, which allows him to exert substantial influence over our business andmanagement.***

Douglas M. Pihl, who isour chairman, president, chief executive officer and a director, owned1,352,501 shares individually and 125,334 shares jointly with his spouse, whichis 8.7% of the outstanding shares of our common stock as of February 28,2006, assuming the 470,238 shares subject to our restricted stock awards as ofsuch date are outstanding. He is our single largest stockholder. Accordingly,he is able to exert significant control over our affairs including, but notlimited to, the election of directors. As of February 28, 2006, Mr. Pihl’sspouse owned individually 2,834 shares of our common stock and warrants topurchase 137,492 shares, of which Mr. Pihl disclaims any beneficialownership. Mr. Pihl’s spouse disclaims any beneficial ownership of sharesowned individually by Mr. Pihl. Mr. Pihl’s spouse is a registeredrepresentative with the underwriter of our initial public offering. Mr. Pihlalso disclaims beneficial ownership of 8,001 shares of our common stock ownedby irrevocable trusts for which he is the grantor.

***We may encounterdifficulties in managing our growth and expanding our operations successfully.***

If we successfullyintroduce our FPOAs to the marketplace, we will need to expand our development,marketing and sales capabilities. If our operations expand, we expect that wewill need to manage additional relationships with various strategic partners,suppliers and other third parties. Our ability to manage our operations and anygrowth will require us to make appropriate changes and upgrades, as necessary,to our operational, financial and management controls, reporting systems andprocedures. Our inability to manage growth could delay the execution of ourbusiness plan or disrupt our operations.

***Changes inaccounting principles, including recent changes in employee stock optionaccounting rules, may adversely affect our reported operating results and ourefforts and success in recruiting and retaining employees.***

Technology companies, including us, have a history ofusing employee stock programs to hire, incentivize and retain employees in acompetitive marketplace. We do not recognize and currently are not required torecognize compensation expense for stock options we issue to employees, exceptin limited cases involving any modifications of stock options. Instead, wedisclose in the notes to our financial statements information about the amountsof such charges if they were expensed.

In December 2004, theFinancial Accounting Standards Board, or FASB, adopted a new accountingstandard that will require companies, including us, to record equity-basedcompensation expense for stock options and any employee stock purchase planrights granted to employees based on the fair value of the equity instrument atthe time of grant. We will be required to record these expenses beginning January 1,2006. We will apply the prospective adoption method. The actual amount ofexpense that we recognize will depend on the value of our common stock at thetime of any grants of options and other stock awards to employees. The changein accounting rules may lead to an increased loss, if we recognize a netloss, or a decrease in reported earnings, if we have earnings. This could alsoadversely affect our ability to use employee stock plans to attract and rewardemployees and could result in a competitive disadvantage to us 

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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, or SEC,the Public Company Accounting Oversight Board or various other bodies formed topromulgate and interpret accounting principles which have not yet beenannounced or adopted.

***We are incurringand will incur increased costs as a result of being a public company.***

On October 26, 2005,which was the effective date of our initial public offering, we became apublicly-held company. As a public company, we are incurring and will incursignificant legal, accounting and other expenses that we did not incur as aprivate company. The Sarbanes-Oxley Act of 2002 and new rules subsequentlyimplemented by the SEC and The Nasdaq National Market have required changes incorporate governance practices of public companies. We expect these new rules andregulations to increase our legal and financial compliance costs significantlyand to make some activities more time consuming and costly. For example, inanticipation of becoming a public company, we created additional boardcommittees and have adopted and are implementing policies regarding internalcontrols and disclosure controls and procedures. We also are incurring and willincur additional costs associated with our public company reportingrequirements. We may need to hire additional accounting and financial staffwith appropriate public company experience and technical accounting knowledge,and we cannot assure you that we will be able to do so in a timely fashion orwithout incurring material costs. We also expect that these new rules andregulations will make it more difficult and more expensive for us to obtain andmaintain director and officer liability insurance, and we may be required toaccept reduced policy limits and coverage or incur substantially higher coststo obtain and maintain the same or similar coverage. As a result, it may be moredifficult for us to attract and retain qualified persons to serve on our boardof directors or as executive officers. We are currently evaluating andmonitoring developments with respect to these new rules, and we cannot predictor estimate the amount of additional costs we may incur or the timing of suchcosts.

***If we are unable tosuccessfully address the material weakness in our internal controls, ourability to report our financial results on a timely and accurate basis may beadversely affected.***

In connection with their audits of our financialstatements for the years ended December 31, 2004 and 2005, our independentregistered public accounting firm has reported two conditions, which togetherconstitute a material weakness in the internal controls over our ability toproduce financial statements free from material misstatements. 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. Ourindependent registered public accounting firm reported to our board ofdirectors that we do not have a sufficient number of financial personnel withadequate training and experience in accounting and financial reporting, and ourcontrols do not ensure that operating expenses and stock compensationtransactions are identified and recorded accurately and in the appropriateaccounting period. These two conditions, in combination, constitute a materialweakness in our internal controls.

Our board of directors agrees that the conditionsidentified by our independent registered public accounting firm constitute amaterial weakness. We have developed a plan to address this material weaknessthat includes the addition of our new chief financial officer and controller,as well as the performance of an assessment of our current accounting andreporting policies and procedures, assessment of our financial accounting andreporting staff requirements, implementation of supervisory reviews by ourchief financial officer and controller, implementation of new accountingpolicies and procedures, and the hiring and training of additional financialaccounting and reporting staff. We hired a new chief financial officer in June 2005and a new controller in July 2005. In addition to this plan, our new chieffinancial officer and controller are assessing our system of internal controlsover financial reporting and intend to 

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implement controlsdesigned to assure that, among other things, operating expenses and stockcompensation transactions are identified and accurately recorded.

We will have had onlylimited operating experience with the remedial measures we have made to date,and we have significant additional remedial measures that we must make. Wecannot provide assurance that the measures we have taken to date or any futuremeasures will adequately remediate the material weakness reported by ourindependent registered public accounting firm. In addition, we cannot becertain that additional material weaknesses in our internal controls will notbe discovered in the future. Any failure to remediate the material weaknessreported by our independent registered public accounting firm or to implementrequired new or improved controls, or difficulties encountered in theirimplementation, could harm our operating results, cause us to fail to meet ourreporting obligations or result in material misstatements in our financialstatements. Any such failure also could adversely affect the results of theperiodic management evaluations and annual auditor attestation reportsregarding the effectiveness of our internal control over financial reportingthat will be required when the SEC’s rules under Section 404 of theSarbanes-Oxley Act of 2002 become applicable to us beginning with our AnnualReport on Form 10-K for the year ending December 31, 2007 to befiled in early 2008. Inadequate internal controls could also cause investors tolose confidence in our reported financial information, which could cause ourstock price to decline.

***We will be exposedto risks relating to evaluations of controls required by Section 404 ofthe Sarbanes-Oxley Act of 2002.***

Changing laws, regulationsand standards relating to corporate governance and public disclosure, includingthe Sarbanes-Oxley Act of 2002 and related regulations implemented by the SECand The Nasdaq National Market, are creating uncertainty for public companies,increasing legal and financial compliance costs and making some activities moretime consuming. We will be evaluating our internal controls systems to allowmanagement to report on, and our independent registered public accounting firmto attest to, our internal controls. We will be performing the system andprocess evaluation, testing and any necessary remediation required to complywith the management certification and auditor attestation requirements of Section 404of the Sarbanes-Oxley Act of 2002. While we anticipate being able to fullyimplement the requirements relating to internal controls and all other aspectsof Section 404 by the December 31, 2007 deadline, we cannot becertain as to the timing of completion of our evaluation, testing andremediation actions or their impact on our operations because there is presentlyno precedent available by which to measure compliance adequacy. If we are notable to implement the requirements of Section 404 in a timely manner orwith adequate compliance, we may be subject to sanctions or investigation byregulatory authorities, including the SEC or The Nasdaq National Market. Thistype of action could adversely affect our financial results, investors’confidence in our company and our ability to access capital markets and couldcause our stock price to decline. In addition, the controls and procedures thatwe will implement may not comply with all of the relevant rules andregulations of the SEC and The Nasdaq National Market. If we fail to developand maintain effective controls and procedures, we may be unable to provide therequired financial information in a timely and reliable manner.

***Our board ofdirectors may issue and fix the terms of shares of our preferred stock withoutstockholder approval, which could adversely affect the voting power of holdersof our common stock or any change in control of MathStar.***

Our board of directors isauthorized, without stockholder action, to establish various classes or seriesof preferred stock from time to time and to determine the rights, preferencesand privileges of any unissued classes or series including, among othermatters, any dividend rights, dividend rates, conversion rights, voting rights,terms of redemption, liquidation preferences, sinking fund terms, the number ofshares constituting any such series and the description thereof, and to issueany such shares. Our board of 

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directorsmay, without stockholder approval, issue shares of a class or series ofpreferred stock with voting and conversion rights that could adversely affectthe voting power of the holders of the common stock and may have the effect ofdelaying, deferring or preventing a change in control of us.

***We will not paycash dividends on our common stock in the foreseeable future.***

We intend to retain anyearnings or cash flow to finance the development of our business. Accordingly,we do not anticipate the payment of cash dividends on our common stock in theforeseeable future. We have not paid any dividends in the past, and we may berestricted or prevented from paying cash dividends by loan covenants with anylenders.

***The anti-takeoverprovisions of the Delaware General Corporation Law, or DGCL, may delay orprevent transactions that are favorable to our stockholders.***

As a Delaware corporation,we are subject to provisions of the Delaware General Corporation Law, or DGCL,regarding “business combinations,” as that term is defined in the DGCL. We may,in the future, consider adopting additional anti-takeover measures. Theanti-takeover provisions of the DGCL, and any future anti-takeover measuresadopted by us, may, in certain circumstances, delay, deter or prevent takeoverattempts and other changes in control of the company not approved by our boardof directors. As a result, our stockholders may lose opportunities to disposeof their shares at favorable prices generally available in takeover attempts orthat may be available under a merger proposal, and the market price, voting andother rights of the holders of common stock may also be affected.

**Item 2. Properties**

Until March 2006, ourprincipal office was located at 5900 Green Oak Drive, Minnetonka, Minnesota in60,000 square feet of space. The lease for this location is for an initial termof 63-1/2 months, commencing on January 15, 2002, and has twothree-year extension options. We also lease office space in San Jose,California; Dallas, Texas; and Hillsboro, Oregon, near Portland. The San Joseoffice is approximately 200 square feet, and the lease expires in July 2006.The Dallas office is approximately 300 square feet, and the lease expires on July 31,2006. The Hillsboro office is approximately 11,900 square feet, and the leaseexpires on February 28, 2011. Rents under all of the leases averageapproximately $21,000 per month. In March 2006, we relocated our corporateheadquarters to the Hillsboro, Oregon facility. We consider our leasedfacilities to be adequate for the foreseeable future.

**Item 3. Legal Proceedings**

We are currently not aparty to any legal proceedings.

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

No matters were submittedto a vote of our stockholders during the fourth quarter ended December 31,2005.

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**PART II**

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

(a)   Since October 27, 2005, our common stockhas been listed on The Nasdaq National Market under the symbol “MATH.”  Before October 27, 2005, there was nopublic market for our common stock. The following table shows the high and lowsales prices for our common stock as reported on The Nasdaq National Market forthe periods indicated. As of March 17, 2006, there were 17,448,000 sharesof our common stock issued and outstanding. 

| ** **                                       | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| Year ended  December 31, 2005               |       |     |       |    |       |
| Fourth quarter (beginning October 27, 2005) |       | $        | 6.57       |    | $          | 5.26 |   |
| Year ended  December 31, 2006               |       |     |       |    |       |
| First quarter  (through March 17, 2006)     |       | $        | 5.75       |    | $          | 4.70 |   |

 

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 ofstockholders of record at February 28, 2006 was approximately 3,000.

(b)   Notapplicable.

(c)   Not applicable.

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**Item6. Selected Financial Data**

The selected financialdata below should be read in conjunction with “Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operation” and the financialstatements and notes thereto included elsewhere in this report.

| ** **                                                               | ** ** | **Year ended December 31,**                            | ** ** | **Period from  Inception  (April 14, 1997)**

**to December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2001**                                                              | ** ** | **2002**                                                                                   | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                               | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Statement  of Operations Data:**                                       |       |                                                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Net revenue                                                              |       | $                                                                     | —     |                                                                                       | $          | 17 |   | $ | 50 |   | $ | 130 |   | $ | 134 |   |   | $ | 880 |   |   |
| Cost of sales                                                            |       |                                                                  |       |                                                                                       |       |   |   | 53 |   | 52 |   |   | 105 |   |   |
| Gross profit                                                             |       | —                                                                |       | 17                                                                                         |       | 50 |   | 77 |   | 82 |   |   | 775 |   |   |
| Operating  expenses:                                                     |       |                                                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                                                 |       | 3,121                                                                 |       | 3,440                                                                                      |       | 7,903 |   | 5,192 |   | 8,734 |   |   | 29,967 |   |   |
| Selling, general and  administrative                                     |       | 2,670                                                                 |       | 2,840                                                                                      |       | 3,221 |   | 3,691 |   | 6,058 |   |   | 19,274 |   |   |
| Total operating expenses                                                 |       | 5,791                                                                 |       | 6,280                                                                                      |       | 11,124 |   | 8,883 |   | 14,792 |   |   | 49,241 |   |   |
| Loss from operations                                                     |       | (5,791                                                                | )          | (6,263                                                                                     | )          | (11,074 | ) | (8,806 | ) | (14,710 | ) |   | (48,466 | ) |   |
| Other income (expense)                                                   |       | 508                                                                   |       | 82                                                                                         |       | 47 |   | 57 |   | (4,225 | ) |   | (3,154 | ) |   |
| Loss from continuing  operations                                         |       | (5,283                                                                | )          | (6,181                                                                                     | )          | (11,027 | ) | (8,749 | ) | (18,935 | ) |   | (51,620 | ) |   |
| Loss from discontinued  operations(1)                                    |       | (8,346                                                                | )          | (23,528                                                                                    | )          | — |   | — |   | — |   |   | (31,874 | ) |   |
| Net loss                                                                 |       | $                                                                     | (13,629    | )                                                                                          | $          | (29,709 | ) | $ | (11,027 | ) | $ | (8,749 | ) | $ | (18,935 | ) |   | $ | (83,494 | ) |   |
| Basic and diluted loss  per share—continuing operations             |       | $                                                                     | (0.98      | )                                                                                          | $          | (0.94 | ) | $ | (1.56 | ) | $ | (0.95 | ) | $ | (1.56 | ) |   |   |   |   |
| Basic and diluted loss  per share—discontinued operations           |       | $                                                                     | (1.56      | )                                                                                          | $          | (3.59 | ) | $ | (— | ) | $ | — |   | $ | — |   |   |   |   |   |
| Basic and diluted net  loss per share                                    |       | $                                                                     | (2.54      | )                                                                                          | $          | (4.53 | ) | $ | (1.56 | ) | $ | (0.95 | ) | $ | (1.56 | ) |   |   |   |   |
| Weighted average number  of common shares outstanding, basic and diluted |       | 5,367                                                                 |       | 6,551                                                                                      |       | 7,048 |   | 9,209 |   | $ | 12,121 |   |   |   |   |   |
| ** **                                                               | ** ** | **As  of December 31,**                                          | ** ** | ** **                                                                                 | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **2001(2)**                                                           | ** ** | **2002**                                                                                   | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance  Sheet Data:**                                                 |       |                                                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                |       | $                                                                     | 5,461      |                                                                                       | $          | 4,773 |   | $ | 2,805 |   | $ | 4,132 |   | $ | 20,149 |   |   |   |   |   |
| Working capital                                                          |       | 4,636                                                                 |       | 4,469                                                                                      |       | 1,809 |   | 3,904 |   | 19,677 |   |   |   |   |   |
| Total assets                                                             |       | 22,020                                                                |       | 5,846                                                                                      |       | 3,244 |   | 4,504 |   | 22,202 |   |   |   |   |   |
| Total liabilities                                                        |       | 1,166                                                                 |       | 724                                                                                        |       | 1,152 |   | 487 |   | 2,028 |   |   |   |   |   |
| Deficit accumulated  during development stage                       |       | (15,074                                                               | )          | (44,783                                                                                    | )          | (55,810 | ) | (64,559 | ) | (83,494 | ) |   |   |   |   |
| Total stockholders’  equity                                         |       | 20,854                                                                |       | 5,122                                                                                      |       | 2,092 |   | 4,017 |   | 20,174 |   |   |   |   |   |

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(1)           Our acquisition of Digital MediaCom, Inc.in August 2001 resulted in a new and separate operating segment, thephysical media device, or PMD, segment. In August 2002, due to events andchanges in circumstances, which included a severe downturn in the market forthe acquired in process PMD development projects. We committed to a plan tosell the PMD operating segment, which was comprised of the acquired DigitalMediaCom operations. Accordingly, we tested the PMD assets for impairment andrecorded a $13,306 goodwill impairment. This amount was included in the $23,528loss from discontinued operations in 2002. On November 15, 2002, we soldor disposed of the assets of our PMD operating segment, including all of thevaluable technology, property and equipment, licensed software and employees,for $1,752 in cash and the assumption by the buyer of $187 in liabilities.There was no gain or loss on the sale because the assets of the PMD operatingsegment were written down to their estimated net realizable value in August 2002.

(2)         The 2001 balance sheet data includes the assets andliabilities of the PMD operating segment that was discontinued in August 2002.

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**Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

*You should read the following discussion and analysis of ourfinancial condition and results of operations together with our financialstatements and the related notes appearing at the end of this Annual Report on Form 10-K.Some of the information contained in this discussion and analysis or set forthelsewhere in this Annual Report on Form 10-K, including informationwith respect to our plans and strategy for our business and related financing,includes forward looking statements that involve risks and uncertainties. Youshould review “Item 1A. Risk Factors” for a discussion of important factorsthat could cause actual results to differ materially from the results describedin or implied by the forward-looking statements contained in the followingdiscussion and analysis.*

**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 demonstrated working versions of our first chip and provided an earlyrelease of our design tools to a limited number of customers. To date, we haverecognized only nominal revenue from research services provided under grantsfrom governmental agencies, engineering services and sales of prototype chipsand our field programmable object array, or FPOA, 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 2001, 2002, and in the cumulative period frominception (April 14, 1997) through December 31, 2005.

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 to a smallnumber of early customers. Although there can be no assurance, we expect toproduce FPOA chips that will be ready for a broader market release and webelieve we will begin selling to customers in the first half of 2006.

**Financial Operations Overview**

From inception through December 31,2005, we had gross revenues of $880,000, a loss from continuing operations of$51,620,000, and a loss from our discontinued PMD operations of $31,874,000. AtDecember 31, 2005, we had federal and state income tax net operating losscarryforwards of approximately $62,554,000. The operating loss carryforwardswill expire in the calendar years from 2014 to 2022. At December 31, 2005,we had federal and state research credit carryforwards of approximately $2,874,000.The research credit carryforwards will expire in the calendar years from 2014to 2022. Under the Internal Revenue Code of 1986, the utilization of these netoperating loss and research credit carryforwards may be limited as a result ofsignificant changes in our ownership.

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***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 ofsalaries and related costs of our engineering organization, fees paid to thirdparty consultants 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 periodbefore technological feasibility. Accordingly, all such costs have been chargedto operations as incurred. We expect to incur significant additional researchand development 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, general corporate activities andan allocation 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 to support sales ofFPOA chips in worldwide markets and to support our growth and operation as apublic company.

**CriticalAccounting Policies 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 anddevelopment services and was recognized as the services were performed.Customer payments received in advance of providing services were recorded ascustomer deposits. Costs related to this revenue consisted primarily of salaryand related benefits of certain employees and were included in research anddevelopment expenses.

Revenue after 2002resulted primarily from the sale of prototype products and product developmentkits. We recognize revenue for these products when:

·       persuasiveevidence of an arrangement exists;

·       deliveryhas occurred;

·       thesales price is fixed or determinable;

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·       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, wemade marketing support payments to one customer. Such payments are reported asa reduction of revenue in accordance with Emerging Issues Task Force, or EITF,Issue 01-09, *Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*.

***Accounts Receivable***

Accounts receivable areinitially recorded at fair value upon the sale of products or services tocustomers. They are stated net of allowances for uncollectible accounts, whichrepresent estimated losses resulting from the inability of customers to makethe 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.

***Stock-Based Compensation***

We account for non-employee stock-based compensationawards based on the fair value of the equity instruments issued in accordance withthe with Statement of Financial Accounting Standards, or SFAS, No. 123, *Accounting for Stock-Based Compensation*,and EITF Issue No. 96 18, *Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction With Selling, Goods or Services*. Total stockcompensation expense related to non-employee stock-based compensation awardstotaled $26,000, $50,000 and $515,000 in 2003, 2004 and 2005.

We account for stock-based compensation to employeesunder the intrinsic-value method of accounting prescribed by AccountingPrinciples Board, or APB, Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, anddisclose the effect of the differences which would result had we applied thefair value method of accounting on a pro forma basis, as permitted by SFAS No. 123.The minimum value method that was used prior to becoming a public company tomeasure fair value assumes that our stock price volatility is zero. As a publiccompany, we no longer apply the minimum value method and estimate the fairvalue of employee stock-based compensation using an option pricing model thatincludes a volatility factor representative of a comparable public company.This will result in an increase in the estimated fair value of our employeestock options granted after completion of our initial public offering. Infuture accounting periods, the determination of valuation variables such asvolatility and holding period could also affect our expense computation.

The determination of the fair value of our commonstock before our initial public offering involves considerable judgment. Inmaking this determination, we evaluated, among other things, our common stocktransactions, current market conditions and operational milestones.

In December 2004, theFinancial Accounting Standards Board issued SFAS No. 123R, *Share-Based Payment*. SFAS No. 123Rrevised SFAS No. 123 and supersedes APB Opinion No. 25. The revisedstatement addresses the accounting for share-based payment transactions withemployees and other third parties, eliminates the ability to account forshare-based payments using APB Opinion No. 25, and requires that thecompensation costs relating to such transactions be recognized in the statementof operations based upon the grant date fair value of those instruments. Therevised statement is effective for us in the first quarter of 2006 which beginson January 1, 2006. We expect that adoption of SFAS No. 123R 

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willresult in significant charges to operations beginning in 2006. However, we havenot yet determined the amount of such charges.

***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.

**RecentlyIssued Accounting Pronouncements**

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

**Results of Operations**

***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. Revenuein 2005 consisted of $59,000 generated from the sale of development kits 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 68% or $3,542,000 to $8,734,000 for the yearended December 31, 2005 compared to $5,192,000 for the year endedDecember 31, 2004. The $3,542,000 increase was the result of increasedpayroll costs ($1,110,000), contract engineering costs ($1,890,000) andmaterial costs ($540,000). The increase in research and development costs isprimarily due to engineering costs associated with the design changes needed tocommercialize our FPOA technology.

*Selling,General and Administrative.*   Selling, general andadministrative costs increased 63% or $2,367,000 from $3,691,000 for the yearended December 31, 2004 to $6,058,000 for the year ended December 31,2005. The $2,367,000 increase was the result of increased compensation costs of$1,384,000, of which $651,000 was non-cash expense related to stock options andrestricted stock awards, and the remaining increase was primarily costsassociated with building the selling, general and administrative infrastructureand increased costs associated with being a public company of $983,000. These increasedcosts include legal fees, independent auditor fees, travel, insurance, printingand transfer agent costs.

*Other Income (Expense).**  *For the year endedDecember 31, 2005, other expense of $4,225,000 included $4,395,000 ofinterest expense associated with the convertible notes issued inApril 2005 (which included the amortization of discount recorded for thevalue of the beneficial conversion feature and the warrants issued to the noteholders and interest costs). This interest expense is partially offset byinterest income on invested cash balances of $170,000. Other income for theyear ended December 31, 2004 of $57,000 consisted of interest income oninvested cash balances.

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***Years ended December 31, 2003 and 2004***

*Revenueand Cost of Goods Sold.*   For the year endedDecember 31, 2003, we recognized $50,000 of revenue compared to $130,000of revenue for the year ended December 31, 2004, an increase of $80,000.Revenue for the year ended December 31, 2003 consisted of revenue from thesale to one customer of prototype chips. Revenue for the year endedDecember 31, 2004 consisted of revenue from selling product developmentkits. Costs of goods sold for the year ended December 31, 2004 are thecost of the third party software licenses. There were no third party softwarelicenses included in the sale for the year ended December 31, 2003, andall costs of developing our prototype chips were expensed as research anddevelopment costs as incurred.

*Researchand Development.*   Research and development costsdecreased 34% or $2,711,000 from $7,903,000 for the year ended December 31,2003 to $5,192,000 for the year ended December 31, 2004. The decrease wasa result of lower compensation costs ($1,889,000), lower engineering and designconsulting costs ($1,278,000) and lower licensed intellectual property costs($240,000) offset by higher computer-aided design, or CAD, software licensecosts ($349,000) and higher product development costs ($225,000). During 2003,we reorganized our research and development efforts to execute on the change offocus from fixed function chips to reprogrammable platform chips. As a resultof this change in focus, we reorganized our research and development staff byterminating the employment of some engineers and spending fewer dollars onconsultants. All severance amounts were paid before December 31, 2003. Wewere also able to stop paying for licensed intellectual property. These costsavings were partially offset by additional costs for CAD software licenses andcosts for prototype boards.

*Selling,General and Administrative.*   Selling, general andadministrative costs increased 15% or $470,000 from $3,221,000 for the yearended December 31, 2003 to $3,691,000 for the year ended December 31,2004. The increase was the result of increased payroll costs ($920,000) as webegan building a marketing organization to commercialize our FPOA chip. Thiswas partially offset by lower rent expense and lower depreciation as weconsolidated facilities.

*Other Income (Expense).*   Forthe years ended December 31, 2003 and 2004, other income consisted ofinterest income from invested cash and cash equivalent balances and was $47,000for 2003 and $57,000 for 2004. The increase in 2004 was primarily the result ofa larger average cash and cash equivalent balance.

**Liquidity and Capital 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, 2005, we raised netproceeds of $71,351,000 from sales of common stock and common stock warrantsand $5,500,000 from sales of 8% convertible promissory notes and common stockwarrants. During 2002, we received net proceeds of $13,658,000 from theissuance of common stock. During 2003, we received net proceeds of $2,493,000from the issuance of common stock and $5,304,000 from the issuance of warrantsto purchase our common stock. During 2004, we received net proceeds of$7,978,000 from sales of our shares for $4.80 per share in a private placementand net proceeds of $2,645,000 from the exercises of warrants to purchase ourcommon stock.  During 2005, we receivednet proceeds of $24,633,000 in our initial public offering and $5,500,000,consisting of principal and interest due under our 8% convertible promissorynote that were converted to common stock.

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 is in the process ofbeing manufactured. We anticipate that we will have available for sale the newversion of our FPOA chip in the first half of 2006, although such productionand sale cannot be assured. Going forward, our results of operations willdepend 

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upon how long it takes andhow successful we are in achieving market acceptance of 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 12 months. However, we anticipate seeking additional financing during2006. Our long-term financing requirements will depend significantly on ourability to penetrate the market with our FPOA chip technology. If existingcash, cash equivalents and cash generated from operations are insufficient tosatisfy our liquidity requirements, we may seek to sell additional equity ordebt securities. If additional funds are raised through the issuance of debt orequity securities, these securities may have rights senior to those associatedwith our common stock, and they could contain covenants that would restrict ouroperations. If we are unable to obtain additional financing or successfullymarket our products on a timely basis, we would have to slow our productdevelopment and marketing efforts and may be unable to continue our operations.

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

Net cash used in operatingactivities was $9,611,000, $9,311,000 and $13,740,000,  for the years ended December 31, 2003,2004 and 2005. Net cash used for operating activities for the years ended December 31,2003 and 2004 was to fund our on-going research and development activities andour selling, general and administrative costs. Net cash used for operatingactivities for the year ended December 31, 2005 was to fund on-goingresearch and development activities and restructure and grow the sales,marketing and administrative organization in order to begin thecommercialization of our FPOA technology.

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

No cash was used ininvesting activities for the year ended December 31, 2003. For the yearsended December 31, 2004 and 2005, $13,000 and $312,000 was used ininvesting activities for the purchase of property and equipment, consistingprimarily of acquisitions of computers and office equipment to support ouroperations. We expect our capital expenditures in 2006, to be approximately$1,000,000.

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

Net cash provided byfinancing activities was $7,643,000, $10,651,000 and $30,068,000, for the yearsended December 31, 2003, 2004 and 2005. 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, 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, 2005 (in thousands):

| ** **            | ** ** | **Due in the Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                                             | ** ** | **2007**   | ** ** | **2008**   | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Operating leases      |       | $                                                                    | 1,288      |       | $          | 628        |       | $ | 269 |   | $ | 275 |   | $ | 283 |   |   | $ | 47 |   |   | $ | 2,790 |   |
| Purchase  obligations |       | 601                                                                  |       |       |       |       |       |   |   |   |   |   |   |   |   | 601 |   |
| Total                 |       | $                                                                    | 1,889      |       | $          | 628        |       | $ | 269 |   | $ | 275 |   | $ | 283 |   |   | $ | 47 |   |   | $ | 3,391 |   |

 

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**Off-Balance Sheet Arrangements**

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. In addition,we do not engage in trading activities involving non exchange traded contracts.As such, we are not materially exposed to any financing, liquidity, market orcredit risk that could arise if we had engaged in these relationships.

**Item 7A. Quantitative and Qualitative Disclosuresabout 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 interestrate risk arising from our investments.

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

Unauditedquarterly financial data for each of the eight quarters in the two-year periodended December 31, 2005 is as follows (the numbers in the table may not addup due to rounding):

| ** **                                            | ** ** | **Three Months Ended**                                      | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                            | ** ** | **March 31**                                                     | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **2004**                                              |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Net revenue                                           |       |                                                                  | $          | — |   |   | $ | — |   | $ | 100 |   | $ | 30 |   |
| Cost of sales                                         |       |                                                                  | —     |   |   | — |   | 45 |   | 8 |   |
| Gross profit                                          |       |                                                                  | —     |   |   | — |   | 55 |   | 22 |   |
| Operating  expenses:                                  |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Research and development                              |       |                                                                  | 1,280      |   |   | 880 |   | 1,342 |   | 1,690 |   |
| Selling, general and administrative                   |       |                                                                  | 836        |   |   | 987 |   | 973 |   | 895 |   |
| Total operating expenses                              |       |                                                                  | 2,116      |   |   | 1,867 |   | 2,315 |   | 2,585 |   |
| Loss from  operations                                 |       |                                                                  | (2,116     | ) |   | (1,867 | ) | (2,260 | ) | (2,563 | ) |
| Other income (expense)                                |       |                                                                  | 14         |   |   | 19 |   | 14 |   | 10 |   |
| Net loss                                              |       |                                                                  | $          | (2,102 | ) |   | $ | (1,848 | ) | $ | (2,246 | ) | $ | (2,553 | ) |
| Basic and diluted  net loss per share                 |       |                                                                  | $          | (0.25 | ) |   | $ | (0.20 | ) | $ | (0.24 | ) | $ | (0.26 | ) |
| Weighted average  number of common shares outstanding |       |                                                                  | 8,333      |   |   | 9,101 |   | 9,468 |   | 9,925 |   |
| **2005**                                              |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Net revenue                                           |       |                                                                  | $          | 15 |   |   | $ | 25 |   | $ | 15 |   | $ | 79 |   |
| Cost of sales                                         |       |                                                                  | 7          |   |   | 8 |   | — |   | 37 |   |
| Gross profit                                          |       |                                                                  | 8          |   |   | 17 |   | 15 |   | 42 |   |
| Operating  expenses:                                  |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Research and development                              |       |                                                                  | 2,572      |   |   | 2,006 |   | 1,806 |   | 2,350 |   |
| Selling, general and  administrative                  |       |                                                                  | 1,023      |   |   | 1,435 |   | 1,519 |   | 2,081 |   |
| 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 |   |

 

38

----

**Report of Independent Registered Public AccountingFirm**

To the Board of Directors and Stockholdersof MathStar, Inc.

In our opinion, the accompanying balance sheets andthe related statements of operations, changes in stockholders’ equity and cashflows present fairly, in all material respects, the financial position ofMathStar, Inc. (a development stage company) (the “Company”) at December 31,2004 and 2005, and the results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2005, and cumulativelyfor the period from April 14, 1997 (date of inception) to December 31,2005, in conformity with accounting principles generally accepted in the UnitedStates of America. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. We conducted our audits of thesestatements in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for our opinion.

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.

/s/PricewaterhouseCoopers LLPMinneapolis, MinnesotaFebruary 17, 2006, except forNote 8, as to which the date is March 30, 2006

39

----

**MathStar, Inc.(A development stage company)**

**BalanceSheets**

| ** **                                                                                                                                                  | ** ** | **December 31,**                                                   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2004**                                                                | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                  | ** ** | **(in thousands, except   per share amounts)** | ** ** |
| **Assets**                                                                                                                                                  | ** ** | ** **                                                              | ** ** | ** ** | ** ** |
| Current assets                                                                                                                                              | ** ** | ** **                                                              | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                                                                                                                   |       | $                                                                       | 4,132      |   | $ | 20,149 |   |
| Accounts receivable                                                                                                                                         |       | 29                                                                      |       | 75 |   |
| Prepaid expenses and other current assets                                                                                                                   |       | 230                                                                     |       | 1,480 |   |
| Total current assets                                                                                                                                        |       | 4,391                                                                   |       | 21,704 |   |
| Property and equipment, net                                                                                                                                 |       | 109                                                                     |       | 347 |   |
| Other assets                                                                                                                                                |       | 4                                                                       |       | 151 |   |
| Total assets                                                                                                                                                |       | $                                                                       | 4,504      |   | $ | 22,202 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                              |       |                                                                    |       |   |   |
| Current liabilities                                                                                                                                         |       |                                                                    |       |   |   |
| Accounts payable                                                                                                                                            |       | $                                                                       | 251        |   | $ | 734 |   |
| Accrued expenses                                                                                                                                            |       | 236                                                                     |       | 1,294 |   |
| Total liabilities                                                                                                                                           |       | 487                                                                     |       | 2,028 |   |
| Commitments and  contingencies (Note 10)                                                                                                                    |       |                                                                    |       |   |   |
| 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; 11,140 and 17,415 shares issued and outstanding at  December 31, 2004 and 2005, respectively |       | 111                                                                     |       | 175 |   |
| Additional paid-in capital                                                                                                                                  |       | 68,465                                                                  |       | 105,717 |   |
| Unearned compensation                                                                                                                                       |       | —                                                                  |       | (2,224 | ) |
| Deficit accumulated during the development stage                                                                                                            |       | (64,559                                                                 | )          | (83,494 | ) |
| Total stockholders’ equity                                                                                                                             |       | 4,017                                                                   |       | 20,174 |   |
| Total liabilities  and stockholders’ equity                                                                                                            |       | $                                                                       | 4,504      |   | $ | 22,202 |   |

 

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

40

----

**MathStar, Inc.**

**(Adevelopment stage company)**

**Statementsof Operations**

| ** **                                                     | ** ** | **Year Ended  December 31,**                                | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)  Through  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2003**                                                              | ** ** | **2004**                                                                                                              | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenue                                                        |       | $                                                                     | 50         |                                                                                                                  | $          | 130 |   | $ | 134 |   |   | $ | 880 |   |   |
| Cost of sales                                                  |       | —                                                                |       | 53                                                                                                                    |       | 52 |   |   | 105 |   |   |
| Gross margin                                                   |       | 50                                                                    |       | 77                                                                                                                    |       | 82 |   |   | 775 |   |   |
| Operating expenses                                             |       |                                                                  |       |                                                                                                                  |       |   |   |   |   |   |   |
| Research and development                                       |       | 7,903                                                                 |       | 5,192                                                                                                                 |       | 8,734 |   |   | 29,967 |   |   |
| Selling, general and administrative                            |       | 3,221                                                                 |       | 3,691                                                                                                                 |       | 6,058 |   |   | 19,274 |   |   |
|                                                           |       | 11,124                                                                |       | 8,883                                                                                                                 |       | 14,792 |   |   | 49,241 |   |   |
| Operating loss                                                 |       | (11,074                                                               | )          | (8,806                                                                                                                | )          | (14,710 | ) |   | (48,466 | ) |   |
| Interest income                                                |       | 47                                                                    |       | 57                                                                                                                    |       | 170 |   |   | 1,420 |   |   |
| Interest expense                                               |       | —                                                                |       | —                                                                                                                |       | (4,395 | ) |   | (4,591 | ) |   |
| Other income, net                                              |       | —                                                                |       | —                                                                                                                |       | — |   |   | 17 |   |   |
| Net loss from continuing operations                            |       | (11,027                                                               | )          | (8,749                                                                                                                | )          | (18,935 | ) |   | (51,620 | ) |   |
| Loss from  discontinued operations (Note 4)                    |       | —                                                                |       | —                                                                                                                |       | — |   |   | (31,874 | ) |   |
| Net loss                                                       |       | $                                                                     | (11,027    | )                                                                                                                     | $          | (8,749 | ) | $ | (18,935 | ) |   | $ | (83,494 | ) |   |
| Basic and diluted  loss per share from continuing operations   |       | $                                                                     | (1.56      | )                                                                                                                     | $          | (0.95 | ) | $ | (1.56 | ) |   |   |   |   |
| Basic and diluted  loss per share from discontinued operations |       | $                                                                     | —     |                                                                                                                  | $          | — |   | $ | — |   |   |   |   |   |
| Basic and diluted  loss per share                              |       | $                                                                     | (1.56      | )                                                                                                                     | $          | (0.95 | ) | $ | (1.56 | ) |   |   |   |   |
| Weighted  average basic and diluted shares outstanding         |       | 7,048                                                                 |       | 9,209                                                                                                                 |       | 12,121 |   |   |   |   |   |

 

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

41

----

**MathStar, Inc. (A development stage company)**

**Statements of Changes in Stockholders’ Equity Cumulative for the Period from Inception (April 14, 1997) Through December 31, 2005**

   

| ** **                                                                                           | ** ** | ** **                                                            | ** ** | **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 |   |
|                                                                                                      |            |                                                                       |            |                 |            |                       |            |                 |            |                       |            |                        |            |                                             |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

42

----

**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, 2005**

 

| ** **                                                                    | ** ** | ** **                                                            | ** ** | **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)** | ** ** |
| **Balances  at December 31,  2003**                                      |       |                                                                  |       |            |       |                  | 7,648      |            |       |                  | 76         |                   |       |                                        | 57,826     |                    |       |   | — |   |   |   | — |   |   |   | (55,810 | ) |   | 2,092 |   |
| 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 |   |
|                                                                               |            |                                                                       |            |                 |            |                       |            |                 |            |                       |            |                        |            |                                             |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

43

----

**MathStar, Inc.**

**(Adevelopment stage company)**

**Statements of CashFlows**

| ** **                                                                                                            | ** ** | **Year Ended  December 31,** | ** ** | **Cumulative  for the Period  from Inception  (April 14, 1997)**

**Through  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2003**                               | ** ** | **2004**                                                                                                                  | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands)**                | ** ** |
| **Cash flows from operating activities**                                                                              | ** ** | ** **                             | ** ** | ** **                                                                                                                | ** ** | ** ** | ** ** |   | ** ** |   |   |
| Net loss                                                                                                              |       | $                                      | (11,027    | )                                                                                                                         | $          | (8,749 | ) | $ | (18,935 | ) |   | $ | (83,494 | ) |   |
| Adjustments to reconcile net loss to net cash used in  operating activities                                           | ** ** | ** **                             | ** ** | ** **                                                                                                                | ** ** | ** ** | ** ** |   | ** ** |   |   |
| Depreciation                                                                                                          |       | 358                                    |       | 183                                                                                                                       |       | 74 |   |   | 1,533 |   |   |
| Amortization of  beneficial conversion feature 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                                                                                             |       | 175                                    |       | 50                                                                                                                        |       | 1,166 |   |   | 2,241 |   |   |
| Goodwill  impairment                                                                                                  |       | —                                 |       | —                                                                                                                    |       | — |   |   | 13,306 |   |   |
| Change in operating  assets and liabilities, net of effects of acquisition                                       |       |                                   |       |                                                                                                                      |       |   |   |   |   |   |   |
| Accounts  receivable                                                                                                  |       | —                                 |       | (29                                                                                                                       | )          | (46 | ) |   | 70 |   |   |
| Prepaid expenses  and other assets                                                                                    |       | 302                                    |       | (101                                                                                                                      | )          | (896 | ) |   | (991 | ) |   |
| Accounts payable                                                                                                      |       | 68                                     |       | (188                                                                                                                      | )          | 178 |   |   | 281 |   |   |
| Accrued expenses                                                                                                      |       | 513                                    |       | (477                                                                                                                      | )          | 862 |   |   | 1,076 |   |   |
| Net cash used in  operating activities                                                                                |       | (9,611                                 | )          | (9,311                                                                                                                    | )          | (13,740 | ) |   | (58,064 | ) |   |
| **Cash flows from investing activities**                                                                              | ** ** | ** **                             | ** ** | ** **                                                                                                                | ** ** | ** ** |   |   |   |   |   |
| Cash used in acquisition,  net of cash acquired                                                                       |       | —                                 |       | —                                                                                                                    |       | — |   |   | (791 | ) |   |
| Purchase of property and  equipment                                                                                   |       | —                                 |       | (13                                                                                                                       | )          | (312 | ) |   | (1,720 | ) |   |
| Proceeds from sale of  discontinued operations                                                                        |       | —                                 |       | —                                                                                                                    |       | — |   |   | 1,752 |   |   |
| Purchases of  held-to-maturity securities                                                                             |       | —                                 |       | —                                                                                                                    |       | — |   |   | (10,000 | ) |   |
| Sales of held-to-maturity  securities                                                                                 |       | —                                 |       | —                                                                                                                    |       | — |   |   | 10,233 |   |   |
| Net cash used in  investing activities                                                                                |       | —                                 |       | (13                                                                                                                       | )          | (312 | ) |   | (526 | ) |   |
| **Cash flows from financing activities**                                                                              | ** ** | ** **                             | ** ** | ** **                                                                                                                | ** ** | ** ** | ** ** |   | ** ** |   |   |
| Proceeds from issuance of  common stock, net of offering costs                                                        |       | 2,493                                  |       | 7,978                                                                                                                     |       | 24,633 |   |   | 66,047 |   |   |
| 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                                  |       | —                                                                                                                    |       | — |   |   | 5,304 |   |   |
| Proceeds from exercise of  warrants, net of costs                                                                     |       | —                                 |       | 2,645                                                                                                                     |       | 235 |   |   | 2,908 |   |   |
| Collection of  subscription receivable                                                                                |       | —                                 |       | 27                                                                                                                        |       | — |   |   | 27 |   |   |
| Proceeds from exercise of  stock options                                                                              |       | —                                 |       | 1                                                                                                                         |       | — |   |   | 1 |   |   |
| Principal payments on  notes receivable from stockholders                                                             |       | —                                 |       | —                                                                                                                    |       | — |   |   | 245 |   |   |
| Principal payments on  notes payable to stockholders                                                                  |       | (125                                   | )          | —                                                                                                                    |       | — |   |   | (250 | ) |   |
| Repurchase of common  stock                                                                                           |       | —                                 |       | —                                                                                                                    |       | — |   |   | (257 | ) |   |
| Payments on capital lease  obligations                                                                                |       | (29                                    | )          | —                                                                                                                    |       | — |   |   | (486 | ) |   |
| Net cash provided  by financing activities                                                                            |       | 7,643                                  |       | 10,651                                                                                                                    |       | 30,068 |   |   | 78,739 |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                                 |       | (1,968                                 | )          | 1,327                                                                                                                     |       | 16,017 |   |   | 20,149 |   |   |
| **Cash and cash equivalents**                                                                                         | ** ** | ** **                             | ** ** | ** **                                                                                                                | ** ** | ** ** | ** ** |   | ** ** |   |   |
| Beginning of period                                                                                                   |       | 4,773                                  |       | 2,805                                                                                                                     |       | 4,132 |   |   | — |   |   |
| End of period                                                                                                         |       | $                                      | 2,805      |                                                                                                                      | $          | 4,132 |   | $ | 20,149 |   |   | $ | 20,149 |   |   |
| **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 |   |   |
| Exercise of warrants for  subscription receivable                                                                     |       | 27                                     |       | —                                                                                                                    |       | — |   |   | 27 |   |   |
| Capital lease obligation  incurred for acquisition of fixed assets                                                    |       | —                                 |       | —                                                                                                                    |       | — |   |   | 426 |   |   |
| Repurchase of common stock with notes payable                                                                         |       | —                                 |       | —                                                                                                                    |       | — |   |   | 250 |   |   |
| Prepaid licenses  included in accrued expenses                                                                        |       | —                                 |       | —                                                                                                                    |       | 601 |   |   | 601 |   |   |
| 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.

44

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**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (in thousands, except per share amounts)**

**1.**   Nature of the Business and GoingConcern

MathStar, Inc. (the “Company”) was incorporatedas a Minnesota corporation in April 1997 and reincorporated under Delawarelaw during 2005. The Company is a fabless semiconductor company addressing thereconfigurable logic markets with a new class of platform chips designed to behigh performance, reconfigurable integrated circuits based on the Company’sproprietary silicon object technology. Since its inception, the Company hasdevoted substantially all of its efforts to business planning, research anddevelopment, recruitment of management and technical staff, acquiring operatingassets and raising capital. The Company has generated only nominal revenuesfrom the sale of development kits that support customer development ofapplications for one of the Company’s products, the sale of product prototypesand contractual research and development services. Accordingly, the Company isconsidered to be in the development stage as defined by Statement of FinancialAccounting Standards (“SFAS”) No. 7, *Accountingand Reporting by Development Stage Enterprises*.

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

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’sability to continue as a going concern. Management intends to seek additionalequity financing during 2006. However, there can be no assurance that suchadditional funding will be available on terms acceptable to the Company or atall.

**2.**   Summary of Significant AccountingPolicies

**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.

45

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**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

**Fair Value ofFinancial Instruments**

The carrying amounts of theCompany’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.

**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**

Revenue prior to 2003 resulted from contractualresearch and development services and was recognized as the services wereperformed. Customer payments received in advance of providing services wererecorded as customer deposits. Costs related to these revenues consistedprimarily of salary and related benefits of certain employees and were includedin operating expenses.

46

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**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

Revenue after 2002 resulted from the sale of prototypeproducts and the sale of product development kits. The Company recognizesrevenue for these products when persuasive evidence of an arrangement exists,delivery has occurred, the sales price is fixed or determinable, collectibility is reasonably assuredand there are no post-delivery obligations. During 2004 and 2005, marketingsupport was paid to a customer of the Company. Such payments are reported as areduction of revenue in accordance with Emerging Issues Task Force Issue 01-09,*Accounting for Consideration Given by aVendor to a Customer (Including a Reseller of the Vendor’s Products)*.

During 2005, revenue alsoresulted from contractual research and development services that was recognizedas the services were performed. Costs related to these revenues consistedprimarily of salary and related benefits of certain employees and were includedin cost of sales.

**Stock-BasedCompensation**

In accordance with SFAS No. 123, *Accounting for Stock-Based Compensation*,the Company has 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 is 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 Companyaccounts for stock-based compensation to nonemployees using the fair valuemethod prescribed by SFAS No. 123. Compensation cost for stock optionsgranted to nonemployees is measured based on the fair value of the option atthe date of grant with the unvested portion revalued at each balance sheetdate. Compensation costs, if any, are amortized over the underlying optionvesting terms.

Thefollowing table presents the pro forma effect on net loss if the Company hadapplied the fair value recognition provisions for SFAS No. 123 tostock-based employee compensation:

| ** **                                                                                                                 | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** ** | ** ** | **Cumulative**                 | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                                                                                                 | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** ** | ** ** | **for the Period**   | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** ** | ** ** | **from Inception**        | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** ** | ** ** | **(April 14, 1997)** | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** ** | ** ** | **Through**                    | ** ** |
| ** **                                                                                                                 | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                 | ** ** | **2003**                                   | ** ** | **2004**              | ** ** | **2005**   | ** ** | **2005**                       | ** ** |
| Net loss as  reported                                                                                                      |       | $                                          | (11,027    | )                     | $          | (8,749     | )          | $                              | (18,935    | ) |   | $ | (83,494 | ) |   |
| Add: Total  stock-based employee compensation expense included in net loss, as reported                                    |       | 148                                        |       | —                |       | 651        |       |                           | 1,475      |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all employee awards |       | (369                                       | )          | (174                  | )          | (912       | )          |                           | (2,697     | ) |   |
| Pro forma net  loss                                                                                                        |       | $                                          | (11,248    | )                     | $          | (8,923     | )          | $                              | (19,196    | ) |   | $ | (85,163 | ) |   |
| Basic and diluted loss  per share:                                                                                         |       |                                       |       |                  |       |       |       |                           |       |   |   |
| As reported                                                                                                                |       | $                                          | (1.56      | )                     | $          | (0.95      | )          | $                              | (1.56      | ) |   |   |   |   |
| Pro forma                                                                                                                  |       | $                                          | (1.60      | )                     | $          | (0.97      | )          | $                              | (1.58      | ) |   |   |   |   |

 

47

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

**Advertising Costs**

Advertising costs arecharged to operations as incurred. Advertising costs were $4, $3 and $14 forthe years ended December 31, 2003, 2004 and 2005, respectively, and $137cumulative for the period from inception (April 14, 1997) through December 31,2005.

**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 financial reportingpurposes 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.

**Comprehensive Loss**

Comprehensive loss, as definedin SFAS No. 130, *ReportingComprehensive Income*, includes all changes in equity during a periodfrom nonowner sources. The Company has not had any changes in stockholders’equity from nonowner 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 shares outstandingduring the period, including stock options, warrants and convertible notespayable, using the treasury stock method. Options and warrants to purchase 3,672,2,611 and 4,021 shares of common stock were outstanding at December 31,2003, 2004 and 2005, respectively, but were not included in the computation ofnet loss per share as their effect was anti-dilutive. Common shares issuableupon exercise of the convertible notes payable and related accrued interest andshares of the Company’s contingently issuable restricted stock also were notincluded in the computation of net loss per share as their effect wasanti-dilutive (see Note 6).

**New AccountingPronouncements**

In December 2004, the FASB issued SFAS No. 123R,*Share-Based Payment*. SFAS No. 123Rrevised SFAS No. 123 and supersedes Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*(“APBOpinion No. 25”). The revised statement addresses the accounting forshare-based 

48

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**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

payment transactions withemployees and other third parties, eliminates the ability to account forshare-based payments using APB Opinion No. 25 and requires that thecompensation costs relating to such transactions be recognized in the statementof operations based upon the grant-date fair value of those instruments. Therevised statement is effective for the Company in the first quarter of 2006which begins on January 1, 2006. The Company expects that adoption of SFASNo. 123R will result in significant charges to operations beginning in2006.

Under SFAS No. 123R, the Company must determinethe appropriate fair value model to be used for valuing share-based payments,the amortization method for compensation costs and the transition method to beused at the date of adoption. The transition methods include prospective andretroactive adoption alternatives. The Company will adopt SFAS No. 123Rusing the prospective method. Because the Company has historically followed the“minimum value” method permitted by SFAS No. 123, the prospective methodwill require the Company to record compensation expense only for options issuedafter the closing of the Company’s initial public offering in November 2005.

In May 2005, the Financial Accounting StandardsBoard issued SFAS No. 154, *AccountingChanges and Error Corrections*. This new standard replaces AccountingPrincipals Board Opinion (“APB”) No. 20, *AccountingChanges*, and SFAS No. 3, *ReportingAccounting Changes in Interim Financial Statements*. This statementchanges the requirements for the accounting for and reporting of a change inaccounting principle and applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. When a pronouncement includes specific transitionprovisions, those provisions should be followed. APB No. 20 required thatmost voluntary changes in accounting principle be recognized by including innet income of the period of the change the cumulative effect of changing to thenew accounting principle. This statement requires retrospective application toprior period financial statements of changes in accounting principle, unless itis impracticable to determine either the period-specific effects or the cumulativeeffect of the change. The provisions of SFAS No. 154 are effective forfiscal years beginning after December 15, 2005. As such, the Company isrequired to adopt SFAS No. 154 by January 1, 2006. The Company doesnot expect the adoption of this statement to have an impact on its financialstatements.

**3.**   Selected Balance SheetInformation

Thefollowing presents prepaid expenses and other current assets:

| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Prepaid license  fees |       | $                     | 108        |   | $ | 775 |   |
| Prepaid insurance     |       | 25                    |       | 165 |   |
| Prepaid rent          |       | —                |       | 89 |   |
| Other                 |       | 97                    |       | 451 |   |
|                  |       | $                     | 230        |   | $ | 1,480 |   |

 

49

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

Thefollowing presents property and equipment, net:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Computer  equipment                |       | $                     | 896        |   | $ | 1,003 |   |
| Purchased  software                |       | 425                   |       | 425 |   |
| Furniture and  fixtures            |       | 165                   |       | 370 |   |
|                               |       | $                     | 1,486      |   | $ | 1,798 |   |
| Less: Accumulated  depreciation    |       | (1,377                | )          | (1,451 | ) |
| Total property and  equipment, net |       | $                     | 109        |   | $ | 347 |   |

 

Depreciation expense was $358, $183 and $74 for theyears ended December 31, 2003, 2004 and 2005 and $1,533 cumulative for theperiod from inception (April 14, 1997) through December 31, 2005.

The followingpresents accrued expenses:

| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Accrued rent               |       | $                     | 146        |   | $ | 117 |   |
| Accrued  compensation      |       | 90                    |       | 417 |   |
| Accrued  professional fees |       | —                |       | 320 |   |
| Other                      |       | —                |       | 440 |   |
| Total accrued expenses     |       | $                     | 236        |   | $ | 1,294 |   |

 

**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 convertedinto options and warrants to purchase 781 shares of the Company’s common stock.The total 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.

50

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

**Goodwill Impairmentand Discontinued Operations**

In August 2002, due to events and changes incircumstances which included a severe downturn in the market for the acquiredin process development projects, management and the Board of Directorscommitted to a plan to sell the physical media device (“PMD”) operating segmentwhich was comprised of the acquired DMC operations. Accordingly, the Companytested the PMD assets for impairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-LivedAssets*, and SFAS No. 142, *Goodwilland Other Intangible Assets*, and recorded a $13,306 goodwillimpairment charge.

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.

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.**   Note Payable to Stockholder

On January 16, 2002,the Company agreed to purchase 500 shares of the Company’s common stock from astockholder in exchange for a note payable of $250. The note bore interest at5% and was due in four equal installments through 2002. At December 31,2002, the remaining balance due was $125. During 2003, the Company repaid theoutstanding balance of this note payable.

**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, 3,411 of the 90,000 shares of common stock have been reserved forissuance under the Company’s Stock Option and Restricted Stock Plans. Eachshare of common stock entitles the holder to one vote.

**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.

51

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

**Warrants**

In connection with itsinitial public offering, the Company issued warrants to purchase 400 commonshares to the selling agent at an exercise price of $7.20 per share expiring inOctober 2010.

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

In March 2005, theCompany granted fully vested warrants to purchase 33 common shares at anexercise price of $6.00 per share to a consultant of the Company. In August 2005,the Company granted warrants to purchase 80 common shares at an exercise priceof $6.30 per share to a consultant of the Company. These warrants vest ratablyover three years beginning retroactively to October 2004. Total stockcompensation expense related to these warrants during the year ended December 31,2005 was $247. The fair value of the warrants was measured as they were earnedusing the Black-Scholes option pricing model and the following assumptions at December 31,2005:  term—10 years; volatility—73.8%;risk-free interest rate—4.35%; and expected dividend yield of zero.

In connection with theissuance of  common stock by the Companyfrom January 2004 to August 2004, the Company issued warrants to theselling agent to purchase 244 shares of common stock at an exercise price of$4.80. 200 of the warrants expire on March 24, 2009, and the remaining 44warrants expire on August 15, 2009.

In 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 expenserelated to these warrants during the years ended December 31, 2004 and2005 and cumulative for the period from inception (April 14, 1997) throughDecember 31, 2005 was $50, $515 and $565, respectively. Unvestedstock-based compensation related to these warrants at December 31, 2005 was$840. The fair value of these warrants was measured as they were earned usingthe Black-Scholes option pricing model and the following assumptions at December 31,2005: term—10 years; volatility—68%; risk-free interest rate—4.47%; andexpected dividend yield of zero.

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 2,000 three-year warrants to purchaseshares of the Company’s common stock. These warrants, which expire if notexercised three years after issuance, consisted of 1,000 Part A Warrantswith an exercise price of $1.50 and 1,000 Part B Warrants with an exerciseprice of $2.25.

Thewarrants are redeemable at the Company’s option upon at least 30 days’ noticeat a redemption price of $0.01 per warrant under any of the followingcircumstances:

·       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.

52

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

·       Part AWarrants were redeemable by the Company when the Company gave notice that ithad fabricated and successfully tested and demonstrated the functionality ofits Field Programmable Object Array chip (the “Chip”) and also receivedcommitments from at least two customers that will use the Chip in at least oneof 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 silicon object chips of at least$2,500.

During 2004, the Companygave notice that it had achieved the milestones required to permit the Companyto redeem the Part A warrants. In December 2004, the Company calledfor redemption of all Part A warrants. Proceeds from the exercise of Part Awarrants to purchase 981 shares and Part B warrants to purchase 646shares, whose holders voluntarily elected to exercise, were $2,645 net ofoffering costs of $279. The remaining Part A warrants to purchase 19shares were exercised in December 2003 and January 2005.

In connection with thesale of warrants to purchase shares of the Company’s common stock from April toJuly 2003, the Company issued warrants to the selling agent to purchase200 shares of the Company’s common stock at an exercise price of $4.89. Ofthese warrants, warrants to purchase 183 shares expire on June 29, 2008,and the remaining warrants to purchase 17 shares expire on July 7, 2008.

In connection with theissuance of common stock by the Company from April 2002 to August 2002,the Company issued warrants to the selling agent to purchase 146 shares ofcommon stock at an exercise price of $10.50. The warrants expire on July 18,2007.

In connection with theacquisition of DMC in August 2001, warrants to purchase shares of DMCcommon stock were converted to warrants to purchase 37 shares of the Company’scommon stock at an exercise price of $7.76. Of these warrants, warrants topurchase 34 shares expired on various dates through December 31, 2005, andthe remaining warrants to purchase 3 shares expire on various dates through March 2006.

In connection with theissuance of common stock by the Company in July and November 2000,the Company issued warrants to the selling agent to purchase 224 shares ofcommon stock at an exercise price of $8.25. All of these warrants had expiredas of December 31, 2005.

During December 2003, warrants to purchase 18shares were exercised in exchange for a subscription receivable for $27. Thesubscription receivable was paid in January 2004.

53

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

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 - $10.50 |   |
| 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      |                                 |       | $ | 1.50 - $10.50 |   |
| Warrants issued                                          |       |                      | 497        |                                 |       | $ | 4.80 - $6.00 |   |
| Warrants  exercised                                      |       |                      | (1,627     | )                                    |       | $ | 1.50 - $2.25 |   |
| Outstanding at December 31, 2004                    |       |                      | 1,458      |                                 |       | $ | 1.50 - $10.50 |   |
| Warrants issued                                          |       |                      | 880        |                                 |       | $ | 4.80 - $7.20 |   |
| Warrants  exercised                                      |       |                      | (101       | )                                    |       | $ | 1.50 - $2.25 |   |
| Warrants expired                                         |       |                      | (253       | )                                    |       | $ | 7.77 - $8.25 |   |
| Outstanding at  December 31, 2005                   |       |                      | 1,984      |                                 |       | $ | 1.50 - $10.50 |   |

 

**Notes Receivable**

In 1998 and 2000, theCompany issued stock to certain stockholders totaling $15 and $230,respectively, under subscription agreements in exchange for notes receivablewith no stated interest rate. In 1999 and 2000, the note holders repaid $15 and$230, respectively.

**Restricted Stock**

In 2004 and 2005, theCompany issued 84 and 408 shares of restricted common stock to certainemployees of the Company. These shares were granted effective upon the closingof the Company’s initial public offering and will vest on October 26, 2006so long as the holders are then employees of the Company. The Company isrecognizing compensation expense equal to the grant date fair value of thecommon shares ($2,741) pro rata over the one-year vesting period. During2005, the Company recognized $447 of compensation expense related to theserestricted shares, net of the reversal of $70 compensation expense recorded for47 restricted shares cancelled before vesting. The remaining estimatedcompensation expense of $2,224 will be recognized over the remaining vestingperiod.

54

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

**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 in an initial public offering, if any. If an initialpublic offering did not occur on or before April 28, 2006 or any extendedmaturity date of the notes, the notes would have been convertible into sharesof the Company’s common stock at a price of $4.80 per share. The Company couldhave elected to extend the maturity of the notes for up to six months if an initialpublic offering had not closed on or before April 28, 2006. However, thenotes were payable in full 30 days after the closing date an initial publicoffering.

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 was 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 $5,430 ofthe 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 quarter endedDecember 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 price providesapproximately a $2.19 conversion benefit to the note holders for each of the 1,146shares into which the notes were convertible.

**7.**   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 issuance of incentive and nonqualified stock options todirectors, officers and employees of and advisers to the Company at exerciseprices as determined by the Board of Directors on the date of grant,respectively. 

55

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

These options haveexercise prices and vesting terms established by a committee of the Board ofDirectors at the time of each grant. Vesting terms of outstanding options aregenerally four years. In no event are the options exercisable more than tenyears after the date of grant.

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, respectively.

56

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

Inconnection with the acquisition of DMC (Note 4), the Company assumed DMC’sstock option plan. 744 shares of the Company’s common stock have been reservedfor issuance under the assumed plan and the related options are included in thefollowing 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 |   |   |
| 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 |   |   |

 

57

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| ** **               | ** ** | **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        |       |                         | 118        |                         |       |   | 1.35 |   |   |   | $ | 0.87 |   |   |   | 118 |   |   |   | $ | 0.87 |   |   |
| $  3.45-$4.89  |       |                         | 993        |                         |       |   | 7.47 |   |   |   | $ | 4.72 |   |   |   | 321 |   |   |   | $ | 4.53 |   |   |
| $  5.25        |       |                         | 38         |                         |       |   | 4.24 |   |   |   | $ | 5.25 |   |   |   | 38 |   |   |   | $ | 5.25 |   |   |
| $  5.85-$6.30  |       |                         | 656        |                         |       |   | 9.61 |   |   |   | $ | 6.24 |   |   |   | 67 |   |   |   | $ | 6.30 |   |   |
| $  8.25        |       |                         | 136        |                         |       |   | 4.97 |   |   |   | $ | 8.25 |   |   |   | 136 |   |   |   | $ | 8.25 |   |   |
| $10.50                   |       |                         | 96         |                         |       |   | 5.88 |   |   |   | $ | 10.50 |   |   |   | 79 |   |   |   | $ | 10.50 |   |   |
|                     |       |                         | 2,037      |                         |       |   |   |   |   |   |   |   |   |   | 758 |   |   |   |   |   |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Stock options outstanding at December 31, 2005,include 56 options that were granted to nonemployees and 1,981 options thatwere granted to employees. During the year ended December 31, 2003, andcumulative for the period from inception (April 14, 1997) through December 31,2005, total stock-based compensation expense related to options issued tononemployees measured using the fair value method as prescribed by SFAS No. 123,was $26 and $142, respectively. Total stock-based compensation expense relatedto options issued to employees, including options assumed in connection withthe acquisition of DMC, measured using the intrinsic value method, asprescribed by APB Opinion No. 25, was $148, $204 and $1,028 for the yearsended December 31, 2003 and 2005 and cumulative for the period frominception (April 14, 1997) through December 31, 2005. Compensationexpense related to employee stock options that will be amortized into futureoperating expenses was $932 at December 31, 2005.

Theweighted-average fair value of employee options on the date of grant orassumption was as follows:

| ** **                                                                                       | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **Cumulative**                 | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                                                                       | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **for the Period**   | ** ** |
| ** **                                                                                       | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **from Inception**        | ** ** |
| ** **                                                                                       | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **(April 14, 1997)** | ** ** |
| ** **                                                                                       | ** ** | **Year Ended**   | ** ** | **Through**           | ** ** |
| ** **                                                                                       | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                       | ** ** | **2003**              | ** ** | **2004**              | ** ** | **2005**   | ** ** | **2005**                       | ** ** |
| For options  granted with exercise prices above the fair value of common stock              |       | —                |       | —                |       | —     |       |                           | $          | 0.01 |   |   |
| For options  granted with exercise prices at the fair value of common  stock |       | $                     | 0.69       |                  | $          | 0.77       |       | $                              | 3.73       |   |   | $ | 1.74 |   |   |
| For options granted or  assumed with exercise prices below the fair value of common stock        |       | —                |       | —                |       | 1.50       |       |                           | $          | 4.03 |   |   |
|                                                                                                  |            |                       |            |                       |            |            |            |                                |            |  |  |  |  |  |  |

 

58

----

**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

Forthe purpose of determining fair values using the minimum value method foremployee grants and the fair value method for nonemployee grants as prescribedby SFAS No. 123, the Company used the Black-Scholes option pricing modelwith the following weighted average assumptions:

| ** **                                                                 | ** ** | **Year Ended**   | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                 | ** ** | **December 31,** | ** ** |
| ** **                                                                 | ** ** | **2003**              | ** ** | **2004** | ** ** | **2005** | ** ** |
| Expected option  term—employee                                        | ** ** | 5 years               |       | 5 years |   | 5 years |   |
| Expected option  term—nonemployee                                     | ** ** | 4 years               |       | N/A |   | N/A |   |
| Expected  volatility factor—employee (before initial public offering) | ** ** | 0                     | %          | 0 | % | 0 | % |
| Expected  volatility factor—employee (after initial public offering)  |       | N/A                   |       | N/A |   | 73.8 | % |
| Expected  volatility factor—nonemployee                               | ** ** | 81.60                 |       | N/A |   | N/A |   |
| Expected dividend  yield                                                   | ** ** | 0                     | %          | 0 | % | 0 | % |
| Risk free  interest rate—employee                                     | ** ** | 3.01                  | %          | 3.51 | % | 4.35 | % |
| Risk free interest  rate—nonemployee                                  | ** ** | 4.53                  | %          | N/A |   | N/A |   |

 

**8.**   Income Taxes

Thecomponents of deferred income taxes are as follows:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Net operating  loss carryforwards                  | ** ** | $                     | 19,447     |   | $ | 25,461 |   |
| Research and  experimentation credit carryforwards | ** ** | 2,503                 |       | 2,669 |   |
| Accrued expenses  and stock options                | ** ** | 257                   |       | 822 |   |
| Total deferred tax assets                          | ** ** | 22,207                |       | 28,952 |   |
| Valuation  allowance                               | ** ** | (22,207               | )          | (28,952 | ) |
| Net deferred tax asset                             | ** ** | $                     | —     |   | $ | — |   |

 

The Company hasestablished valuation allowances to fully offset its deferred tax assets due touncertainty about the Company’s ability to generate the future taxable incomenecessary to realize these deferred tax assets, particularly in light of theCompany’s recent history of significant operating losses. The valuationallowance increases by $6,745 in 2005. Future utilization of available netoperating loss carryforwards may be limited under Internal Revenue Code Section 382as a result of significant changes in ownership. These limitations could resultin expiration of these net operating loss carryforwards before they areutilized.

For the years ended December 31,2004 and 2005, and cumulative for the period from inception (April 14,1997) through December 31, 2005, the Company has generated federal netoperating loss carryforwards of approximately $8,650, $13,937 and $62,554,respectively.

TheCompany’s federal net operating loss carryforwards and state net operating losscarryforwards expire in various calendar years from 2014 through 2025.Available research and development credit 

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**MathStar, Inc. (A development stage company)**

**Notes to Financial Statements (Continued) (in thousands, except per share amounts)**

carryforwards at December 31, 2005, include federaland state amounts of $2,287 and $587, respectively, with expiration dates incalendar years 2015 through 2025.

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

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

 

**9.**   401(k) Savings Plan

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.

**10.**   Commitments

**Operating Leases**

The Company leases itsoffice and research facilities and certain office equipment undernoncancellable operating leases. Total rent expense under these operatingleases was $1,403, $859, $1,074 for the years ended December 31, 2003,2004 and 2005, respectively, and $4,102 cumulative for the period frominception (April 14, 1997) through December 31, 2005.

Futureminimum lease payments under noncancellable operating leases at December 31,2004, are as follows:

| **Year Ending December 31,** |       |   |       |
|-----------------------------------|------------|--------|------------|
| 2006                              | ** ** | $      | 1,288      | ** ** |
| 2007                              | ** ** | 628    | ** ** |
| 2008                              | ** ** | 269    | ** ** |
| 2009                              | ** ** | 275    | ** ** |
| 2010                              | ** ** | 283    | ** ** |
| 2011 and  thereafter              | ** ** | 47     | ** ** |
|                              | ** ** | $      | 2,790      | ** ** |

 

**SoftwareLicense Agreements**

The Company licensescertain internal use software under noncancellable license agreements. Futurepayments under noncancellable license agreements at December 31, 2005,were $301.

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

Not applicable.

**Item 9A. Controls and Procedures**

**Evaluationof Disclosure Controls and Procedures**

We maintain disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended) that are designed to reasonablyensure that information required to be disclosed by us in the reports we fileor submit under the Securities Exchange Act of 1934, as amended, is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer, or personsperforming similar functions, as appropriate to allow timely decisionsregarding required disclosure. In designing and evaluating our disclosurecontrols and procedures, we recognize that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and we necessarily are required toapply our judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

Our management evaluated,with the participation of our Chief Executive Officer and Chief FinancialOfficer, the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered in this AnnualReport on Form 10-K. Based on this evaluation, and because of thematerial weakness related to our controls over the preparation, review andpresentation and disclosure of our financial statements as described below, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were not effective as of the end of theperiod covered in this Annual Report on Form 10-K. To address thematerial weakness described below, we have expanded our disclosure controls andprocedures to include additional analysis and other procedures over thepreparation of the financial statements included in this report. Accordingly,our management has concluded that the financial statements included in thisreport fairly present in all material respects our financial position, resultsof operations and cash flows for the periods presented in conformity withgenerally accepted accounting principles.

**Changesin Internal Control over Financial Reporting**

A material weakness is a control deficiency or acombination of control deficiencies that results in more than a remotelikelihood that a material misstatement of the annual or interim consolidatedfinancial statements will not be prevented or detected. Our management hasconcluded that as of December 31, 2005, we did not maintain effectivecontrols over the preparation, review, presentation and disclosure of ourfinancial statements. Specifically, as of December 31, 2004, ourindependent registered public accounting firm reported to our board ofdirectors that we do not have a sufficient number of financial personnel withadequate training and experience in accounting and financial reporting, and ourcontrols do not ensure that operating expenses and stock compensationtransactions are identified and recorded accurately and in the appropriateaccounting period. These two conditions, in combination, constitute a materialweakness in our internal controls. This control deficiency could result in amisstatement of the presentation and disclosure of our financial statementsthat would result in a material misstatement in our annual or interim financialstatements that would not be prevented or detected. Accordingly, managementagrees that this control deficiency constitutes a material weakness in ourinternal control over financial reporting.

The changes in ourinternal control over financial reporting that occurred during the quarterended December 31, 2005 that have materially affected, or are reasonablylikely to materially affect, our internal 

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controlover financial reporting, are described below under the heading “—Management’sPlan for Remediation of Material Weakness.”

**Management’sPlan for Remediation of Material Weakness**

Management is taking steps to remediate the materialweakness in our internal control over financial reporting. Management’s plan toaddress this material weakness includes the addition of our new chief financialofficer and controller, as well as the performance of an assessment of ourcurrent accounting and reporting policies and procedures, assessment of ourfinancial accounting and reporting staff requirements, implementation ofsupervisory reviews by our chief financial officer and controller,implementation of new accounting policies and procedures, and the hiring andtraining of additional financial accounting and reporting staff. We hired a newchief financial officer in June 2005 and a new controller in July 2005.In addition to this plan, our new chief financial officer and controller areassessing our system of internal controls over financial reporting and intendto implement controls designed to assure that, among other things, operatingexpenses and stock compensation transactions are identified and accuratelyrecorded.

Management believes theadditional control procedures designed, when implemented, will fully remediatethe material weakness.  We are uncertainwhen the material weakness will be fully remediated, and we will need a periodof time over which to demonstrate that these controls are functioningappropriately and to conclude that we have adequately remediated the materialweakness.

**Item 9B. Other Information**

Not applicable.

**PART III**

Items 10 through 14 ofthis Annual Report on Form 10-K are omitted because we will filebefore April 30, 2006 a definitive Proxy Statement (the “Proxy Statement”)conforming to Schedule 14A involving the election of directors. The informationrequired by Items 10, 11, 12, 13 and 14 of Part III of the Form 10-Kare hereby 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. 3—Ratification ofAppointment of Independent Registered Public Accounting Firm” and “Section 16(a) BeneficialOwnership Reporting Compliance.”

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**PART IV**

**Item 15. Exhibits and Financial Statement Schedules**

**Financial Statements and Schedules**

(a)(1)   TheFinancial Statements, together with the report thereon of our independentregistered public accounting firm, are included on the pages indicatedbelow:
|                                                                                                                                                                    | ** ** | **Page** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of  Independent Registered Public Accounting Firm                                                                                                           |       | 39       |       |
| Balance Sheets as  of December 31, 2004 and 2005                                                                                                              |       | 40       |       |
| Statements of  Operations for the years ended December 31, 2003, 2004 and 2005 and  cumulative from inception (April 14, 1997) to December 31, 2005 |       | 41       |       |
| Statements of  Stockholders’ Equity from inception (April 14, 1997) to  December 31, 2005                                                           |       | 42       |       |
| Statements of  Cash Flows for the years ended December 31, 2003, 2004 and 2005 and  cumulative from inception (April 14, 1997) to December 31, 2005 |       | 44       |       |
| Notes to Consolidated  Financial Statements                                                                                                                        |       | 45       |       |

 

(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 3.1 to the Registration Statement).                                                                                                                                                                                                                                                                                                                       |       |   |   |
|             | 3.2        |                                 |       | By-laws of  MathStar, Inc. (incorporated by reference to Exhibit 3.2 to the  Registration Statement).                                                                                                                                                                                                                                                                                                                                            |       |   |   |
|             | 4.1        |                                 |       | Form of  common stock certificate of MathStar, Inc. (incorporated by reference to  Exhibit 4.1 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 10.11 to the Registration Statement).                                                                                                                                                                                                                     |       |   |   |

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|        | 10.4  |   |   | Office Lease  Agreement dated June 1, 2005 by and between Mark Tanasbourne, LLC and  MathStar, Inc. (incorporated by reference to Exhibit 10.12 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 10.13 to the Registration Statement).                                                                                        |   |   |   |
|   | 10.6  |   |   | Full-Time  Permanent Engagement Resources Agreement dated June 30, 2005 by and  between Tatum CFO Partners, LLP and MathStar, Inc. (incorporated by  reference to Exhibit 10.14 to the Registration Statement).                                                                                     |   |   |   |
|   | 10.7  |   |   | Schedule of  Executive Officer Compensation and Director Compensation for 2005  (incorporated by reference to Exhibit 10.15 to Amendment No. 3 to  the Registration Statement filed by MathStar, Inc. with the SEC on  October 7, 2005).*                                                      |   |   |   |
|   | 10.8  |   |   | 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).*   |   |   |   |
|   | 10.9  |   |   | Form of  Restated Bridge Loan and Subscription Agreement for April 2005 note and  warrant financing of MathStar, Inc. (incorporated by reference to  Exhibit 10.17 to the Registration Statement).                                                                                             |   |   |   |
|   | 10.10 |   |   | Form of  Bridge Note for April 2005 note and warrant financing of  MathStar, Inc. (incorporated by reference to Exhibit 10.18 to the  Registration Statement).                                                                                                                                 |   |   |   |
|   | 10.11 |   |   | Form of  Bridge Warrant for April 2005 note and warrant financing of  MathStar, Inc. (incorporated by reference to Exhibit 10.19 to the  Registration Statement).                                                                                                                              |   |   |   |
|   | 10.12 |   |   | 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).**                                                                          |   |   |   |
|   | 10.13 |   |   | 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 10.20 to the Registration  Statement).                                                                      |   |   |   |
|   | 10.14 |   |   | 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). |   |   |   |
|   | 10.15 |   |   | 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).**                                                                           |   |   |   |
|   | 10.16 |   |   | Business  Development Agreement dated December 28, 2005 by and between  MathStar, Inc. and Summit Design, Inc. (filed electronically  herewith).***                                                                                                                                                 |   |   |   |
|   | 10.17 |   |   | Schedule of  Executive Officer and Director Compensation for 2006 (filed electronically  herewith).*                                                                                                                                                                                                               |   |   |   |

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|        | 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 31, 2006 | 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 31,  2006 |
| Douglas  M. Pihl                       |          | Chairman of the Board of  Directors   (Principal Executive Officer)                      |       |                 |
| /s/ JAMES W. CRUCKSHANK |          | Vice President of  Administration and                                                    |       | March 31,  2006 |
| James  W. Cruckshank                   |          | Chief Financial Officer  (Principal Financial  Officer and Principal Accounting Officer) |       |                 |
| /s/ BENNO  G. SAND                |          | Director                                                                                 |       | March 31,  2006 |
| Benno  G. Sand                         |          |                                                                                     |       |                 |
| /s/ MERRILL  A. MCPEAK                 |          | Director                                                                                 |       | March 31,  2006 |
| Merrill  A. McPeak                     |          |                                                                                     |       |                 |
| /s/ MORRIS  GOODWIN, JR.          |          | Director                                                                                 |       | March 31,  2006 |
| Morris Goodwin, Jr.               |          |                                                                                     |       |                 |

 

 

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