<PAGE>
                                                                    EXHIBIT 10.3

                              SETTLEMENT AGREEMENT

This Settlement Agreement ("Agreement") is made as of February 28, 2002 (the
"Effective Date") by and between Pacific Aerospace & Electronics, Inc., a
Washington corporation ("PA&E"), and Herman L. Jones ("Jones"). All capitalized
terms not otherwise defined in this Agreement have the meaning set forth in the
Technology Transfer Agreement between PA&E and Jones dated as of December 30,
1998 (the "Technology Transfer Agreement").

                                    RECITALS

   A. Pursuant to the Technology Transfer Agreement, Jones transferred to PA&E
his ownership interest in certain Technology and Technology Patents. To secure
certain obligations of PA&E, Jones maintained a security interest in the
Technology and the Technology Patents pursuant to a Patent Security Agreement
dated as of December 30, 1998 (the "Original Security Agreement"). The
Technology Patents consist of the following U.S. patent and U.S and European
patent applications:

               (i)    U.S. Serial No. 09/302,590
               (ii)   U.S. Serial No. 09/303,196 (now U.S. Patent No. 6,284,389)
               (iii)  E.P. Serial No. 99'920'345.8

   B. PA&E is in default under certain provisions of the Technology Transfer
Agreement and the Original Security Agreement. However, the parties have agreed
to terminate those agreements and enter into this Agreement, pursuant to which
PA&E will retain ownership of the Technology and Technology Patents and PA&E
will make certain payments to Jones, as set forth below.

                                    AGREEMENT

In consideration of the mutual promises and releases set forth in this
Agreement, the receipt and sufficiency of which are acknowledged, the parties
agree as follows:

1. TERMINATION OF EXISTING AGREEMENTS. The Technology Transfer Agreement and the
Original Security Agreement are each hereby terminated as of the Effective Date.

2. OWNERSHIP OF TECHNOLOGY AND TECHNOLOGY PATENTS. PA&E and Jones agree that
PA&E will continue to own the Technology and the Technology Patents, including
without limitation any existing or future improvements, modifications, and
developments relating thereto, and that Jones has, and will have, no interest in
the Technology or the Technology Patents other than his security interest
described in Section 5.1, below. Notwithstanding the foregoing, PA&E agrees
that, during the term of the security interest described in Section 5.1, PA&E
will not: (i) license the Technology Patents to any person or entity unless (a)
the license provides for royalty payments to the owner of the Technology Patents
of at least 3% and (b) PA&E applies any


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<PAGE>

prepayment of royalties or other payments on the license to reduce the
outstanding principal balance of the Note referred to in Section 4.2, below; or
(ii) permit any liens or encumbrances on the Technology Patents other than
Jones' security interest and permitted licenses.

3. PURCHASE PRICE. As consideration for the agreements contained herein, PA&E
will pay to Jones an amount equivalent to $950,000, which will be payable as
described in Section 4.2, below (the "Purchase Price"). The Purchase Price is in
lieu of, and will fully satisfy, all past, current, and future amounts owing to
Jones under the Technology Transfer Agreement, and PA&E will have no other
obligations to Jones with respect to the Technology or the Technology Patents.

4. PAYMENT OF PURCHASE PRICE.

   4.1. Transfer of Building. $200,000 of the Purchase Price will be paid by
PA&E transferring to Jones the building owned by PA&E in Cashmere, WA (the
"Building"), free and clear of all liens and encumbrances. The Building transfer
will be effected as soon as reasonably practicable after the closing of the
exchange transaction currently contemplated by PA&E and its senior subordinated
noteholders, as more fully described in PA&E's SEC filings that are publicly
available as of the Effective Date. The parties acknowledge that, in order to
effect transfer of the Building to Jones, PA&E must obtain the consent of its
senior lenders to the proposed Building transfer. PA&E agrees to use its best
efforts to obtain any required consents and releases, and PA&E agrees that it
must effect the transfer unless those consents and releases cannot be obtained
in good faith. However, if the Building cannot be transferred by June 1, 2002,
the $200,000 value will be added to the outstanding principal balance of the
Note (as defined in Section 4.2), as provided in the Note.

   4.2 Note. $750,000 will be paid pursuant to a promissory note in the form of
EXHIBIT A (the "Note") to be signed upon execution of this Agreement. The
principal amount of the Note could be increased to $950,000 in accordance with
Section 4.1.

5. DEFAULT; REMEDIES.

   5.1 Security Interest. Jones will retain a security interest in the
Technology Patents to secure Jones' interests in the event of a Payment Default
(as defined in Section 5.2.) Upon execution of this Agreement and the Note, the
parties will also execute a Patent Security Agreement in the form of EXHIBIT B
(the "Security Agreement") to document this security interest.

   5.2 Payment Default. For purposes of this Agreement, a Payment Default will
occur if: (i) PA&E fails to make a required payment under the Note; (ii) Jones
notifies PA&E in writing of the late payment; and (iii) PA&E does not, within 90
days after receipt of the notice, make the late payment, including any accrued
interest, and make any other payments that become due prior to expiration of the
90-day grace period.


                                      -2-
<PAGE>

   5.3 Jones' Remedies. In the event of a Payment Default (and not for any other
reason), Jones will have the right, at his discretion, to elect either one, but
not both, of the two following remedies:

           5.3.1 Acceleration. Jones may elect to accelerate PA&E's payment
obligations under the Note, so that all principal and any accrued interest would
become immediately due and payable. If Jones elected this remedy, a penalty of
5% of the outstanding principal amount would also become immediately due and
payable.

           5.3.2 Exercise of Security Interest. Alternatively, Jones may elect
to exercise his security interest and obtain ownership of the Technology Patents
in accordance with the Security Agreement. If Jones exercises this remedy, he
will not be obligated to license the Technology Patents to PA&E.

6. MUTUAL RELEASE. As of the Effective Date, PA&E and Jones forever release and
discharge each other and their respective officers, directors, employees,
agents, heirs, subsidiaries, affiliates and assigns from any and all claims,
causes of action, rights and damages (including attorneys' fees and costs), that
either of them has, or may have, whether known or unknown, in any way arising
out of or in connection with the Technology Transfer Agreement or the Original
Security Agreement. Each party agrees and covenants not to bring or voluntarily
aid in any claim, suit, civil action, complaint, arbitration, or administrative
action in any city, state or federal court or agency or arbitration tribunal
with respect to any such claim, cause of action, right or damage.

7. GENERAL SETTLEMENT PROVISIONS.

   7.1 Attorneys' Fees and Costs. Each party will pay its own attorneys' fees
and costs incurred in preparing and consummating this Agreement, the Note, and
the Security Agreement.

   7.2 No Admissions. This Agreement and all documents executed in order to
effect its terms shall not be construed as an admission or evidence of liability
by any party. Neither this Agreement nor any of its terms may be offered or
received into evidence for any purpose other than for the purposes of effecting
this settlement or for the enforcement or interpretation of this Agreement, the
Note and the Security Agreement.

   7.3 No Assignment of Claims. Each party represents and warrants that it has
not transferred or assigned, and after the date of this Agreement shall not
transfer or assign, its interests in any claim to be released pursuant to this
Agreement.

   7.4 Confidentiality. The parties shall keep the existence and the terms of
this Agreement confidential, except for such disclosure (i) as PA&E or Jones may
need to make to their respective attorneys and accountants or to their
respective actual or potential lenders and investors; (ii) as PA&E may be
required to make pursuant to applicable securities laws and regulations; (iii)
as either party may be required to make by applicable law, court proceeding or
arbitration proceeding; or (iv) as either party may need to make to prospective
licensees or sublicensees of the Technology or the Technology Patents under
duties of confidentiality at least


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<PAGE>

as protective as those set forth in this Agreement. Both parties agree to
maintain the Technology, Technology Patents, and proprietary information related
thereto ("Confidential Material") in confidence and not to disclose or grant use
of such material to anyone who is not under a duty of confidentiality at least
as protective as the duty of confidentiality contained in this Agreement. Each
party agrees that it will use at least the same standard of care to protect the
Confidential Material as it uses to protect its own confidential material of a
similar nature, which in no event will be less than reasonable care. PA&E's duty
to maintain the confidentiality of the Confidential Material will cease upon
full payment of Jones under the Note, and Jones's duty to maintain the
confidentiality of the Confidential Material will cease upon his obtaining
ownership of the Technology Patents after a Payment Default. "Confidential
Material" does not include information to the extent that it can be established
by competent proof that such information (i) was already known to the receiving
party who did not have an obligation of confidentiality at the time of
disclosure by the disclosing party (which the parties agree has not occurred as
of the date of this Agreement); (ii) is or becomes generally available to the
public through no fault of the receiving party; (iii) was disclosed to the
receiving party, other than under an obligation of confidentiality, by a third
party who had no obligation to the disclosing party not to disclose such
information to others; (iv) is independently developed by the other party
without use of Confidential Material; or (v) is required by applicable law to be
disclosed, provided that the receiving party uses reasonable efforts to limit
the disclosure and provides the disclosing party with a reasonable opportunity
to review the disclosure and interpose its objections.

8. ARBITRATION. Any dispute between the parties under this Agreement involving
its interpretation or the obligations of a party shall be determined by binding
arbitration conducted in accordance with the Expedited Procedures of the
Commercial Arbitration Rules of the American Arbitration Association, in the
County of Snohomish, State of Washington. The parties will agree on a single
arbitrator, or, if they cannot agree within 10 business days after notice from
one party to the other of its intent to arbitrate, an arbitrator will be
selected by the American Arbitration Association. The arbitrator shall have the
authority to permit discovery, to the extent deemed appropriate by the
arbitrator, upon request of a party. The cost of the arbitration shall be borne
equally pending the arbitrator's award. The arbitrator shall have no authority
to award punitive or consequential damages. The resulting arbitration award may
be enforced in any applicable court located in Snohomish County, Washington.

9. MISCELLANEOUS

   9.1 Voluntary Agreement. The parties each acknowledge that this Agreement has
been made voluntarily by each of them, after consultation with independent legal
counsel.

   9.2 Attorneys' Fees and Costs. The prevailing party in any legal action to
enforce or interpret this Agreement shall be entitled to reimbursement of its
reasonable attorneys' fees and costs, including those incurred in an arbitration
or upon appeal, from the non-prevailing party.

   9.3 Notices. Any notices with regard to this Agreement will be delivered
personally or sent by overnight courier or by registered or certified mail,
return receipt requested, to the parties at the addresses set forth below, or
such other address as a party may designate in writing:


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           TO PA&E:                    Pacific Aerospace & Electronics, Inc.
                                       430 Olds Station Road, Third Floor
                                       Wenatchee, WA 98801
                                       Attn: President

                  with a copy to:      Ann W. Speckman, Esq.
                                       1501 Western Ave. #100
                                       Seattle, WA 98101

           TO JONES:                   Jack Jones
                                       2650 E. Sunlight Beach Road
                                       Clinton, WA 98236

                  with a copy to:      Theodore A. Finegold
                                       Jeffers, Danielson, Sonn & Aylward, P.S.
                                       2600 Chester Kimm Road
                                       P.O. Box 1688
                                       Wenatchee, WA 98807-1688

   9.4 Assignment; Successors. The parties shall not assign their rights or
obligations under this Agreement to any third party without the other party's
prior written consent, which shall not be unreasonably withheld. However,
consent will not be required for Jones to assign his rights and obligations to a
business entity, at least a majority of which is owned by him, or for PA&E to
assign its rights and obligations to a wholly-owned subsidiary (provided that
PA&E agrees to guarantee payment of the Note). Subject to the foregoing, all
rights and obligations arising under this Agreement shall be binding upon the
parties' permitted successors-in-interest.

   9.5 Severability. If any portion of this Agreement is found to be
unenforceable by a court of competent jurisdiction, then the remaining portion
shall continue in full force and effect to the extent possible.

   9.6 Governing Law; Jurisdiction. This Agreement shall be governed by the laws
of the State of Washington. The parties agree to submit to the exclusive
jurisdiction of, and venue laid in, any court of competent jurisdiction located
in King County, Washington.

   9.7 Construction. This Agreement has been mutually negotiated between the
parties and shall not be construed against any either of them.

   9.8 Entire Agreement. This Agreement, the Note, and the Security Agreement
constitute the full and entire agreement between the parties with respect to the
issues contained in this Agreement. This Agreement supersedes all prior
discussions, understandings or agreements, oral or written, relating to such
issues. This Agreement may not be amended or waived except by a subsequent
writing signed by all of the parties.


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   9.9 Counterparts. This Agreement may be signed in counterparts, which
together shall form one and the same instrument.

JONES:                                     PA&E:
                                           Pacific Aerospace & Electronics, Inc.

/s/ Herman L. Jones                        By /s/ Donald A. Wright
---------------------                        --------------------------
Herman L. Jones                            Donald A. Wright
                                           President and CEO


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<PAGE>

CONSENT OF SPOUSE:

   The undersigned hereby consents to the execution of this Agreement by her
spouse, individually, and on behalf of their respective marital communities.

Dated:  February 26, 2002


/s/ Roni Jones
--------------------------
Roni Jones


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                                                                       EXHIBIT A

                                 PROMISSORY NOTE

ORIGINAL PRINCIPAL:  $750,000                                      Wenatchee, WA
                                                               February 28, 2002


1. PROMISE TO PAY. For value received, PACIFIC AEROSPACE & ELECTRONICS, INC., a
Washington corporation ("PA&E"), unconditionally promises to pay to the order of
Herman L. Jones ("Jones"), at 2650 E. Sunlight Beach Road, Clinton, WA 98236, or
at such other place as the holder hereof from time to time may designate in
writing, the principal sum of SEVEN HUNDRED FIFTY THOUSAND AND NO/100 DOLLARS,
($750,000.00), plus interest and such other sums as may become payable under the
terms of this Note.

2.  PAYMENTS.  Payments under this Note will be due and payable as follows:

        (a) $150,000.00 will be payable by company check or wire transfer in one
        lump sum, without interest, on August 28, 2002;

        (b) $600,000.00, plus interest thereon, will be payable in 96 equal
        monthly installments of principal and interest, on the first day of each
        calendar month, beginning on June 1, 2002.

        (c) In the event that PA&E is not able to transfer its Cashmere building
        to Jones by June 1, 2002, as required by the Settlement Agreement
        between the parties dated of even date herewith (the "Settlement
        Agreement"), the $600,000.00 principal amount referred to in Section
        2(b) of this Note will automatically be increased to $800,000.00, and
        the outstanding principal amount of this Note will increase to
        $950,000.00. In such event, the $800,000.00 adjusted amount, plus
        interest thereon, will be payable in 96 equal monthly installments of
        principal and interest, on the first day of each calendar month,
        beginning on June 1, 2002.

        (d) PA&E may completely or partially prepay this Note at any time or
        from time to time without penalty. Payments shall be applied first to
        accrued interest and then to principal.

3. INTEREST. Interest shall accrue on the unpaid principal balance of the
amounts owing under Section 2(b) of this Note (as adjusted in accordance with
Section 2(c), if applicable), from the date hereof at the rate of six percent
(6%) per annum until the date on which the amounts owing under this Note are
fully repaid.

4. SECURITY. This Note is secured by a security interest in certain Patent
Collateral, as defined in the Security Agreement between the parties dated of
even date herewith (the "Security


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<PAGE>

Agreement"). Additional rights and obligations of Jones and PA&E are set forth
in the Security Agreement and the Settlement Agreement.

5. PAYMENT DEFAULT. For purposes of this Note, a Payment Default will occur if:
(i) PA&E fails to make a required payment under the Note; (ii) Jones notifies
PA&E in writing of the late payment; and (iii) PA&E does not, within 90 days
after receipt of the notice, make the late payment, including any accrued
interest, and make any other payments that become due under this Note prior to
expiration of the 90-day grace period.

6. REMEDIES. In the event of a Payment Default (and not for any other reason),
Jones will have the right, at his discretion, to elect either one, but not both,
of the two following remedies, which are Jones's exclusive remedies:

        (a) Jones may elect to accelerate PA&E's payment obligations under this
        Note, so that all principal and any accrued interest would become
        immediately due and payable. If Jones elected this remedy, a penalty of
        5% of the outstanding principal amount would also become immediately due
        and payable; or

        (b) Alternatively, Jones may elect to exercise his security interest and
        obtain ownership of the Patent Collateral in accordance with the
        Security Agreement.

7. ARBITRATION. Any dispute between the parties under this Note involving its
interpretation or the obligations of a party shall be determined by binding
arbitration conducted in accordance with the Expedited Procedures of the
Commercial Arbitration Rules of the American Arbitration Association, in the
County of Snohomish, State of Washington. The parties will agree on a single
arbitrator, or, if they cannot agree within 10 business days after notice from
one party to the other of its intent to arbitrate, an arbitrator will be
selected by the American Arbitration Association. The arbitrator shall have the
authority to permit discovery, to the extent deemed appropriate by the
arbitrator, upon request of a party. The cost of the arbitration shall be borne
equally pending the arbitrator's award. The arbitrator shall have no authority
to award punitive or consequential damages. The resulting arbitration award may
be enforced in any applicable court located in Snohomish County, Washington.

8. ATTORNEYS' FEES. If any action, judicial or nonjudicial, is brought on this
Note, or if it is placed in the hands of an attorney for collection or advice
following the expiration of the cure period for any default, then PA&E promises
to pay all of Jones's costs and expenses in connection herewith through any
appeal or in bankruptcy.

9. WAIVERS. PA&E, all endorsers, and all persons liable or to become liable on
this Note hereby waive presentment, demand, protest and notice of demand,
protest and nonpayment, and any defense or claim that resort must first be had
to any security or to any other person, and authorize the holder of this Note,
without affecting its liability hereunder, from time to time, to renew, extend,
or change the time for payment or the other terms of this Note, to take and hold
security for the payment of this Note, to release or exchange the security
therefor, to apply any such security to such obligations as the holder may
determine in its sole discretion, and to release, substitute, or add to those
liable or to become liable on this Note.


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<PAGE>

10. GOVERNING LAW. This Note shall be governed by and construed in accordance
with the laws of the State of Washington, United States of America, without
regard to rules regarding conflicts of laws.

11. SUCCESSORS AND ASSIGNS. The provisions of this Note shall inure to the
benefit of and be binding on any successor to PA&E and shall extent to any
holder hereof.



                                          PACIFIC AEROSPACE & ELECTRONICS, INC.



                                          By:    /s/ Donald A. Wright
                                             ---------------------------------
                                          Its: President/CEO
                                              --------------------------------

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