UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

ý    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2003

or

o    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period
From                            to

Commission file number 1-13317

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DOT HILL SYSTEMS CORP.(Exact name of registrant as specified in its charter)

|DELAWARE(State of incorporation)                                         |  | 13-3460176(IRS Employer Identification No.)
|------------------------------------------------------------------------ |  | -------------------------------------------
|6305 El Camino Real
Carlsbad, CA(Address of principal executive offices) |  | 92009(zip code)                            

(760) 931-5500(Registrant's telephone number, including area code)

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Securities
registered pursuant to Section 12(b) of the Act:

|Title of each class           |  | Shares outstanding at
March 11, 2004 |  | Name of each exchange on which registered
|----------------------------- |  | ------------------------------------ |  | -----------------------------------------
|Common stock, $.001 par value |  | 43,315,222                           |  | Nasdaq National Market                   



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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. Yes ý No o

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which
the common equity was last sold as of June 30, 2003 was $281,434,426. Documents incorporated by reference: Portions of the registrant's definitive proxy statement for its 2004 annual meeting of
stockholders are incorporated by reference into Part III of this Form 10-K.



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DOT HILL SYSTEMS CORP.  INDEX TO ANNUAL REPORT ON FORM 10-K  FOR THE YEAR ENDED DECEMBER 31, 2003

|         |  | PART I                                                                                                       |  |   
|-------- |  | ------------------------------------------------------------------------------------------------------------ |  | --
|Item 1.  |  | Business                                                                                                     |  | 1 
|Item 2.  |  | Properties                                                                                                   |  | 25
|Item 3.  |  | Legal Proceedings                                                                                            |  | 25
|Item 4.  |  | Submission of Matters to Vote of Security Holders                                                            |  | 25
|         |  | PART II                                                                                                      |  |   
|Item 5.  |  | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 26
|Item 6.  |  | Selected Financial Data                                                                                      |  | 26
|Item 7.  |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                        |  | 27
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 38
|Item 8.  |  | Financial Statements and Supplementary Data                                                                  |  | 39
|Item 9.  |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                         |  | 39
|Item 9A. |  | Controls and Procedures                                                                                      |  | 39
|         |  | PART III                                                                                                     |  |   
|Item 10. |  | Directors and Executive Officers of the Registrant                                                           |  | 40
|Item 11. |  | Executive Compensation                                                                                       |  | 40
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 40
|Item 13. |  | Certain Relationships and Related Transactions                                                               |  | 40
|Item 14. |  | Principal Accountant Fees and Services                                                                       |  | 40
|         |  | PART IV                                                                                                      |  |   
|Item 15. |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                                             |  | 41

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Forward-Looking Statements

Certain statements contained in this report, including, but not limited to, statements regarding the development, growth and expansion of our business, our
intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer and other statements contained herein regarding matters that are
not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
1934, as amended, and are subject to the "safe harbor" created by those sections. Future filings with the Securities and Exchange Commission, or SEC, future press releases and future oral or written
statements made by us or with our approval, which are not statements of historical fact, may also contain forward-looking statements. Because such statements include risks and uncertainties, many of
which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements. Some of the factors that could cause actual results to differ
materially from those expressed or implied by such forward-looking statements are set forth in the section entitled "Certain Risk Factors Related to the Company's Business," in the section entitled
"Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere throughout this Annual Report on Form 10-K.

Readers
are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and, except as
required by applicable law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the
occurrence of unanticipated events.

PART I

Item 1. Business

We are a provider of storage systems for organizations requiring high reliability, high performance networked storage and data management solutions in an open
systems architecture. Our storage solutions consist of integrated hardware and software products employing a modular system that allows end-users to add capacity as needed. Our broad range
of products, from medium capacity stand-alone storage units to complete turn-key, multi-terabyte storage area networks, provides end-users with a cost-effective
means of addressing increasing storage demands without sacrificing performance. Our SANnet products have been distinguished by certification as Network Equipment Building System, or NEBS, Level 3 and
are MIL STD-810F compliant based on their ruggedness and reliability.

Our
products and services are sold worldwide to end-users primarily through our channel partners, including original equipment manufacturers, or OEMs, systems integrators, or
SIs, and value-added resellers, or VARs. In May 2002, we entered into a three-year OEM agreement with Sun Microsystems, or Sun, to provide our storage hardware and software products
for private label sales by Sun, and that agreement was recently extended until May 2007. We have been shipping our products to Sun for resale to Sun's customers since October 2002. We
continue to develop new products for resale by Sun and other channel partners and expect to begin shipping several new products later in 2004.

In
February 2004, we acquired all the outstanding shares of Chaparral Networks, Inc., or Chaparral, a privately-held storage system provider. We expect to
integrate Chaparral's redundant arrays of independent disks, or RAID, controller and router technology into our line of storage products. We plan to retain Chaparral's Colorado facility as a research
and development hub and to continue to use Chaparral's team of engineers and facility support personnel.

As
part of our focus on indirect sales channels, we have outsourced substantially all of our manufacturing operations to Solectron Corporation, or Solectron. Our agreement with Solectron
allows

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us
to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of Solectron's manufacturing and procurement economies of scale.

We
were formed in 1999 by the combination of Box Hill Systems Corp. and Artecon, Inc., or Artecon. We reincorporated in Delaware in 2001. Our website address is
http://www.dothill.com. Information contained on our website does not constitute a part of this Annual Report on
Form 10-K. Our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and all
amendments to those reports that we file with the SEC are currently available free of charge to the general public through our website. These reports are accessible on our website promptly after being
filed with the SEC and are also accessible through the SEC's website which may be found at http://www.sec.gov. In addition, you may read and copy the materials we file with the SEC at the SEC's Public
Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330.

Industry Background

Growth of Data Storage

The efficient generation, storage and retrieval of digital data and content has become increasingly strategic and mission-critical to organizations. The volume of
this data continues to grow rapidly, driven by several factors including:



According
to Gartner, Inc., or Gartner, the total storage capacity of all worldwide external, controller-based disk storage systems shipped will grow by 64.1% on a compounded
annual basis between 2002 and 2007, reaching 3.6 million terabytes, or TB, in 2007.

Traditionally,
storage vendors have designed products for markets differentiated by capacity, performance, price and feature set. These storage markets are typically identified as:



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In
addition to dramatic increases in the overall volume of data, the storage market has been influenced by the following major trends:

Migration to Network Computing.Computing processes and architectures have evolved from mainframe computing systems toward a
centrally managed network computing environment characterized by multiple operating systems and server platforms that must share information. Organizations require large-scale data storage solutions
offering:



Organizations
have responded by implementing tailored networks, optimized for data storage functions, that facilitate data access and protection.

Increasing Focus on Total Cost of Ownership and Return on Investment.IT managers are increasingly focused on lowering the
total cost of ownership and increasing their return on investment on each technology purchase. IT managers evaluate total cost of ownership and return on investment based upon several metrics,
including initial purchase price, ease of provisioning, scalability, reliability and
redundancy, ease of management, IT staff productivity, operating costs and after-sale service and support.

Storage Area Networks

Customers require storage systems that enable them to capture, protect, manage and archive data across a variety of storage platforms and applications without
sacrificing performance. Historically, the Small Computer Systems Interface, or SCSI, was the primary method of connecting storage to servers. Then, the Fibre Channel protocol was developed, which
enables storage devices to connect to servers over a networked architecture, allowing end-users to connect multiple storage devices with high bandwidth throughput over long distances and
centrally manage their storage environment. Centrally managed network storage systems are designed to provide connectivity across multiple operating systems and devices and may be based on either open
or proprietary technology standards. Gartner estimates that by 2007 network storage product sales will represent over 76.9% of the worldwide external disk storage market compared to approximately
60.5% of the market in 2002, growing at a 12.3% compound annual growth rate, or CAGR, from $8.5 billion in 2002 to $15.2 billion in 2007.

Storage
area networks, or SANs, apply the benefits of a networked approach to data storage applications, allowing large blocks of data to move efficiently and reliably between multiple
storage devices and servers without interrupting normal network traffic. SANs provide high scalability, connectivity and fault-tolerance, which permit IT managers to create and manage centralized
pools of storage and backup devices with redundant data paths. With the addition of file-sharing software, SANs also allow multiple hosts to share consolidated data, dramatically reducing
the need to duplicate, move

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and
manage multiple files in a wide variety of data-intensive applications. SANs primarily employ Fibre Channel technology.

Demand for High Performance, Affordable Network Storage Solutions

Customers increasingly demand higher performing, affordable solutions to address expanding storage requirements, interoperability across disparate systems, the
need for improved connectivity and rising data management costs. Customers are also demanding open standards architecture and modular systems that allow them to add capacity as needed. These demands
have created significant opportunities for network storage system solutions that are affordable and provide high performance.

Reliability

Perhaps one of the greatest requirements for many customers is that their stored data be available, and that the systems upon which they are stored by reliable.
For example, Internet-related customers can lose significant revenue for every minute their sites are inoperable and users can't access data from the web site. Similarly, the operations of corporate
customers can grind to a halt if precious data is lost or unavailable. For these reasons, a storage system's reliability is often the critical factor in making a choice among storage systems.

Our Solutions

We offer a broad line of networked data storage solutions composed of standards-based hardware and software for open systems environments. Many of the performance
attributes demanded by high-end/data center end-users are incorporated into our products, at prices that are suitable for the entry-level or midrange markets. Our
end-users consist of entry-level, midrange and high-end/data center users, requiring cost-effective, easily managed, high performance, reliable storage systems. Our
product lines range from approximately 72 gigabyte, or GB, to complete 35 TB storage systems. These offerings allow our products to be integrated in a modular building block fashion or configured into
a complete storage solution, increasing OEM flexibility in creating differentiated products. Modular products also allow our indirect channel partners to customize solutions, bundling our products
with value-added hardware, software and services.

Our
products and services are intended to provide users with the following benefits:



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Following
the acquisition of Chaparral in February 2004, we intend to continue to offer customers existing Chaparral products along with our products, and to integrate Chaparral's
RAID controller and router technology into our future products and product lines.

Our Strategy

Our objective is to focus on profitable growth and capture an increasing share of the open systems storage solution market.

Focus on Profitable Growth.We have focused our business strategy in several ways to enhance our margins and increase
profits.



Develop and Expand OEM Relationships.In May 2002, we entered into an OEM agreement with Sun under which Sun resells
our SANnet II and SANscape products to its customers under Sun's private label. Our agreement with Sun was expanded in January and March 2004 to extend the term by three years and include
additional products under the agreement. In addition to Sun, we have other OEM partners, including Comverse Technology, Inc., or Comverse Technology, and Motorola, Inc., or Motorola, for
our hardware products and Storage Technology Corporation, or StorageTek, and Network Appliance, Inc., or NetApp, for our software products. We intend to continue seeking additional OEM
relationships with other industry leaders to sell current and future products and expand the number of products offered to existing OEM partners to enable them to address new markets.

Broaden Non-OEM Channels to Diversify Revenues.We intend to continue expanding our non-OEM sales
channels through SIs and VARs in order to decrease our revenue concentration with

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OEMs. In
the second quarter of 2003, we launched a new channel marketing program and added 17 new non-OEM channel partners. In addition, we continue to sell direct to service
providers, including NTT/Verio, Ofoto, a division of Kodak, and MCI/UUNET.

Grow and Extend Technology Leadership.We view our core competencies as the research, design and engineering of modular open
storage systems. We believe that focused research and development on advanced, cost effective storage technologies is critical to our ongoing success. We intend to accelerate our expenditures on
technology development and integration in order to offer more complete storage solutions and enhance our existing products to benefit our channel partners' efforts to increase sales. We expect to
introduce our SANnet II Serial Advanced Technology Attachment, or SATA, and SANnet II Fabric Attached Storage, or FAS, products later this year.

Pursue Strategic Alliances, Partnerships and Acquisitions.We will continue to evaluate and selectively pursue strategic
acquisitions, alliances and partnerships that are complementary to our business. We believe that growth of the network storage market will create additional opportunities to expand our business. In
addition, we believe the most efficient pursuit of these opportunities will be through strategic alliances and relationships, which allow us to leverage our existing design and marketing
infrastructure while capitalizing on products, technologies and channels that may be available through potential strategic partners.

Our Products

We design our family of open systems storage hardware and software products with the reliability, flexibility and performance necessary to meet IT managers' needs
for easily scalable cost effective solutions. We currently offer storage systems in Fibre Channel and SCSI configurations. Our software offerings consist of storage management applications, which can
manage any one or all of our storage system configurations, and performance enhancing software that we sell bundled with our storage systems or license separately to OEM customers.

All
of our SANnet II products are NEBS Level 3 certified and MIL-STD-810F compliant. NEBS guidelines were originally developed by Bellcore, now Telcordia, as
ultra-high reliability standards for telecommunications equipment, including storage products. There are three levels of NEBS specifications. The most rugged and reliable equipment is
rated carrier-class NEBS Level 3. The NEBS standards mandate a battery of tests designed to simulate the extreme conditions resulting from natural or man-made disasters and cover a range
of product requirements for operational continuity. MIL-STD-810F is a military standard created by the U.S. Government. It involves a range of tests used to measure the
reliability of equipment in extreme conditions, including physical impact, moisture, vibration and high and low temperatures. These standards address system ruggedness and reliability, which are
increasingly important requirements for end-users.

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Our
primary products include the following:

|Product Line                             |  | Description                                                                               |  | General
Availability |  | Capacity                                  |  | Target Market            |  | Features                                                                                                                                                  
|---------------------------------------- |  | ----------------------------------------------------------------------------------------- |  | -------------------- |  | ----------------------------------------- |  | ------------------------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Hardware                                 |  |                                                                                           |  |                      |  |                                           |  |                          |  |                                                                                                                                                           
|SANnet II SCSI                           |  | 2 unit high, 12 to 36 drives, Ultra160 SCSI DAS storage                                   |  | 4Q02                 |  | 72 GB to 5.25 TB using 146 GB SCSI drives |  | Entry-level and Midrange |  | Compact 3.5 inch high enclosures, fully redundant RAID using SCSI connections, expandable storage capacity                                                
|SANnet II FC                             |  | 2 unit high, 12 to 192 drives, 2 Gigabit Fibre Channel DAS and SAN storage                |  | 1Q03                 |  | 72 GB to 28 TB using 146 GB FC drives     |  | Entry-level and Midrange |  | Complete SAN solution in a single enclosure, scalable performance and capacity without interruptions                                                      
|SANnet II Blade                          |  | 1 unit high, 4 to 12 drives, Ultra320 SCSI DAS                                            |  | 4Q03 DAS             |  | 72 GB to 1.75 TB using 146 GB SCSI drives |  | Entry-level              |  | Highly rack-optimized design, provides genuine hardware RAID functionality, connects to low-cost server SCSI ports                                        
|SANnet II SATA                           |  | 2 unit high, 12 to 192 drives, 2 Gigabit Fibre Channel DAS and SAN storage                |  | 2Q04                 |  | 1 TB to 48 TB using 250 GB SATA drives    |  | Entry-level and Midrange |  | Complete SAN solution in a single enclosure, supports FC and SATA drives simultaneously, scalable performance and capacity without interruptions          
|SANnet II FAS (Embedded FC SAN Switches) |  | 2 unit high, 12 to 192 drives, 2 Gigabit and 10 Gigabit Fibre Channel DAS and SAN storage |  | 4Q04                 |  | 72 GB to 28 TB using 146 GB FC drives     |  | Entry-level and Midrange |  | Complete SAN solution in a single enclosure, internal fabric SAN switches, 10 Gigabit SAN support, scalable performance and capacity without interruptions
|Rio                                      |  | 1 unit RAID controller                                                                    |  | 3Q02                 |  | N/A                                       |  | Entry-level and Midrange |  | RAID controller attachable to JBOD to allow for RAID protection                                                                                           
|Riva                                     |  | RAID controller board                                                                     |  | 2Q03                 |  | N/A                                       |  | Entry-level and Midrange |  | Complete SAN solution, scalable performance                                                                                                               
|Software                                 |  |                                                                                           |  |                      |  |                                           |  |                          |  |                                                                                                                                                           
|SANpath                                  |  | Storage area networking software                                                          |  | 1Q00                 |  | N/A                                       |  | Entry-level and Midrange |  | Load balancing, multipathing, path fail over, path fail back and LUN masking                                                                              
|SANscape                                 |  | Storage management software                                                               |  | 1Q00                 |  | N/A                                       |  | Entry-level and Midrange |  | Graphical and command line consoles with diagnostics, monitoring and reporting                                                                            

We expected to release a network attached storage version of SANnet II in the 2003 to 2004 time frame. However, we have chosen to delay that
product's development indefinitely in favor of other future products.

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SANnet II Family of Storage Solutions.We introduced our next generation open systems storage products,
 our SANnet II family,
during the fourth quarter of 2002. SANnet II provides enterprise class functionality to the entry-level, midrange and high-end storage markets at attractive prices. Through our SANnet II
family of networked storage solutions, we offer compact, rugged RAID arrays that support SAN and direct attached storage, or DAS, configurations. The SANnet II products provide 99.9998% uptime and are
tested to operate in extreme environmental conditions. In addition, our SANnet II products share a common modular architecture and unified management system that integrates our SANpath and SANscape
management software.



Chaparral Products.We acquired the following products in our acquisition of Chaparral. We expect to integrate Chaparral's
RAID controller and router technology into our line of storage products.



Software.We develop application software technologies and products that are complementary to our overall storage solutions.
Our host-based software is delivered as two primary application suites: SANpath and SANscape. Our software supports widely used open systems platforms, including Linux, Unix, and Windows.



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Sales and Marketing

We market and distribute our products globally through our channel partners and directly to certain customers. Our channel partners consist of OEMs, SIs and VARs,
which we use to cost-effectively pursue a wide range of potential end-users. We rely on multiple channels to reach end-user customers that range in size from small
businesses to government agencies and large multinational corporations. We have established a channel partner program consisting of three tiers which distinguishes and rewards our partners for their
levels of commitment and performance. We maintain a sales and marketing organization operating out of our headquarters in Carlsbad, California, with regional offices in Germany, Japan, the
Netherlands, Singapore and the United Kingdom as well as several smaller localized field sales offices throughout North America. Our products are sold under the Dot Hill brand name and under the names
of our OEM customers. For the year ended December 31, 2001, sales to one customer accounted for approximately 15%. For the years ending 2002 and 2003, sales to another customer for
approximately 25%, and 83%, respectively. For the year ended December 31, 2001, our accounts receivable from one customer was approximately 16%. For the year ended December 31, 2002, our
accounts receivable from two customers were approximately 11% and 43%. For the year ended December 31, 2003, our accounts receivable from two customers were 12% and 56%. Generally, our
customers have no minimum purchase requirements and have certain rights to extend, delay or cancel shipment of their orders without penalty.

As
of December 31, 2003, our worldwide sales team consisted of 60 sales employees and 6 marketing employees.

OEMs

Our primary distribution channel is through OEMs. We have several OEM relationships and are actively developing new ones. Currently OEM partners include
Comverse Technology, Motorola and Sun. OEMs generally resell our products under their own brand name and typically assume responsibility for marketing, sales, service and support. Our OEM
relationships allow us to sell into geographic or vertical markets where each OEM has significant presence. For the years ended December 31, 2002 and 2003, OEM sales represented 55.9% and 85.9%
of our net revenue, respectively. Sales to Sun accounted for 25.0% and 83.4% of our net revenue for the years ended December 31, 2002 and 2003, respectively. Sales to Comverse Technology
accounted for 15.0%, 9.5% and 2.0% of our net revenue for the years ended December 31, 2001, 2002 and 2003, respectively.

Systems Integrators and Value Added Resellers

Most of our non-OEM products are sold in conjunction with SIs and VARs who work closely with our sales force to sell our products to
end-users. SIs and VARs generally resell our products under the Dot Hill brand name and share responsibility with us for marketing, sales, service and support.

In
North America we sell directly to SIs and VARs. In markets outside of North America, we have relationships with a number of distributors who offer our products to local VARs or, in
some countries, directly to end-users. We believe international markets represent an attractive growth opportunity and

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intend
to expand the scope of our international sales efforts by continuing to actively pursue additional international distributors and resellers.

Service Providers

We sell directly to service providers, who integrate our storage products into their proprietary systems and provide access to their systems and related services
to end-users. Our current service providers include NTT/Verio, Ofoto and MCI/UUNET.

Marketing

We support our OEM, SI and VAR channels with a broad array of marketing programs designed to build our brand name, attract additional channel partners and
generate end-user demand. Our product marketing team, located in Carlsbad, California, focuses on product strategy, product development roadmaps, the new production introduction process,
product lifecycle management, demand assessment and competitive analysis. The product marketing team also ensures that product development activities, product launches, channel marketing program
activities and ongoing demand and supply planning occur on a well-managed, timely basis in coordination with our development, manufacturing and sales groups, as well as our sales channel
partners. The groups work closely with our sales and research and development groups to align our product development roadmap to meet key channel technology requirements.

Our Relationship with Sun

In May 2002, we entered into a three-year OEM agreement with an annual renewal to provide our SANnet II and SANscape products for private label
sales by Sun. This agreement was recently extended until May of 2007. During October 2002, we began shipping to Sun the first product in our SANnet II family of systems, SANnet II SCSI, for
resale to Sun's customers. We began shipping our SANnet II FC to Sun in March 2003 and expect to begin delivery of a third product, SANnet II Blade, during the first quarter of 2004. We are
developing new products for sale by Sun and expect our relationship to continue to expand. There are no minimum purchase agreements or guarantees in our agreement with Sun, and the agreement does not
obligate Sun to purchase its storage solutions exclusively from us.

As
of December 31, 2003, Sun held the right to acquire from us a number of shares of common stock equal to up to 3.2% of our common stock outstanding. In May 2002, in
connection with the original OEM agreement, we issued a warrant to Sun to purchase 1,239,527 shares of our common stock. In February 2003, we issued a warrant to Sun in connection with a
private placement of our preferred stock. As of December 31, 2003, this warrant was exercisable for 154,752 shares of our common stock. Under the terms of the warrants, we are obligated to
file a registration statement with respect to the resale of all of the shares of our common stock issuable upon exercise of the warrants.

We
believe that our relationships with market leaders like Sun strengthen our credibility in the marketplace, validate our technology and enable us to sell our products to a much broader
customer base. In addition to expanding and enhancing our relationships with current OEM customers and other types of channel partners, we intend to add additional OEM customers as a part of our
overall strategy.

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End-users

End-users of our products represent a wide variety of industries and range from small businesses to large enterprises, government agencies and other
institutions. Our products are currently installed across many industries and markets. The table below lists representative end-users of our products:

|Defense Agencies |  | Entertainment            |  | Financial Services |  | Government Agencies
|---------------- |  | ------------------------ |  | ------------------ |  | -------------------
|                |  | Department of National   |  |                   |  | AOL Time Warner    
|                 |  | Defense and Canadian     |  |                   |  | CBS MarketWatch    
|                 |  | Forces                   |  |                   |  | Fox Cable Networks 
|                |  | U.K. Ministry of Defense |  |                   |  | Home Box Office    
|                |  | U.S. Air Force           |  |                   |  | Vivendi Universal  
|                |  | U.S. Army                |  |                    |  |                    
|                |  | U.S. Navy                |  |                    |  |                    
|                 |  |                          |  |                    |  |                    

|Healthcare |  | Industrial/Technology |  | Telecommunications |  | Universities     
|---------- |  | --------------------- |  | ------------------ |  | -----------------
|          |  | Arena Pharmaceuticals |  |                   |  | Boeing           
|          |  | Bracco Diagnostics    |  |                   |  | General Dynamics 
|          |  | GenVault              |  |                   |  | Lockheed Martin  
|          |  | Merck & Company       |  |                   |  | Raytheon         
|          |  | St. Jude Children's   |  |                   |  | Texas Instruments
|           |  | Research Hospital     |  |                    |  |                  
|           |  |                       |  |                    |  |                  

Customer Service and Support

We recognize that providing comprehensive, proactive and responsive support is essential to establishing new customer accounts and securing repeat business. We
provide comprehensive, 24 hours a day, seven days a week, 365 days a year, global customer service and support, either directly or through third party service providers, aimed at
simplifying installation, reducing field failures, minimizing system downtime and streamlining administration. Through direct and third party service providers, we maintain a global network of
professional engineers and technicians who provide telephonic technical support in various languages from strategically-located global response centers on a 24 hour, seven day basis. In
addition, we provide four hour on-site service response on a global basis. We also offer all of our customers access to SANsolve, our web-hosted interactive support knowledge
base that gives our customers the ability to find answers to technical questions as well as initiate and track all support issues.

As
part of our shift away from direct sales, we have also taken steps to better align our service and support structure with our new indirect sales model. We have:



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Despite
our shift away from direct sales, we plan to continue to maintain our current service offerings, including onsite support contracts. These services will be performed either
directly by us, or through the increased use of third party service providers.

Research and Development

Our research and development team is focused on developing innovative storage and networking products, storage management software for the open systems market,
and the integration of our newly-acquired controller and router technology into Dot Hill designed storage systems. We have a history of industry firsts, including the first successfully commercialized
hot-swappable SCSI Disk Array and RAID storage system for the Unix environment, and the first NEBS Level 3 certified and MIL STD-810F tested line of storage systems. We believe
that our success depends on our ability to continuously develop products that meet changing customer needs and to anticipate and proactively respond to highly evolving technology in a timely and
cost-effective manner. We also generally design and develop our products to have a modular architecture that can be scaled to meet customer needs and modified to respond to technological
developments in the open systems computing environment across product lines.

Our
areas of expertise include Linux, Unix and Windows driver and system software design, SAN storage resource management software design, data storage system design and integration,
controller and router design and technology and high-speed data interface design. We are currently focusing development efforts on our next-generation family of storage systems
and on our software products. Projects include the launch of additional members of the SANnet II family of systems, improvements to our storage software offerings and next generation
high-speed solutions that will take advantage of the latest transports and technologies.

Our
research and development activities are directed by individuals with significant expertise and industry experience. Our total research and development expenses were
$10.0 million and $11.9 million for the years ended December 31, 2002 and 2003, respectively.

Manufacturing and Suppliers

Since 2002, we have outsourced substantially all of the manufacturing operations for our SANnet I and SANnet II systems and RAID controllers to third party
manufacturing companies. We plan to integrate Chaparral's RAID controller and router technology into our line of storage products. By outsourcing manufacturing we have been able to reduce expenses
related to our internal manufacturing operations and focus on our research and development activities. Under our OEM agreement with Sun, Sun has the right to require that we use a third party to
manufacture our products. This external manufacturer must meet Sun's engineering, qualification and logistics requirements.

Intellectual Property

Our success depends significantly upon our proprietary technology. We have received registered trademark protection for the marks SANnet®,
SANpath®, SANscape®, Dot Hill®, Dot Hill Systems® and the Dot Hill logo. With the acquisition of Chaparral, we acquired registered trademark protection
for the marks Raidar®, Rio®, Riva® and Stratis®. We have attempted to protect our intellectual property rights primarily through copyrights, trade
secrets, employee and third party nondisclosure agreements and other measures. We have registered trademarks and will continue to evaluate the registration of additional trademarks as appropriate. We
claim common law protection for, and may seek to register, other trademarks. In addition, we generally enter into confidentiality agreements with our employees and with key vendors and suppliers.

12

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As
of December 31, 2003, we had been awarded a total of eight U.S. patents. We do not believe that those patents will provide us with any material competitive advantage. However,
with the acquisition of Chaparral, we acquired one issued U.S. patent, two allowed U.S. patents and 13 U.S. patent applications that are in various stages of the patenting process. These patents and
applications generally cover RAID controller and SAN technology. If we are unable to protect our intellectual property or infringe intellectual property of a third party, our operating results could
be harmed.

Competition

The storage market is intensely competitive and is characterized by rapidly changing technology. We compete primarily against independent storage system
suppliers, including EMC Corporation, Hitachi Data Systems, LSI Logic Corp. and Network Appliance, Inc. We also compete with traditional suppliers of computer systems, including
Dell Inc., Hewlett-Packard Development Company, L.P. and IBM Corp., which market storage systems as well as other computer products.

Many
of our existing and potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other
resources. As a result, they may have more advanced technology, larger distribution channels, stronger brand names, better customer service and access to more customers than we do. Other large
companies with significant resources could become direct competitors, either through acquiring a competitor or through internal efforts. Additionally, a number of new, privately held companies are
currently attempting to enter the storage market, some of which may become significant competitors in the future.

We
believe the principal competitive factors in the storage systems market are:



We
believe that we compete favorably in each of these categories. To remain competitive, we believe we must invest significant resources in developing new products, enhancing our current
products, and maintaining high quality standards and customer satisfaction.

Employees

As of December 31, 2003, we had 196 full-time employees, of whom 66 were engaged in sales and marketing, 70 in research and development, 41 in
manufacturing, 17 in general management and administration and two in customer service and support. We acquired an additional 51 employees as part of our acquisition of Chaparral in
February 2004, of whom 11 were engaged in sales and marketing, 22 in research and development, five in manufacturing, eight in general management and administration and five in customer service
and support. We have not had a work stoppage among our employees and none of our employees are represented under collective bargaining agreements. We consider our relations with our employees to be
good.

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Executive Officers of the Registrant at December 31, 2003

|Name                |  | Age |  | Position                                                                  |  | Officer since
|------------------- |  | --- |  | ------------------------------------------------------------------------- |  | -------------
|James L. Lambert    |  | 50  |  | Chief Executive Officer, President and Director                           |  | August 1984* 
|Preston S. Romm     |  | 50  |  | Chief Financial Officer, Vice President, Finance, Treasurer and Secretary |  | November 1999
|Dana W. Kammersgard |  | 48  |  | Chief Technical Officer                                                   |  | August 1984* 

---

All
officers are elected by the board of directors and serve at the pleasure of the board of directors as provided in our bylaws.

James L. Lamberthas served as a director and our Chief Executive Officer since August 2000. From August 1999 to
August 2000, Mr. Lambert served as our Chief Operating Officer and Co-Chief Executive Officer. Since August 1999, he has also served as our President and a director. A
founder of Artecon, Mr. Lambert served as President, Chief Executive Officer and director of Artecon from its inception in 1984 until August 1999. Mr. Lambert currently serves as
a director of the Nordic Group of Companies, a group of privately held companies. He holds a B.S. and an M.S. in Civil and Environmental Engineering from University of Wisconsin, Madison.
Mr. Lambert is William R. Savey's son-in-law.

Preston S. Rommhas served as our Chief Financial Officer, Vice President, Finance and Treasurer since November 1999.
Mr. Romm has also served as our Secretary since April 2001. From January 1997 to November 1999, Mr. Romm was Vice President of Finance, Chief Financial Officer and
Secretary of Verteq, Inc., a privately-held semiconductor equipment manufacturer. From November 1994 to January 1997, Mr. Romm was Vice President of Finance and
Chief Financial Officer of STM Wireless, Inc., a wireless data and voice equipment manufacturer. From July 1990 to November 1994, Mr. Romm was Vice President and Controller
of MTI Technology Corporation, a provider of data storage systems. Mr. Romm holds a B.S. in Accounting from the University of Maryland and a M.B.A. from American University.

Dana W. Kammersgardhas served as our Chief Technical Officer since August 1999. Mr. Kammersgard was a founder of Artecon
and served as a director from its inception in 1984 until August 1999. At Artecon, Mr. Kammersgard served in various positions since 1984, including Secretary and Senior Vice President
of Engineering from March 1998 until August 1999 and as Vice President of Sales and Marketing from March 1997 until March 1998. Prior to co-founding Artecon,
Mr. Kammersgard was the director of software development at CALMA, a division of General Electric Company. Mr. Kammersgard holds a B.A. in Chemistry from the University of California,
San Diego.

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Certain Risk Factors Related to the Company's Business

Our business, results of operations and financial condition may be materially and adversely affected due to any of the following risks.
The risks described below are not the only ones we face. Additional risks we are not presently aware of or that we currently believe are immaterial may also impair our business operations. The trading
price of our common stock could decline due to any of these risks. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this
Form 10-K, including our financial statements and related notes.

Under our OEM agreement with Sun, Sun is not required to make minimum purchases or purchase exclusively from us, and we cannot assure you that our
relationship with Sun will not be terminated or will generate significant sales.

Our business is highly dependent on our relationship with Sun. Sales to Sun accounted for 25.0% and 83.4% of our net revenue for the years ended
December 31, 2002 and 2003, respectively. Our OEM agreement with Sun had an initial term of three years and has been renewed by Sun through May 2007. However, there are no minimum
purchase requirements or guarantees in our agreement with Sun, the agreement does not obligate Sun to purchase its storage solutions exclusively from us and Sun may cancel purchase orders submitted
under the agreement at any time. Sun may terminate the entire contract prior to the contract expiration date upon the occurrence of certain events that are not remedied within a specified cure period.
The decision by Sun not to renew its contract with us, to terminate the contract, to cease making purchases or to cancel purchase orders would cause our revenues to decline substantially. We cannot be
certain if, when or to what extent Sun might terminate its contract with us, cancel purchase orders, cease making purchases or elect not to renew the contract upon the expiration of the initial term.
We expect to receive a substantial majority of our projected net revenue for the year ended December 31, 2004 from sales of our products to Sun. We cannot assure you that we will achieve these
expected sales levels. If we do not achieve the sales levels we expect to receive from Sun, our business and result of operations will be significantly harmed.

Any decline in Sun's sales could harm our business.

A substantial majority of our revenues are generated by sales to Sun, which sells our products as separate units or bundled with its servers. If Sun's storage
related sales decline, our revenues will also
decline and our business could be materially harmed. In addition, Sun's quarterly operating results typically fluctuate downward in the first quarter of their fiscal year when compared with the
immediately preceding fourth quarter. If these fluctuations cause Sun to decrease purchases of our storage products, our results in the first quarter of Sun's fiscal years, which is our third quarter,
could be harmed.

We are dependent on sales to a relatively small number of customers.

Because we intend to expand sales to channel partners, we expect to experience continued concentration in our customer base. As a result, if our relationship with
any of our customers is disrupted, we would lose a significant portion of our anticipated net revenue. We cannot guarantee that our relationship with Sun or other channel partners will expand or not
otherwise be disrupted. Factors that could influence our relationship with significant channel partners, including Sun, include:



15

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None
of our contracts with our existing channel partners, including Sun, contain any minimum purchasing commitments. Further, we do not expect that future contracts with channel
partners, if any, will include any minimum purchasing commitments. Changes in the timing or volume of purchases by our major customers could result in lower net revenue. In addition, our existing
contracts do not require our channel partners to purchase our products exclusively or on a preferential basis over the products of any of our competitors. Consequently, our channel partners may sell
the products of our competitors.

The loss of one or more suppliers could slow or interrupt the production and sales of our products.

Solectron, our third party manufacturer, relies on third parties to supply key components of our storage products. Many of these components are available only
from limited sources in the quantities and quality we require. Solectron purchases the majority of our redundant arrays of independent disks, or RAID, controllers from Infortrend
Technology, Inc., or Infortrend. Solectron may not be able to purchase the type or quantity of components from third party suppliers as needed in the future.

From
time to time there is significant market demand for disk drives, RAID controllers and other components, and we may experience component shortages, selective supply allocations and
increased prices of such components. In such event, we may be required to purchase our components from alternative suppliers. Even if alternative sources of supply for critical components such as disk
drives and controllers become available, incorporating substitute components into our products could delay our ability to deliver our products in a timely manner. For example, we estimate that
replacing Infortrend's RAID controllers with those of another supplier would involve several months of hardware and software modification, which could significantly harm our ability to meet our
customers' orders for our products, damage our customer relationships and result in a loss of sales.

The integration of Chaparral may be difficult, resulting in costs or leading to disruptions in relationships with customers or suppliers, any of which
could have an adverse effect on our financial results and operations.

In February 2004, we acquired all the outstanding shares of Chaparral. Integrating Chaparral's technologies and businesses will be a complex,
time-consuming and possibly expensive process. Before the acquisition, Chaparral had its own business, culture, products, customers, employees and systems. After the acquisition, the
companies intend to operate as a combined organization using common information and communication systems, operating procedures, financial controls and human resource practices. We cannot be assured
that the engineers from Chaparral and other employees whom we wish to retain will continue their employment relationships with us. In offering both our product lines and those of Chaparral, we will
incur the expenses involved with supporting and producing two different product lines. Eventually, we expect to merge the product lines, and in doing so we risk losing customers who preferred one line
over the other.

Further,
we may not be able to integrate the Chaparral technology, particularly the RAID technology, into our product lines as we now plan. Certain customers may seek alternative sources
of product, supply, or service due to these perceptions or based simply upon a desire not to do business with the combined company. Further, our relationships with suppliers may become disrupted, as
the suppliers (particularly of RAID controllers) fear a threat of being replaced by the technology acquired in the transaction.

Our
combined company also will have more distribution channels than we had prior to the acquisition. The combined company's resellers may target similar sales opportunities. These
overlapping sales efforts could adversely affect relationships with resellers and other sales channels, and result in resellers being less willing to market our products aggressively, or at all.

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Other
possible risks stemming from the acquisition of Chaparral may include:



Manufacturing disruptions could harm our business.

We rely on Solectron to manufacture substantially all of our products. If our agreement with Solectron is terminated or if Solectron does not perform its
obligations under our agreement, it could take several months to establish alternative manufacturing for our products and we may not be able to fulfill our customers' orders in a timely manner. Under
our OEM agreement with Sun, Sun has the right to require that we use a third party to manufacture our products. Such an external manufacturer must meet Sun's engineering, qualification and logistics
requirements. If our agreement with Solectron terminates, we may be unable to find another external manufacturer that meets Sun's requirements.

With
our increased use of third-party manufacturers, our ability to control the timing of shipments has continued and will continue to decrease. Delayed shipments could result in the
deferral or cancellation of purchases of our products. Any significant deferral or cancellation of these sales would harm our results of operations in any particular quarter. Net revenue for a period
may be lower than predicted if large orders forecasted for that period are delayed or are not realized, which could result in cash flow problems or a decline in our stock price.

We have experienced losses in the past and may experience losses in the future; we may need to raise additional funds to continue our operations.

For the years ended December 31, 2001 and 2002, we incurred net losses of $43.4 million and $34.3 million, respectively. We cannot assure you
that we will be profitable in any future period. We have expended, and will continue to be required to expend, substantial funds to pursue research and development projects, enhance marketing efforts
and otherwise operate our business. Our future capital requirements will depend on, and could increase substantially as a result of, many factors, including:



Our
available cash, cash equivalents and short-term investments as of December 31, 2003 totaled $191.5 million (of which $62 million was used in the
acquisition of Chaparral in February 2004), which, together with cash generated by operations, we believe will finance our operations through at least the next twelve months and we do not now
contemplate the need to raise additional funds. However, unanticipated events, such as Sun's failure to meet its product purchase forecast or extraordinary expenses or operating expenses in excess of
our projections, may require us to raise funds sooner than we expect. We may not be able to raise additional funds on commercially reasonable terms or at all. Any sales of our debt or equity
securities in the future may have a substantial dilutive effect on our

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existing
stockholders. If we are able to borrow funds, we may be required to grant liens on our assets to the provider of any source of financing or enter into operating, debt service or working
capital covenants with any provider of financing that could hinder our ability to operate our business in accordance with our plans. As a result, our ability to borrow money on a secured basis may be
impaired, and we may not be able to issue secured debt on commercially reasonable terms or at all.

Our quarterly operating results have fluctuated significantly in the past and are not a good indicator of future performance.

Our quarterly operating results have fluctuated significantly in the past as shown in the following table and are not a good indicator of future performance.

Quarter

Net Revenue

Net Income (Loss)(in millions)First Quarter 2001

$
18.6

$
(28.7
)Second Quarter 2001


14.9


(5.7
)Third Quarter 2001


12.3


(3.3
)Fourth Quarter 2001


10.5


(5.7
)First Quarter 2002


10.9


(6.2
)Second Quarter 2002


11.2


(8.9
)Third Quarter 2002


8.6


(7.3
)Fourth Quarter 2002


16.3


(11.9
)First Quarter 2003


30.5


(1.5
)Second Quarter 2003


48.4


2.6Third Quarter 2003


51.0


4.3Fourth Quarter 2003


57.5


6.7


In
addition, the announcement of financial results that fall short of the results anticipated by the public markets could have an immediate and significant negative effect on the trading
price of our common stock in any given period.

We may have difficulty predicting future operating results due to both internal and external factors affecting our business and operations, which could
cause our stock price to decline.

Our operating results may vary significantly in the future depending on a number of factors, many of which are out of our control, including:



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If our customers delay or cancel orders or return products, our results of operations could be harmed.

We generally do not enter into long-term purchase contracts with customers, and customers usually have the right to extend or delay shipment of their
orders, return products and cancel orders. As a result, sales in any period are generally dependent on orders booked and shipped
in that period. Delays in shipment orders, product returns and order cancellations in excess of the levels we expect would harm our results of operations.

Our sales cycle varies substantially and future net revenue in any period may be lower than our historical revenues or forecasts.

Our sales are difficult to forecast because the open systems storage market is rapidly evolving and our sales cycle varies substantially from customer to
customer. Customer orders for our products can range in value from a few thousand dollars to over a million dollars. The length of time between initial contact with a potential customer and the sale
of our product may last from three to 24 months. This is particularly true during times of economic slowdown, for sales to channel partners and for the sale and installation of complex
solutions. We have shifted our business strategy to focus primarily on channel partners, with whom sales cycles are generally lengthier, more costly and less certain than direct sales to
end-users.

Additional
factors that may extend our sales cycle, particularly orders for new products, include:



Our
net revenue is difficult for us to predict since it is directly affected by the timing of large orders. Due to the unpredictable timing of customer orders, we may ship products
representing a significant portion of our net revenue for a quarter during the last month of that quarter. In addition, our expense levels are based, in part, on our expectations as to future sales.
As a result, if sales levels are below expectations, our operating results may be disproportionately affected. We cannot assure you that we will experience sales growth in future periods.

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The market for our products is subject to substantial pricing pressure that decreases our margins.

Pricing pressures exist in the data storage market and have harmed and may in the future continue to harm our revenue and earnings. These pricing pressures are
due, in part, to continuing decreases in component prices, such as those of disks and RAID controllers. Decreases in component prices are customarily passed-on to customers by storage
companies through a continuing decrease in the price of storage hardware systems. In addition, because we expect to continue to make most of our sales to a small number of customers, we are subject to
continued pricing pressures from our customers, particularly our OEM customers. Pricing pressures are also due, in part, to the current difficult economic conditions, which have led many companies in
our industry to pursue a strategy of decreasing prices in order to win sales, the narrowing of functional differences among competitors, which forces companies to compete on price as opposed to
features of products, and the introduction of new technologies, which leaves older technology more vulnerable to pricing pressures. To the extent we are unable to offset those pressures with
commensurate cost reductions from our suppliers or by providing new products and features, our margins will be harmed.

Our success depends significantly upon our ability to protect our intellectual property and to avoid infringing the intellectual property of third
parties, which could result in costly, time-consuming litigation or even the inability to offer certain products.

We rely primarily on patents, copyrights, trademarks, trade secrets, nondisclosure agreements and common law to protect our intellectual property. For example, we
have registered trademarks for SANnet, SANpath, SANscape, Stratis, Dot Hill and the Dot Hill logo and with the acquisition of Chaparral, we acquired registered trademarks for Raidar, Rio, Riva and
Stratis. As of December 31, 2003, we had been awarded a total of eight U.S. patents and with the acquisition of Chaparral, we acquired one issued U.S. patent, two allowed U.S. patents and 13
U.S. patent applications that are in various stages of the patenting process. Despite our efforts to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products
or obtain and use information that we regard as proprietary. In addition, the laws of foreign countries may not adequately protect our intellectual property rights. Our efforts to protect our
intellectual property from third party discovery
and infringement may be insufficient and third parties may independently develop technologies similar to ours, duplicate our products or design around our patents.

On
October 17, 2003, Crossroads Systems, or Crossroads, filed a lawsuit against us in the United States District Court in Austin, Texas, alleging that our products infringe two
United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. In March 2004, Chaparral was added as a party
to the lawsuit. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the Fibre Channel
protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads' claims and intend to
vigorously defend against them. We expect to incur significant legal expenses in connection with this litigation. These defense costs, and other expenses related to this litigation, will be expensed
as incurred and will negatively affect our future operating results. Further, parties may assert additional infringement claims against us in the future, which would similarly require us to incur
substantial legal fees and expenses, and distract management from the operations of our business.

We
expect that providers of storage products will increasingly be subject to infringement claims as the number of products and competitors increases. In addition to the formal claims
brought against us by Crossroads, we receive, from time to time, letters from third parties suggesting that we may require a license from such third parties to manufacture or sell our products. We
evaluate all such communications to assess whether to seek a license from the patent owner. We may require licenses that could have a material impact on our business. We may not be able to obtain the
necessary license

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from
a third party on commercially reasonable terms, or at all. Consequently, we could be prohibited from marketing products that incorporate the protected technology or incur substantial costs to
redesign our products in a manner to avoid infringement of third party intellectual property rights.

The market for storage systems is intensely competitive and our results of operations, pricing and business could be harmed if we fail to maintain or
expand our market position.

The storage market is intensely competitive and is characterized by rapidly changing technology. We compete primarily against independent storage system
suppliers, including EMC Corporation, Hitachi Data Systems, LSI Logic Storage Systems and Network Appliance. We also compete with traditional suppliers of computer systems, including Dell Computer
Corporation, Hewlett-Packard Company, and IBM Corporation, which market storage systems as well as other computer products.

Many
of our existing and potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other
resources than us. As a result, they may have more advanced technology, larger distribution channels, stronger brand names, better customer service and access to more customers than we do. Other large
companies with significant resources could become direct competitors, either through acquiring a competitor or through internal efforts. Additionally, a number of new, privately held companies are
currently attempting to enter the storage market, some of which may become significant competitors in the future. Any of these existing or potential competitors may be able to respond more quickly to
new or emerging technologies and changes in customer requirements, devote greater resources to the development, promotion and sale of products or deliver competitive products at lower prices than us.

We
could also lose current or future business to any of our suppliers or manufacturers, some of which directly and indirectly compete with us. Currently, we leverage our supply and
manufacturing relationships to provide a significant share of our products. Our suppliers and manufacturers are very familiar with the specific attributes of our products and may be able to provide
our customers with similar products.

We
expect that competition will increase as a result of industry consolidation and the creation of companies with new, innovative product offerings. Current and potential competitors
have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers.
Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions,
reduced operating margins and potential loss of market share, any of which could harm our business.

We
believe that the principal competitive factors affecting the storage systems market include:



We
cannot assure you that we will be able to successfully incorporate these factors into our products and compete against current or future competitors or that competitive pressures we
face will not harm our business. If we are unable to develop and market products to compete with the products of competitors, our business will be materially and adversely affected. In addition, if
major channel partners who are also competitors cease purchasing our products in order to concentrate on sales of their own products, our business will be harmed.

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The open systems storage market is rapidly changing and we may be unable to keep pace with or properly prepare for the effects of those changes.

The open systems data storage market in which we operate is characterized by rapid technological change, frequent new product introductions, evolving industry
standards and consolidation among our competitors, suppliers and customers. Customer preferences in this market are difficult to predict and changes in those preferences and the introduction of new
products by us or our competitors could render our existing products obsolete. Our success will depend upon our ability to address the increasingly sophisticated needs of customers, to enhance
existing products, and to develop and introduce on a timely basis, new competitive products, including new software and hardware, and enhancements to existing software and hardware, that keep pace
with technological developments and emerging industry standards. If we cannot successfully identify, manage, develop, manufacture or market product enhancements or new products, our business will be
harmed. In addition, consolidation among our competitors, suppliers and customers may harm our business by increasing the resources of our competitors, reducing the number of suppliers available to us
for our product components and increasing competition for customers by reducing customer-purchasing decisions.

A significant percentage of our expenses are fixed, and if we fail to generate revenues in associated periods, our operating results will be harmed.

Although we have taken a number of steps to reduce operating costs, we may have to take further measures to reduce expenses if we continue to experience operating
losses or do not achieve a stable net income. A number of factors could preclude us from successfully bringing costs and expenses in line with our net revenue, such as the fact that our expense levels
are based in part on our expectations as to future sales, and that a significant percentage of our expenses are fixed, which limits our ability to reduce expenses quickly in response to any shortfalls
in net revenue. As a result, if net revenue does
not meet our projections, operating results may be negatively affected. We may experience shortfalls in net revenue for various reasons, including:



In
addition, we typically plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. From
time to time, in response to anticipated long lead times to obtain inventory and materials from our outside suppliers, we may order materials in advance of anticipated customer demand. This advance
ordering has continued and may to result in excess inventory levels or unanticipated inventory write-downs due to expected orders that fail to materialize.

Our business and operating results may suffer if we encounter significant product defects.

Our products may contain undetected errors or failures when first introduced or as we release new versions. During 2004, we plan to introduce new products into
our SANnet II family of systems. We may discover errors in our products after shipment, resulting in a loss of or delay in market acceptance, which could harm our business. Our standard warranty
provides that if the system does not function to published specifications, we will repair or replace the defective component or system without charge. Significant warranty costs, particularly those
that exceed reserves, could adversely impact our business. In addition, defects in our products could result in our customers claiming damages against us for

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property
damage or consequential damage and could also result in our loss of customers and goodwill. Any such claim could distract management's attention from operating our business and, if
successful, result in damage claims against us that might not be covered by our insurance.

Our success depends on our ability to attract and retain key personnel.

Our performance depends in significant part on our ability to attract and retain talented senior management and other key personnel. Our key personnel include
James Lambert, our President and Chief Executive Officer, Dana Kammersgard, our Chief Technical Officer, and Preston Romm, our Chief Financial Officer. If any one of these individuals were to
terminate his employment with us, we would be required to locate and hire a suitable replacement. Competition for attracting talented employees in the technology industry is intense. We may be unable
to identify suitable replacements for any employees that we lose. In addition, even if we are successful in locating suitable replacements, the time and cost involved in recruiting, hiring, training
and integrating new employees, particularly key employees responsible for significant portions of our operations, could harm our business by delaying our production schedule, our research and
development efforts, our ability to execute on our business strategy and our client development and marketing efforts.

Many
of our customer relationships are based on personal relationships between the customer and our sales representatives. If these representatives terminate their employment with us, we
may be forced to expend substantial resources to attempt to retain the customers that the sales representatives serviced. Ultimately, if we were unsuccessful in retaining these customers, our net
revenue would decline.

We
have recently made several reductions in our workforce. Although the reductions were designed to reduce our operating costs, the reductions have increased the responsibilities of our
remaining employees. As a result, we face risks associated with transferring the duties of our former employees to our remaining employees. In addition to the expense involved in retraining employees,
there is a risk that our current work force will be unable to effectively manage all of the duties of our former employees, which could adversely impact our research and development efforts, our
general accounting and operating activities, our sales efforts and our production capabilities.

Our executive officers and directors and their affiliates own a significant percentage of our outstanding shares, which could prevent us from being
acquired and adversely affect our stock price.

As of December 31, 2003, our executive officers, directors and their affiliates beneficially owned approximately 8.8% of our outstanding shares of common
stock. These individual stockholders may be able to influence matters requiring approval by our stockholders, including the election of a majority of our directors. The voting power of these
stockholders under certain circumstances could have the effect of delaying or preventing a change in control of us. This concentration of ownership may also make it more difficult or expensive for us
to obtain financing. Further, any substantial sale of shares by these individuals could depress the market price of our common stock and impair our ability to raise capital in the future through the
sale of our equity securities.

Protective provisions in our charter and bylaws and the existence of our stockholder rights plan could prevent a takeover which could harm our
stockholders.

Our certificate of incorporation and bylaws contain a number of provisions that could impede a takeover or prevent us from being acquired, including, but not
limited to, a classified board of directors, the elimination of our stockholders' ability to take action by written consent and limitations on the ability of our stockholders to remove a director from
office without cause. Our board of directors may issue additional shares of common stock or establish one or more classes or series of preferred stock with such designations, relative voting rights,
dividend rates, liquidation and other

23

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rights,
preferences and limitations as determined by our board of directors without stockholder approval. In addition, we adopted a stockholder rights plan in May 2003 that is designed to
impede takeover transactions that are not supported by our board of directors. Each of these charter and bylaw provisions and the stockholder rights plan gives our board of directors, acting without
stockholder approval, the ability to prevent, or render more difficult or costly, the completion of a takeover transaction that our stockholders might view as being in their best interests.

The exercise of outstanding warrants may result in dilution to our stockholders.

Dilution of the per share value of our common stock could result from the exercise of outstanding warrants. As of December 31, 2003, there were outstanding
warrants to purchase 2,034,551 shares of our common stock. The warrants have exercise prices ranging from $2.97 to $4.50 per share and expire at various dates through March 14, 2008. When the
exercise price of the warrants is less than the trading price of our common stock, exercise of the warrants would have a dilutive effect on our stockholders. The possibility of the issuance of shares
of our common stock upon exercise of the warrants could cause the trading price of our common stock to decline.

Our stock price may be highly volatile and could decline substantially and unexpectedly.

The trading price of our shares of common stock has been affected by the factors disclosed in this section as well as prevailing economic and financial trends and
conditions in the public securities markets. Share prices of companies in technology-related industries, such as ours, tend to exhibit a high degree of volatility. The announcement of financial
results that fall short of the results anticipated by the public markets could have an immediate and significant negative effect on the trading price of our shares in any given period. Such shortfalls
may result from events that are beyond our immediate control, can be unpredictable and, since a significant proportion of our sales during each fiscal quarter tend to occur in the latter stages of the
quarter, may not be discernible until the end of a financial
reporting period. These factors may contribute to the volatility of the trading value of our shares regardless of our long-term prospects. The trading price of our shares may also be
affected by developments, including reported financial results and fluctuations in trading prices of the shares of other publicly-held companies, in our industry generally and our business
segment in particular, which may not have any direct relationship with our business or prospects.

In
the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We could be the target of
similar litigation in the future. Securities litigation could result in the expenditure of substantial funds, divert management's attention and resources, harm our reputation in the industry and the
securities markets and reduce our profitability.

Future sales of our common stock may hurt our market price.

A substantial number of shares of our common stock may become available for resale. If our stockholders sell substantial amounts of our common stock in the public
market, the market price of our common stock could decline. These sales might also make it more difficult for us to sell equity securities in the future at times and prices that we deem appropriate.
In addition, we are obligated to file a registration statement with respect to the resale of up to 1,394,279 shares of our common stock issuable upon exercise of warrants held by Sun.

Geopolitical military conditions, including terrorist attacks and other acts of war, may materially and adversely affect the markets on which our common
stock trades, the markets in which we operate, our operations and our profitability.

Terrorist attacks and other acts of war, and any response to them, may lead to armed hostilities and such developments would likely cause instability in financial
markets. Armed hostilities and

24

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terrorism
may directly impact our facilities, personnel and operations which are located in the United States and internationally, as well as those of our channel partners, suppliers, third party
manufacturer and customers. Furthermore, severe terrorist attacks or acts of war may result in temporary halts of commercial activity in the affected regions, and may result in reduced demand for our
products. These developments could have a material adverse effect on our business and the trading price of our common stock

Item 2. Properties

Our headquarters and principal research and marketing facilities occupy approximately 70,000 square feet in Carlsbad, California, under a renewable lease that
expires in December 2005. In addition, we lease a sales office in Boston, Massachusetts, and six international offices in five countries: Germany, Japan, the Netherlands, Singapore and the
United Kingdom. With the acquisition of Chaparral, we added a research and development facility that occupies approximately 25,000 square feet in Longmont, Colorado, under a lease that expires in July
2007. Solectron manufactures substantially all of our products. We believe that with our existing facilities and Solectron's manufacturing capabilities, we have the capacity to meet any potential
increases to our forecasted production requirements and therefore believe our facilities are adequate to meet our needs in the foreseeable future.

Item 3. Legal Proceedings

On October 17, 2003, Crossroads filed a lawsuit against us in the United States District Court in Austin, Texas, alleging that our products infringe two
United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. In March 2004, Chaparral was added as a party
to the lawsuit. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the Fibre Channel
protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads' claims and intend to
vigorously defend against them. We expect to incur significant legal expenses in connection with this litigation. These defense costs, and other expenses related to this litigation, will be expensed
as incurred and will negatively affect our future operating results.

In
addition to the action discussed above, we are subject to various legal proceedings and claims, asserted or unasserted, which arise in the ordinary course of business. The outcome of
the claims against us cannot be predicted with certainty. We believe that such litigation and claims will not have a material adverse effect on our financial condition or operating results.

Item 4. Submission of Matters to Vote of Security Holders

None.

25

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PART II

Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock traded on the New York Stock Exchange beginning on September 16, 1997 under the symbol "BXH". In August 1999, Box Hill Systems
merged with Artecon and we changed our name to Dot Hill Systems Corp. and our trading symbol changed to "HIL". We moved to the American Stock Exchange on December 12, 2002, where
we continued to trade our common stock under the symbol "HIL". On July 28, 2003, our common stock was included for quotation on the Nasdaq National Market where our common stock
is currently traded under the symbol "HILL".

The
following table sets forth for the periods indicated the per share range of the high and low closing sales prices or closing bid prices, of our common stock as reported on the New
York Stock Exchange, the American Stock Exchange or the Nasdaq National Market, as applicable.

Low

HighYear Ended December 31, 2002First Quarter

$
1.55

$
3.15Second Quarter


2.10


4.69Third Quarter


2.50


3.95Fourth Quarter


1.60


3.50Year Ended December 31, 2003First Quarter

$
3.10

$
6.12Second Quarter


6.01


14.00Third Quarter


13.52


18.95Fourth Quarter


12.66


17.37


On
March 11, 2004 the last reported sale price for our common stock on the Nasdaq National Market was $11.53 per share. As of March 11, 2004, there were 43,315,222 shares
of our common stock outstanding held by approximately 6,975 holders of record.

We
have never paid any cash dividends on our common stock, and currently intend to retain future earnings, if any, to the extent possible to fund the development and growth of our
business. We do not anticipate paying any cash dividends on our common stock in the foreseeable future.

The
information required to be disclosed by item 201(d) of Regulation S-K "Securities Authorized for Issuance Under Equity Compensation
Plans"is included under Item 12 of Part III of this Annual Report on Form 10-K.

Item 6.    Selected Financial Data

In August 1999, Box Hill Systems merged with Artecon and we changed our name to Dot Hill Systems Corp. Our accompanying financial statements have been
retroactively restated to reflect the Merger of Box Hill and Artecon, which was accounted for as a pooling of interests. We derived the selected
consolidated financial data presented below from our consolidated financial statements. You should read the selected consolidated financial data together with our consolidated financial statements and
related notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K.

Statement
of operations data for the years ended December 31, 2001, 2002 and 2003, and the balance sheet data as of December 31, 2002 and 2003 have been derived from our
audited consolidated financial statements which are included elsewhere in this Annual Report on Form 10-K. Statement of operations data for the years ended December 31, 1999
and 2000 and balance sheet data as of

26

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December 31,
1999, 2000 and 2001 have been derived from our audited consolidated financial statements not included herein.

|                              |                                                       | Year Ended December 31,          
|----------------------------- | ----------------------------------------------------- | ---------------------------------
|
|
|Statement of Operations Data: |                                                       |                                  
|                              | Net revenue                                           |                                  
|                              | Cost of goods sold                                    |                                  
|                              |                                                       |                                  
|                              | Gross profit                                          |                                  
|                              |                                                       |                                  
|                              | Operating expenses:                                   |                                  
|                              |                                                       | Sales and marketing              
|                              |                                                       | Research and development         
|                              |                                                       | General and administrative       
|                              |                                                       | Impairment of intangible assets  
|                              |                                                       | Merger and restructuring expenses
|                              |                                                       |                                  
|                              | Operating income (loss)                               |                                  
|                              |                                                       |                                  
|                              | Net income (loss)                                     |                                  
|                              |                                                       |                                  
|                              | Net income (loss) attributable to common stockholders |                                  
|                              |                                                       |                                  
|                              | Net income (loss) per share:                          |                                  
|                              |                                                       | Basic                            
|                              |                                                       |                                  
|                              |                                                       | Diluted                          
|                              |                                                       |                                  
|                              | Weighted average shares outstanding:                  |                                  
|                              |                                                       | Basic                            
|                              |                                                       |                                  
|                              |                                                       | Diluted                          
|                              |                                                       |                                  

|                    |                                                                     | As of December 31,
|------------------- | ------------------------------------------------------------------- | ------------------
|
|
|Balance Sheet Data: |                                                                     |                   
|                    | Cash, cash equivalents, restricted cash and short- term investments |                   
|                    | Working capital                                                     |                   
|                    | Total assets                                                        |                   
|                    | Total long-term debt                                                |                   
|                    | Total stockholders' equity                                          |                   

Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes
thereto included in this Annual Report on Form 10-K.

27

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Overview

We are a provider of storage systems for organizations requiring high reliability, high performance networked storage and data management solutions in an open
systems architecture. Our storage solutions consist of integrated hardware and software products employing a modular system that allows
end-users to add capacity as needed. Our broad range of products, from medium capacity stand-alone storage units to complete turn-key, multi-terabyte storage area networks,
provides end-users with a cost-effective means of addressing increasing storage demands without sacrificing performance.

Our
products and services are sold worldwide to end-users primarily through our channel partners, including OEMs, SIs and VARs. In May 2002, we entered into a
three-year OEM agreement with Sun to provide our storage hardware and software products for private label sales by Sun, and that agreement was recently extended until May 2007. We
have been shipping our products to Sun for resale to Sun's customers since October 2002. We continue to develop new products for resale by Sun and other channel partners and expect to begin
shipping additional new products for resale later this year. We intend to continue expanding our non-OEM sales channels through SIs and VARs in order to decrease our revenue concentration
with OEMs.

As
part of our focus on indirect sales channels, we have outsourced substantially all of our manufacturing operations to third party electronics manufacturing services companies.
Outsourcing allows us to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of various manufacturing and procurement economies
of scale.

We
derive net revenue primarily from sales of our SANnet II family of products. In prior periods, we derived a significant portion of our net revenue from sales of our legacy products
and SANnet I family of products. Except for two OEM customers, one of which continues to buy our SANnet I products and the other of which continues to buy a legacy system, we have transitioned all
customers to our SANnet II products. We derive a portion of our net revenue from services associated with the maintenance service we provide for our installed products. In May 2003, we entered
into a services agreement with Anacomp, Inc. to provide all maintenance, warranty and non-warranty services for our SANnet I and certain legacy products.

Cost
of goods sold includes costs of materials, subcontractor costs, salary and related benefits for the production and service departments, depreciation and amortization of equipment
used in the production and service departments, production facility rent and allocation of overhead.

Sales
and marketing expenses consist primarily of salaries and commissions, advertising and promotional costs and travel expenses. Research and development expenses consist primarily of
project-related expenses and salaries for employees directly engaged in research and development. General and administrative expenses consist primarily of compensation to officers and employees
performing administrative functions and expenditures for administrative facilities. Restructuring expenses consist primarily of employee severance, lease termination costs and other office closure
expenses related to the consolidation of excess facilities.

Other
income is comprised primarily of interest income earned on our cash, cash equivalents, restricted cash and short-term investments and other miscellaneous income and
expense items.

In
February 2004, we acquired all the outstanding shares of Chaparral, a privately-held storage system provider. We expect to integrate Chaparral's RAID controller and
router technology into our line of storage products. We plan to retain Chaparral's Colorado facility as a research and development hub and to continue to use Chaparral's team of engineers and facility
support personnel.

In
August 1999, Box Hill Systems merged with Artecon and we changed our name to Dot Hill Systems Corp. We reincorporated in Delaware in 2001. Our headquarters are located in
Carlsbad, California, and we maintain international offices in Germany, Japan, the Netherlands, Singapore and the United Kingdom.

28

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and use judgment that may impact the reported
amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. As a part of our on-going internal processes, we evaluate our estimates,
including those related to inventory write-downs, warranty cost accruals, revenue recognition, bad debt allowances, long-lived assets valuation, intangible assets valuation, income taxes,
including deferred income tax asset valuation, litigation and contingencies. We base these estimates upon both historical information and other assumptions that we believe are valid and reasonable
under the circumstances. These assumptions form the basis for making judgments and determining the carrying values of assets and liabilities that are not apparent from other sources. Actual results
could vary from those estimates under different assumptions and conditions.

We
believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue for non-software product sales upon transfer of title to the customer. Reductions to revenue for estimated sales returns are also
recorded at that time. These estimates are based on historical sales returns, changes in customer demand and other factors. If actual future returns and allowances differ from past experience,
additional allowances may be required. Certain of our sales arrangements include multiple elements. Generally, these arrangements include delivery of the product, installation, training and product
maintenance. Maintenance related to product sales entitles the customer to basic product support and significantly greater response time in resolving warranty related issues. We allocate revenue to
each element of the arrangement based on its relative fair value. For maintenance contracts this is typically the price charged when such contracts are sold separately or renewed. Because professional
services related to installation and training can be provided by other third party organizations, we allocate revenue related to professional services based on rates that are consistent with other
like companies providing similar services, i.e., the market rate for such services. Revenue from product maintenance contracts is deferred and recognized ratably over the contract term, generally
twelve months. Revenue from installation, training and consulting is recognized as the services are performed.

For
software sales, we apply Statement of Position No. 97-2,Software Revenue Recognition,whereby revenue is
recognized from software licenses at the time the product is delivered, provided there are no significant obligations related to the sale, the resulting receivable is deemed collectible and there is
vendor-specific objective evidence supporting the value of the separate contract elements. For arrangements with multiple elements, we allocate revenue to each element using the residual method based
on vendor specific objective evidence of the undelivered items. A portion of the arrangement fee equal to the fair value of the undelivered elements, typically software maintenance contracts, is
deferred and recognized ratably over the contract term, generally twelve months. Vendor specific objective evidence is based on the price charged when the element is sold separately. A typical
arrangement includes a software licensing fee and maintenance agreement.

Valuation of Inventories

Inventories are comprised of purchased parts and assemblies, which include direct labor and overhead. We record inventories at the lower of cost or market value,
with cost generally determined on a first-in, first-out basis. We perform periodic valuation assessments based on projected sales forecasts and analyzing upcoming changes in
future configurations of our products and record inventory write-downs for excess and obsolete inventory. Although we strive to ensure the accuracy of our

29

---

forecasts,
we periodically are faced with uncertainties. The outcomes of these uncertainties are not within our control, and may not be known for prolonged periods of time. Any significant
unanticipated changes in demand or technological developments could have a significant impact on the value of our inventories and commitments, and consequently, on our operating results. If actual
market conditions become less favorable than those forecasted, additional inventory write-downs might be required, adversely affecting operating results.

Results of Operations

The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated:

Year Ended December 31,2001

2002

2003Net revenue

100.0
%
100.0
%
100.0
%Cost of goods sold

79.6

96.8

76.0Gross profit

20.4

3.2

24.0Operating expenses:Sales and marketing

42.1

48.0

7.5Research and development

11.9

21.4

6.4General and administrative

8.1

11.0

4.0Restructuring expenses

8.7

3.3

Operating income (loss)

(50.4
)
(80.5
)
6.1Net income (loss)

(77.1
)%
(73.1
)%
6.5
%


Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Net Revenue

Net revenue increased $140.5 million, or 299.4%, to $187.4 million for the year ended December 31, 2003 from $46.9 million for the
year ended December 31, 2002. The increase in net revenue was attributable to increased orders for our products from our channel partner, Sun, which accounted for 83.4% of our net revenue for
the year ended December 31, 2003.

Cost of Goods Sold

Cost of goods sold increased $97.1 million, or 213.7%, to $142.5 million for the year ended December 31, 2003 from $45.4 million for
the year ended December 31, 2002. As a percentage of net revenue, cost of goods sold decreased to 76.0% for the year ended December 31, 2003 from 96.8% for the year ended
December 31, 2002. The increase in the dollar amount of cost of goods sold was attributable to greater volume of product sales during the year ended December 31, 2003. The decrease in
cost of goods sold as a percentage of our net revenue was primarily attributable to a more efficient absorption of fixed production costs and to a lesser extent a decrease in inventory write-downs of
$6.6 million.

Gross Profit

Gross profit increased $43.4 million, or 2,909.2%, to $44.9 million for the year ended December 31, 2003 from $1.5 million for the
year ended December 31, 2002. As a percentage of net revenue, gross profit increased to 24.0% for the year ended December 31, 2003 from 3.2% for the year ended December 31, 2002.
The increase in the dollar amount of gross profit was attributable to greater volume of product sales during the year ended December 31, 2003. The increase in gross profit as a

30

---

percentage
of our net revenue was primarily attributable to a more efficient absorption of fixed production costs and to a lesser extent a decrease in inventory write-downs of $6.6 million.

Sales and Marketing Expenses

Sales and marketing expenses decreased $8.4 million, or 37.4%, to $14.1 million for the year ended December 31, 2003 from
$22.5 million for the year ended December 31, 2002. As a percentage of net revenue, sales and marketing expenses decreased to 7.5% for the year ended December 31, 2003 from 48.0%
for the year ended December 31, 2002. The decrease in the dollar amount of sales and marketing expenses was attributable to a reduction in our sales and marketing headcount of 24 employees
between December 31, 2002 and December 31, 2003. The reduction was made in conjunction with our shift toward an indirect sales model, implementation of fixed cost reduction measures,
such as closure of excess and unused facilities, and the refocus of our marketing resources on a smaller population of potential customers.

Research and Development Expenses

Research and development expenses increased $1.9 million, or 19.0%, to $11.9 million for the year ended December 31, 2003 from
$10.0 million for the year ended December 31, 2002. As a percentage of net revenue, research and development expenses decreased to 6.4% for the year ended December 31, 2003 from
21.4% for the year ended December 31, 2002. The increase in the dollar amount of research and development expenses was primarily attributable to an increase in salary and related expenses of
$2.1 million attributable to an increase in the number of our full-time direct engineering team members, an increase of regulatory testing costs of $0.3, an increase of allocable
fixed costs of $0.5 million, offset by a reduction of prototype costs related to the development of our SANnet II product line of $1.5 million. We expect to continue to invest in
research and development and plan to add more members to our research and development team during 2004.

General and Administrative Expenses

General and administrative expenses increased $2.2 million, or 44.0%, to $7.4 million for the year ended December 31, 2003 from
$5.2 million for the year ended December 31, 2002. As a percentage of net revenue, general and administrative expenses decreased to 4.0% for the year ended December 31, 2003 from
11.0% for the year ended December 31, 2002. The increase in the dollar amount of general and administrative expense was attributable to increased bonus expense of $1.8 million, and
increased legal expenses of $0.4 million.

Restructuring Expenses

In March 2001, we announced plans to reduce our full-time workforce by up to 30% and reduce other expenses in response to delays in customer
orders, lower than expected revenues and slowing global market conditions. The cost reduction actions were designed to reduce our breakeven point in light of an economic downturn. The cost reductions
resulted in a charge for employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities. We recorded restructuring expenses in the
first quarter of 2001 of approximately $2.9 million.

In
June 2001, we announced plans to further reduce our full-time workforce by up to 17% and reduce other expenses in response to a continuing economic downturn and
overall decrease in revenue. As a result of these additional restructuring actions, we recorded additional restructuring expenses during the second quarter of 2001 of approximately
$1.5 million.

Employee
termination costs consist primarily of severance payments for 180 employees. Impairment of property and equipment consists of the write-down of certain fixed assets
associated with facility closures. The facility closures and related costs consist of lease termination costs for five sales offices and closure of our New York City office.

31

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During the fourth quarter of 2001, we increased our March 2001 Restructuring accrual by approximately $0.2 million and our June 2001 Restructuring accrual by
approximately $0.3 million due to the continuing deterioration of various real estate markets and the inability to sublet excess space in our Carlsbad and New York City facilities.

During
the fourth quarter of 2002, we again increased our March 2001 Restructuring accrual by approximately $0.7 million and our June 2001 Restructuring accrual by
approximately $0.9 million to reflect additional deterioration of real estate markets in Carlsbad and New York City, as well as the effects of lease buyouts negotiated on several other
facilities and a sublease arrangement reached on another facility.

The
following is a summary of restructuring activity recorded during the years ended December 31, 2002 and 2003:

March 2001 Restructuring

|                                    |  | Accrued
Restructuring
Expenses at
January 1,
2002 |     | Additional
Restructuring
Expenses in
2002 |   | Amounts
Utilized
in
2002 |  | Accrued
Restructuring
Expenses at
December 31,
2002 |      | Amounts
Utilized
in
2003 |   | Accrued
Restructuring
Expenses at
December 31,
2003
|----------------------------------- |  | ------------------------------------------------- | --- | ----------------------------------------- | - | ------------------------ |  | --------------------------------------------------- | ---- | ------------------------ | - | ---------------------------------------------------
|
|Employee termination costs          |  | $                                                 | 2   |                                           | $ |                         |  | $                                                   | (2   | )                        | $ |                                                   
|Facility closures and related costs |  |                                                   | 394 |                                           |   | 693                      |  |                                                     | (426 | )                        |   | 661                                                
|                                    |  |                                                   |     |                                           |   |                          |  |                                                     |      |                          |   |                                                    
|Total                               |  | $                                                 | 396 |                                           | $ | 693                      |  | $                                                   | (428 | )                        | $ | 661                                                
|                                    |  |                                                   |     |                                           |   |                          |  |                                                     |      |                          |   |                                                    

June 2001 Restructuring

|                      |  | Accrued
Restructuring
Expenses at
January 1,
2002 |     | Additional
Restructuring
Expenses in
2002 |   | Amounts
Utilized
in
2002 |  | Accrued
Restructuring
Expenses at
December 31,
2002 |      | Amounts
Utilized
in
2003 |   | Accrued
Restructuring
Expenses at
December 31,
2003
|--------------------- |  | ------------------------------------------------- | --- | ----------------------------------------- | - | ------------------------ |  | --------------------------------------------------- | ---- | ------------------------ | - | ---------------------------------------------------
|
|Facility closures and |  |                                                   |     |                                           |   |                          |  |                                                     |      |                          |   |                                                    
|related costs         |  | $                                                 | 845 |                                           | $ | 857                      |  | $                                                   | (777 | )                        | $ | 925                                                
|                      |  |                                                   |     |                                           |   |                          |  |                                                     |      |                          |   |                                                    

We
believe that there are no unresolved issues or additional liabilities that may result in a significant adjustment to restructuring expenses accrued as of December 31, 2003.

Other Income

Other income increased $0.4 million, or 125.3%, to $0.8 million for the year ended December 31, 2003 from $0.4 million for the year
ended December 31, 2002. The increase was primarily attributable to an increase in interest income realized from short-term investments.

Income Taxes

Our effective income tax rate for the year ended December 31, 2003 of 0.7% is primarily attributable to federal and state minimum tax liabilities as well
as local and foreign taxes. Our effective income tax rate for the year ended December 31, 2003 was significantly reduced through the use of net operating loss carryforwards for which a
valuation allowance had previously been recorded. Our effective income tax rate for the year ended December 31, 2002 was 8.3%, primarily as a result of an

32

---

income
tax benefit resulting from tax refunds made available by recent tax law changes partially offset by state, local and foreign taxes.

As
of December 31, 2003, a valuation allowance of $39.0 million has been provided based upon our assessment of the future realizability of our deferred income tax assets,
as it is currently considered more likely than not that sufficient taxable income will not be generated to realize these temporary differences.

Additionally,
at December 31, 2003, approximately $4.2 million of the valuation allowance is attributable to the potential tax benefit of stock option transactions that
will be credited directly to common stock, if realized.

As
of December 31, 2003, we have federal and state net operating loss carryforwards of approximately $80.7 million and $53.8 million, which begin to expire in 2009
and 2004, respectively. In addition, we have federal tax credit carryforwards of approximately $2.4 million, of which $0.2 million can be carried forward indefinitely to offset future
taxable income, and the remaining $2.2 million will begin to expire in the tax year 2008. We also have state tax credit carryforwards of $2.3 million, of which $2.1 million can be
carried forward indefinitely to offset future taxable income, and the remaining $0.2 million will begin to expire in 2006.

As
a result of the Company's equity transactions, an ownership change, within the meaning of Internal Revenue Code Section 382, occurred on September 18, 2003. As a result,
annual use of the Company's federal net operating loss and credit carry forwards is limited to (i) the aggregate fair market value of Artecon immediately before the ownership change multiplied
by (ii) the long-term tax-exempt rate (within the meaning of Section 382 (f) of the Internal Revenue Code) in effect at that time. The annual limitation is
cumulative and, therefore, if not fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.

We
have not provided for any residual U.S. income taxes on the earnings from our foreign subsidiaries because such earnings are intended to be indefinitely reinvested. Such residual U.S.
income taxes, if any, would be insignificant.

Net Income (Loss)

Net income increased $46.4 million to net income of $12.1 million for the year ended December 31, 2003 from a net loss of
$34.3 million for the year ended December 31, 2002. This increase of $46.4 million was due to an increase in gross profit of $43.4 million, a decrease in operating expenses
of $5.8 million, an increase in other income of $0.4 million offset by a decrease in income tax benefit of $3.2 million.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Net Revenue

Net revenue decreased $9.4 million, or 16.6%, to $46.9 million for the year ended December 31, 2002 from $56.3 million for the year
ended December 31, 2001. The decrease in net revenue was attributable to unfavorable market conditions resulting in a 49.3% decrease in sales from the telecommunications sector and a 38.5%
decrease in sales from the commercial sector, partially offset by an $11.6 million increase in sales to our largest OEM customer.

Cost of Goods Sold

Cost of goods sold increased $0.6 million, or 1.4%, to $45.4 million for the year ended December 31, 2002 from $44.8 million for the
year ended December 31, 2001. As a percentage of net revenue, cost of goods sold increased to 96.8% for the year ended December 31, 2002 from 79.6% for

33

---

the
year ended December 31, 2001. The increase both in absolute terms and as a percentage of net revenue, is attributable to a $8.3 million charge over the course of 2002 for excess and
obsolete inventory, $5.1 million of which was related to the impact that our SANnet II product launch had on inventories of our legacy SANnet product, and $2.0 million in
ramp-up costs and inefficiencies incurred during the fourth quarter of 2002 related to our new SANnet II SCSI product, which was launched in October 2002.

Gross Profit

Gross profit decreased $10.0 million, or 87.0%, to $1.5 million for the year ended December 31, 2002 from $11.5 million for the year
ended December 31, 2001. As a percentage of net revenue, gross profit decreased to 3.2% for the year ended December 31, 2002 from 20.4% for the year ended December 31, 2001. The
decrease in gross profit, both in absolute terms and as a percentage of net revenue, is attributable to a $8.3 million charge over the course of 2002 for excess and obsolete inventory,
$5.1 million of which was related to the impact that our SANnet II product launch had on inventories of our legacy SANnet product, and $2.0 million in ramp-up costs and
inefficiencies incurred during the fourth quarter of 2002 related to our new SANnet II SCSI product, which was launched in October 2002.

Sales and Marketing Expenses

Sales and marketing expenses decreased $1.2 million, or 5.1%, to $22.5 million for the year ended December 31, 2002 from $23.7 million
for the year ended December 31, 2001. As a percentage of net revenue, sales and marketing expenses increased to 48.0% for the year ended December 31, 2002 from 42.1% for the year ended
December 31, 2001. We incurred a one-time charge to sales and marketing expenses of $3.6 million related to the issuance of a warrant to purchase our common stock to Sun in
May 2002. The decrease in the dollar amount of sales and marketing expenses, excluding the charge for the warrant, is attributable to fixed cost reduction measures, such as geographical
restructuring of the sales force and our efforts to focus our marketing resources on a smaller population of potential channel partners.

Research and Development Expenses

Research and development expenses increased $3.3 million, or 50.5%, to $10.0 million for the year ended December 31, 2002 from
$6.7 million for the year ended December 31, 2001. As a percentage of net revenue, research and development expenses increased to 21.4% for the year ended December 31, 2002 from
11.9% for the year ended December 31, 2001. The increase in the dollar amount of research and development expenses is attributable to costs related to the development of our
next-generation SANnet II product line, the first member of which was released in October 2002. In addition, the increase as a percentage of net revenues was due in part to lower
sales revenue during 2002 compared to 2001.

General and Administrative Expenses

General and administrative expenses increased $0.7 million, or 13.6%, to $5.2 million for the year ended December 31, 2002 from
$4.5 million for the year ended December 31, 2001. As a percentage of net revenue, general and administrative expenses increased to 11% for the year ended December 31, 2002 from
8.1% for the year ended December 31, 2001. The increase in the dollar amount of general and administrative expenses resulted primarily from increased premiums for directors and officers
insurance of approximately $0.2 million, and legal expenses of approximately $0.4 million associated with the Sun, Solectron and Infortrend business arrangements.

34

---

Restructuring Expenses

In March 2001, we announced plans to reduce our full-time workforce by up to 30% and reduce other expenses in response to delays in customer
orders, lower than expected revenues and slowing global market conditions. The cost reduction actions were designed to reduce our breakeven point in light of an economic downturn. The cost reductions
resulted in a charge for employee severance, lease termination costs and other office closure expenses related to the consolidation of excess facilities. We recorded restructuring expenses in the
first quarter of 2001 of approximately $2.9 million.

In
June 2001, we announced plans to further reduce our full-time workforce by up to 17% and reduce other expenses in response to a continuing economic downturn and
overall decrease in
revenue. As a result of these additional restructuring actions, we recorded additional restructuring expenses during the second quarter of 2001 of approximately $1.5 million.

During
the fourth quarter of 2001, we increased our March 2001 Restructuring accrual by approximately $0.2 million and our June 2001 Restructuring accrual by
approximately $0.3 million due to the deterioration of various real estate markets and the inability to sublet excess space in our Carlsbad and New York City facilities.

During
the fourth quarter of 2002, we again increased our March 2001 Restructuring accrual by approximately $0.7 million and our June 2001 Restructing accrual by
approximately $0.9 million to reflect additional deterioration of real estate markets in Carlsbad and New York City, as well as the effects of lease buyouts negotiated on several other
facilities and a sublease arrangement reached on another facility.

The
following is a summary of restructuring activity recorded during the years ended December 31, 2001 and 2002:

March 2001 Restructuring

|                                     |  | Restructuring
Expenses
in 2001 |       | Amounts
Utilized
in 2001 |   | Accrued
Restructuring
Expenses at
December 31,
2001 |   | Additional
Restructuring
Expenses
in 2002 |     | Amounts
Utilized
in
2002 |   | Accrued
Restructuring
Expenses at
December 31,
2002
|------------------------------------ |  | ------------------------------ | ----- | ------------------------ | - | --------------------------------------------------- | - | ----------------------------------------- | --- | ------------------------ | - | ---------------------------------------------------
|
|Employee termination                 |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                    
|costs                                |  | $                              | 1,271 |                          | $ | (1,269                                              | ) | $                                         | 2   |                          | $ |                                                   
|Impairment of property and equipment |  |                                | 1,007 |                          |   | (1,007                                              | ) |                                           |    |                          |   |                                                   
|Facility closures and related costs  |  |                                | 792   |                          |   | (398                                                | ) |                                           | 394 |                          |   | 693                                                
|Professional fees and other          |  |                                | 20    |                          |   | (20                                                 | ) |                                           |    |                          |   |                                                   
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                    
|Total                                |  | $                              | 3,090 |                          | $ | (2,694                                              | ) | $                                         | 396 |                          | $ | 693                                                
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                    

35

---

June 2001 Restructuring

|                                     |  | Restructuring
Expenses
in 2001 |       | Amounts
Utilized
in 2001 |   | Accrued
Restructuring
Expenses at
December 31,
2001 |   | Additional
Restructuring
Expenses
in 2002 |     | Amounts
Utilized
in
2002 |   | Accrued
Restructuring
Expenses at
December 31,
2002
|------------------------------------ |  | ------------------------------ | ----- | ------------------------ | - | --------------------------------------------------- | - | ----------------------------------------- | --- | ------------------------ | - | ---------------------------------------------------
|
|Employee termination costs           |  | $                              | 259   |                          | $ | (259                                                | ) | $                                         |    |                          | $ |                                                   
|Impairment of property and equipment |  |                                | 350   |                          |   | (350                                                | ) |                                           |    |                          |   |                                                   
|Facility closures and related costs  |  |                                | 1,206 |                          |   | (361                                                | ) |                                           | 845 |                          |   | 857                                                
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                    
|Total                                |  | $                              | 1,815 |                          | $ | (970                                                | ) | $                                         | 845 |                          | $ | 857                                                
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                    

Other Income

We had net other income of $0.3 million in each of 2002 and 2001. Although there was no change to total other income, interest income decreased by
approximately $0.6 million from 2001 to 2002 as a result of converting higher-yielding investment securities into a lower-yield money market account and offsetting the decrease in interest
income was a decrease in other expense resulting from an approximately $0.7 million accrual made during 2001 for a pending litigation settlement.

Income Taxes

During the second quarter of 2002, we recorded an income tax benefit of $3.3 million related to tax refunds made available by recent tax law changes. We
received $0.9 million of this benefit during 2002 and $2.4 million in 2001.

Our
2002 effective income tax rate of 8.3% reflects federal income tax refunds made available by recent tax law changes partially offset by state, local and foreign taxes. Our effective
income tax rate for 2001 was (54.6)%, primarily as a result of a $16.0 million charge to the income tax provision in connection with an increase in the valuation allowance provided for deferred
income tax assets.

Net Income (Loss)

Net loss decreased $9.1 million to net loss of $34.3 million for the year ended December 31, 2002 from a net loss of $43.4 million for
the year ended December 31, 2001. This decrease of $9.1 million was due to a decrease in gross profit of $10.0 million, a decrease in operating expenses of $0.6 million,
and a decrease in income tax expense of $18.5 million.

Liquidity and Capital Resources

As of December 31, 2003, we had $191.5 million of cash, cash equivalents and short-term investments and working capital of
$177.7 million.

During
September 2003, we received net proceeds of approximately $144.8 million from a secondary public offering of 9,904,000 shares of our common stock at a price of
$15.50 per share.

Subsequent
to December 31, 2003, we consummated the acquisition of Chaparral for a cash purchase price of approximately $62 million plus the assumption of approximately
$4.1 million in liabilities.

For
the year ended December 31, 2003, cash provided by operating activities was $20.7 million compared to cash used in operating activities of $12.4 million for the
same period in 2002. The net cash provided by operating activities is attributable to net income of $12.1 million, a $3.8 million

36

---

decrease
in inventories, a $10.1 million increase in accounts payable, a $3.2 increase in accrued compensation and other expenses, offset by a $8.0 million increase in accounts
receivable, and a $1.6 million increase in prepaid expenses and other assets.

Cash
used in investing activities in 2003 was $55.8 million compared to cash provided by investing activities of $6.2 million for the same period in 2002. The cash used in
investing activities in 2003 resulted from a $58.4 million purchase of short-term investments, a $2.8 million purchase of property and equipment, offset by
$5.4 million for sales of short-term investments.

Cash
provided by financing activities was $163.5 million for 2003, compared to $8.4 million for 2002. The cash provided by financing activities is attributable to net
proceeds from the issuance of common stock of $161.3 million, bank and other borrowings of $45.2 million, exercises of stock options under the Company's 2000 Stock Incentive Plan and the
Company's 2000 Employee Stock Purchase Plan of $5.0 million, a decrease in restricted cash of $2.0 million, offset by payments made on bank and other borrowings of $49.8 million.

We
have an agreement with Wells Fargo Bank, National Association, which allows us to borrow up to $15.0 million under a revolving line of credit that expires May 1, 2004.
The maximum amount we may borrow under this line is limited by the amount of our cash and investment balances held at the bank at any given time and may be reduced by the amount of any outstanding
letters of credit with the bank. Borrowings under this line of credit are collateralized by a pledge of our deposits held at the bank. As of December 31, 2003, the amount available on this line
was $15.0 million. Borrowings under this line of credit incur interest at the bank's prime rate or 50 basis points above LIBOR, at our option. Each month we pay interest only on outstanding
balances, with the principal due at maturity. As of December 31, 2003, there was no balance outstanding under this line of credit.

Our
Japanese subsidiary has two lines of credit with Tokyo Mitsubishi Bank and one line of credit with National Life Finance Corporation in Japan, for borrowings of up to an aggregate of
45 million yen, or approximately $0.4 million as of December 31, 2003, at interest rates ranging from 1.7% to 1.8%. Interest is due monthly, with principal due and payable on
various dates through August 2008. Borrowings are secured by the inventories of our Japanese subsidiary. As of December 31, 2003, the total amount outstanding under the three credit
lines was approximately 26.5 million yen, or approximately $0.2 million.

For
the year ended December 31, 2003, we had cash flow from operations of $20.7 million. We presently expect cash, cash equivalents, short-term investments and
cash generated from operations to be sufficient to meet our operating and capital requirements for at least the next twelve months and to enable us to pursue acquisitions or significant capital
improvements. The actual amount and timing of working capital and capital expenditures that we may incur in future periods may vary significantly and will depend upon numerous factors, including the
amount and timing of the receipt of revenues from continued operations, our ability to manage our relationships with third party manufacturers, the status of our relationships with key customers,
partners and suppliers, the timing and extent of the introduction of new products and services and growth in personnel and operations.

The
following table summarizes our contractual obligations as of December 31, 2003 (in thousands).

|                            |       |   |       | Payments due by period
|--------------------------- | ----- | - | ----- | ----------------------
|
|Long-Term Debt Obligations  |       | $ | 247   |                       
|Operating Lease Obligations |       |   | 4,553 |                       
|                            |       |   |       |                       
|                            | Total |   | $     | 4,800                 
|                            |       |   |       |                       

37

---

Effect of Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force, or EITF, reached a consensus on Issue 00-21,Revenue Arrangements
with Multiple Deliverables. EITF Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products,
services and/or rights to use assets. The provisions of EITF Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not
expect the adoption of EITF Issue 00-21 to have a significant effect on our financial statements.

In
May 2003, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Account Standards, or SFAS, No. 150,Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is
effective for the first interim period beginning after June 15, 2003, with certain exceptions. The adoption of this statement, effective July 1, 2003, had no effect on our financial
statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate and Credit Risk

Our exposure to market rate risk for changes in interest rates relates to our investment portfolio. Our primary investment strategy is to preserve the principal
amounts invested, maximize investment yields, and maintain liquidity to meet projected cash requirements. Accordingly, we invest in instruments such as money market funds, certificates of deposit,
U.S. Government/Agencies bonds, notes, bills and municipal bonds that meet high credit quality standards, as specified in our investment policy guidelines. Our investment policy also limits the amount
of credit exposure to any one issue, issuer, and type of instrument. We do not currently use derivative financial instruments in our investment portfolio and we do not enter into market risk sensitive
instruments for trading purposes. We do not expect to incur any material losses with respect to our investment portfolio.

The
following table provides information about our investment portfolio at December 31, 2002 and 2003. For investment securities, the table presents carrying values at
December 31, and related weighted average interest rates by expected maturity dates.

December 31,2002

2003(amounts in thousands)Cash equivalents

$
10,084

$
127,790Average interest rate


3.3
%

1.0
%Short-term investments

$


$
52,982Average interest rate





1.6
%Total portfolio

$
10,084

$
180,772Average interest rate


3.3
%

1.2
%


We
have a line of credit agreement, which accrues interest at a variable rate. As of December 31, 2003, we had no balance under this line. Were we to incur a balance under this line, we
would be exposed to interest rate risk on such debt.

Foreign Currency Exchange Rate Risk

A portion of our international business is presently conducted in currencies other than the U.S. dollar. Foreign currency transaction gains and losses arising
from normal business operations are credited to or charged against earnings in the period incurred. As a result, fluctuations in the value of

38

---

the
currencies in which we conduct our business relative to the U.S. dollar will cause currency transaction gains and losses, which we have experienced in the past and continue to experience. Due to
the substantial volatility of currency exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations upon future operating results. There can be no assurances that we
will not experience currency losses in the future. We have not previously undertaken hedging transactions to cover currency exposure and we do not intend to engage in hedging activities in the future.

Item 8. Financial Statements and Supplementary Data

The information required by this Item is incorporated by reference from the financial statements beginning on page F-1 of this Annual Report on
Form 10-K.

Item 9. Changes In and Disagreements With Accountants On Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15(e)) as of the end of the period covered by this Annual Report on Form 10-K, have concluded that as of the end of such period, our disclosure controls
and procedures are adequate and sufficient to ensure that information required to be disclosed by us in the reports that we file under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in the SEC's rules and forms.

There
have been no changes in our internal controls over financial reporting during our fourth fiscal quarter of 2003 that materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.

39

---



PART III

Item 10.    Directors and Executive Officers of the Registrant

Some of the information required by this item is incorporated by reference to our Definitive Proxy Statement to be filed with the SEC pursuant to
Regulation 14A in connection with our 2004 annual meeting under the headings "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance." Other information
required by this item is incorporated by reference to Item 1 of Part I of this Annual Report on Form 10-K under the heading "Executive Officers of the Registrant at
December 31, 2003."

Item 11.    Executive Compensation

The information required by this item is incorporated by reference to our Definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A in
connection with our 2004 annual meeting under the heading "Compensation of Executive Officers."

Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information under the heading "Security Ownership of Certain Beneficial Owners and Management" in our Definitive Proxy Statement to be filed with the SEC
pursuant to Regulation 14A in connection with our 2004 annual meeting is incorporated herein by this reference.

The
following table sets forth our equity securities authorized for issuance under equity compensation plans as of December 31, 2003.

|Stock Plan                                     |  | Number of securities to be issued upon exercise of outstanding options and rights |  | Weighted average exercise price of outstanding options and rights |  | Number of securities remaining available for future issuance
|---------------------------------------------- |  | --------------------------------------------------------------------------------- |  | ----------------------------------------------------------------- |  | ------------------------------------------------------------
|2000 Equity Incentive Plan(1)                  |  | 3,030,977                                                                         |  | $4.96                                                             |  | 1,009,240                                                   
|Employee Stock Purchase Plan(2)                |  | Not Applicable                                                                    |  | Not Applicable                                                    |  | 46                                                          
|2000 Non-Employee Directors' Stock Option Plan |  | 224,750                                                                           |  | $6.74                                                             |  | 260,000                                                     
|                                               |  |                                                                                   |  |                                                                   |  |                                                             
|Total                                          |  | 3,255,727                                                                         |  | $5.08                                                             |  | 1,269,286                                                   
|                                               |  |                                                                                   |  |                                                                   |  |                                                             

---

All
of our equity compensation plans have been approved by our stockholders.

Item 13.    Certain Relationships and Related Transactions

The information required by this item is incorporated by reference to our Definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A in
connection with our 2004 annual meeting under the heading "Certain Transactions."

Item 14.    Principal Accountant Fees and Services

The information required by this item is incorporated by reference to our Definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A in
connection with our 2004 annual meeting under the heading "Ratification of Selection of Independent Auditors."

40

---



PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K







|Exhibit
Number |  | Description                                                                                                                                                                                    
|-------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1            |  | Agreement and Plan of Merger dated as of February 23, 2004, by and among the Registrant, DHSA Corp., Chaparral Network Storage, Inc., and C. Timothy Smoot, as Stockholders' Representative.(1)
|3.1            |  | Certificate of Incorporation of the Registrant.(2)                                                                                                                                             
|3.2            |  | By-laws of the Registrant.(2)                                                                                                                                                                  
|4.1            |  | Certificate of Incorporation of the Registrant.(2)                                                                                                                                             
|4.2            |  | By-laws of the Registrant.(2)                                                                                                                                                                  
|4.3            |  | Form of Common Stock Certificate.(3)                                                                                                                                                           
|4.4            |  | Certificate of Designation of Series A Junior Participating Preferred Stock, as filed with the Secretary of State of Delaware on May 19, 2003.(4)                                              
|4.5            |  | Form of Rights Certificate.(4)                                                                                                                                                                 
|4.6            |  | Warrant to Purchase Shares of Common Stock dated May 24, 2002.(5)                                                                                                                              
|4.7            |  | Common Stock Warrant dated December 19, 2002.(5)                                                                                                                                               
|4.8            |  | Warrant to Purchase Shares of Common Stock dated February 14, 2003.(5)                                                                                                                         
|4.9            |  | Common Stock Warrant dated March 14, 2003.(5)                                                                                                                                                  
|10.1           |  | Product Purchase Agreement between the Registrant and Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                                            
|10.2           |  | Product Supplement/Award Letter for Blade Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                           
|10.3           |  | Product Supplement/Award Letter for SCSI Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                            
|10.4           |  | Product Supplement/Award Letter for FC Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                              
|               |  |                                                                                                                                                                                                

41

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|10.5  |  | Employment letter agreement dated August 2, 1999 between the Registrant and James L. Lambert.(7)                                                                      
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.6  |  | Employment letter agreement dated August 2, 1999 between the Registrant and Dana W. Kammersgard.(7)                                                                   
|10.7  |  | Employment offer letter dated November 12, 1999 between the Registrant and Preston Romm.(7)                                                                           
|10.8  |  | Lease for Registrant's headquarters in Carlsbad, California, dated June 9, 1993.(5)                                                                                    
|10.9  |  | 2000 Amended and Restated Equity Incentive Plan.(8)                                                                                                                   
|10.10 |  | Form of Stock Option Agreement (Incentive and Nonstatutory Stock Options) used in connection with the 2000 Amended and Restated Equity Incentive Plan.(8)             
|10.11 |  | Form of Stock Option Grant Notice used in connection with the 2000 Amended and Restated Equity Incentive Plan.(8)                                                     
|10.12 |  | 2000 Amended and Restated Employee Stock Purchase Plan.(8)                                                                                                            
|10.13 |  | 2000 Non-Employee Directors Stock Option Plan.(9)                                                                                                                     
|10.14 |  | Form of Stock Option Agreement used in connection with the 2000 Non-Employee Directors' Stock Option Plan.(9)                                                         
|10.16 |  | Credit Agreement dated February 6, 2001 among the Registrant, Silicon Alley Management, Inc. and Wells Fargo Bank, National Association.(10)                           
|10.17 |  | Revolving Line of Credit Note dated February 6, 2001 issued by the Registrant and Silicon Alley Management, Inc. to Wells Fargo Bank, National Association.(10)        
|10.18 |  | Third Party Security Agreement dated February 6, 2001 made by the Registrant and Silicon Alley Management, Inc. in favor of Wells Fargo Bank, National Association.(10)
|10.19 |  | Manufacturing Agreement between the Registrant and Solectron Corporation, dated May 20, 2002.(11)                                                                      
|10.20 |  | OEM Agreement between the Registrant and Infortrend Technology, Inc, supplier of controllers, dated May 20, 2002.(11)                                                  
|10.21 |  | 2002 Executive Compensation Plan for James L. Lambert, effective January 1, 2002.(12)                                                                                 
|10.22 |  | 2002 Executive Compensation Plan for Dana Kammersgard, effective January 1, 2002.(13)                                                                                 
|10.23 |  | 2002 Executive Compensation Plan for Preston Romm, effective January 1, 2002.(13)                                                                                     
|10.24 |  | 2003 Executive Compensation Plan for James L. Lambert, effective January 1, 2003.(5)                                                                                  
|10.25 |  | 2003 Executive Compensation Plan for Dana Kammersgard, effective January 1, 2003.(5)                                                                                  
|10.26 |  | 2003 Executive Compensation Plan for Preston Romm, effective January 1, 2003.(5)                                                                                      
|10.27 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and James L. Lambert.(14)                                                                    
|10.28 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and Dana Kammersgard.(14)                                                                    
|10.29 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and Preston Romm.(14)                                                                        
|      |  |                                                                                                                                                                        

42

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|10.30 |  | Securities Purchase Agreement, dated as of December 18, 2002, between the Registrant and each of the purchasers listed on the signature pages thereto.(15)
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|10.31 |  | Registration Rights Agreement, dated as of December 18, 2002, between the Registrant and each of the purchasers listed on the signature pages thereto.(15)
|10.32 |  | Securities Purchase Agreement, dated as of March 11, 2003, between the Registrant and each of the purchasers listed on the signature pages thereto.(5)    
|10.33 |  | Registration Rights Agreement, dated as of March 11, 2003, between the Registrant and each of the purchasers listed on the signature pages thereto.(5)    
|10.34 |  | Registration Rights Agreement, dated as of March 4, 2003, between the Registrant and each of the individuals listed on the signature pages thereto.(5)    
|21.1  |  | Subsidiaries of the Registrant.(5)                                                                                                                        
|23.1  |  | Consent of Deloitte & Touche LLP.                                                                                                                         
|24.1  |  | Power of Attorney. Reference is made to the signature page hereto.                                                                                        
|31.1  |  | Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             
|31.2  |  | Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             
|32.1  |  | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                   

---

43

---

44

---



SIGNATURES

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

| |  | DOT HILL SYSTEMS CORP.
(Registrant)
| |  | -----------------------------------
| |  | By:                                
| |  | Date: March 15, 2004               

KNOW
ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints James L. Lambert and Preston Romm, and each of them, as his true and lawful
attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place, and stead, in any and all capacities, to sign any and all
amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection
therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming that all said attorneys-in-fact and agents, or any of them or
their or his substitute or substituted, may lawfully do or cause to be done by virtue hereof.

Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this Registration Statement has been signed below by the following persons on behalf of the Registrant
and in the capacities and on the dates indicated.

|Name                                    |  | Title                                                                                                  |  | Date          
|--------------------------------------- |  | ------------------------------------------------------------------------------------------------------ |  | --------------
|                                        |  |                                                                                                        |  |               
|/s/JAMES L. LAMBERTJames L. Lambert     |  | Chief Executive Officer, President, Chief Operating Officer and Director (Principal Executive Officer) |  | March 15, 2004
|/s/PRESTON ROMMPreston Romm             |  | Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)          |  | March 15, 2004
|/s/CHARLES CHRISTCharles Christ         |  | Chairman of the Board of Directors                                                                     |  | March 15, 2004
|/s/BENJAMIN BRUSSELLBenjamin Brussell   |  | Director                                                                                               |  | March 15, 2004
|/s/NORMAN R. FARQUHARNorman R. Farquhar |  | Director                                                                                               |  | March 15, 2004
|/s/DR. CHONG SUP PARKDr. Chong Sup Park |  | Director                                                                                               |  | March 15, 2004
|/s/W.R. SAUEYW.R. Sauey                 |  | Director                                                                                               |  | March 15, 2004

45

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|Exhibit
Number |  | Description                                                                                                                                                                                    
|-------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1            |  | Agreement and Plan of Merger dated as of February 23, 2004, by and among the Registrant, DHSA Corp., Chaparral Network Storage, Inc., and C. Timothy Smoot, as Stockholders' Representative.(1)
|3.1            |  | Certificate of Incorporation of the Registrant.(2)                                                                                                                                             
|3.2            |  | By-laws of the Registrant.(2)                                                                                                                                                                  
|4.1            |  | Certificate of Incorporation of the Registrant.(2)                                                                                                                                             
|4.2            |  | By-laws of the Registrant.(2)                                                                                                                                                                  
|4.3            |  | Form of Common Stock Certificate.(3)                                                                                                                                                           
|4.4            |  | Certificate of Designation of Series A Junior Participating Preferred Stock, as filed with the Secretary of State of Delaware on May 19, 2003.(4)                                              
|4.5            |  | Form of Rights Certificate.(4)                                                                                                                                                                 
|4.6            |  | Warrant to Purchase Shares of Common Stock dated May 24, 2002.(5)                                                                                                                              
|4.7            |  | Common Stock Warrant dated December 19, 2002.(5)                                                                                                                                               
|4.8            |  | Warrant to Purchase Shares of Common Stock dated February 14, 2003.(5)                                                                                                                         
|4.9            |  | Common Stock Warrant dated March 14, 2003.(5)                                                                                                                                                  
|10.1           |  | Product Purchase Agreement between the Registrant and Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                                            
|10.2           |  | Product Supplement/Award Letter for Blade Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                           
|10.3           |  | Product Supplement/Award Letter for SCSI Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                            
|10.4           |  | Product Supplement/Award Letter for FC Product under agreement with Sun Microsystems, Inc. dated May 24, 2002.(6)                                                                              
|10.5           |  | Employment letter agreement dated August 2, 1999 between the Registrant and James L. Lambert.(7)                                                                                              
|10.6           |  | Employment letter agreement dated August 2, 1999 between the Registrant and Dana W. Kammersgard.(7)                                                                                           
|10.7           |  | Employment offer letter dated November 12, 1999 between the Registrant and Preston Romm.(7)                                                                                                   
|10.8           |  | Lease for Registrant's headquarters in Carlsbad, California, dated June 9, 1993.(5)                                                                                                            
|10.9           |  | 2000 Amended and Restated Equity Incentive Plan.(8)                                                                                                                                           
|10.10          |  | Form of Stock Option Agreement (Incentive and Nonstatutory Stock Options) used in connection with the 2000 Amended and Restated Equity Incentive Plan.(8)                                     
|10.11          |  | Form of Stock Option Grant Notice used in connection with the 2000 Amended and Restated Equity Incentive Plan.(8)                                                                             
|10.12          |  | 2000 Amended and Restated Employee Stock Purchase Plan.(8)                                                                                                                                    
|10.13          |  | 2000 Non-Employee Directors Stock Option Plan.(9)                                                                                                                                             
|               |  |                                                                                                                                                                                                

46

---

|10.14 |  | Form of Stock Option Agreement used in connection with the 2000 Non-Employee Directors' Stock Option Plan.(9)                                                         
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.16 |  | Credit Agreement dated February 6, 2001 among the Registrant, Silicon Alley Management, Inc. and Wells Fargo Bank, National Association.(10)                           
|10.17 |  | Revolving Line of Credit Note dated February 6, 2001 issued by the Registrant and Silicon Alley Management, Inc. to Wells Fargo Bank, National Association.(10)        
|10.18 |  | Third Party Security Agreement dated February 6, 2001 made by the Registrant and Silicon Alley Management, Inc. in favor of Wells Fargo Bank, National Association.(10)
|10.19 |  | Manufacturing Agreement between the Registrant and Solectron Corporation, dated May 20, 2002.(11)                                                                      
|10.20 |  | OEM Agreement between the Registrant and Infortrend Technology, Inc, supplier of controllers, dated May 20, 2002.(11)                                                  
|10.21 |  | 2002 Executive Compensation Plan for James L. Lambert, effective January 1, 2002.(12)                                                                                 
|10.22 |  | 2002 Executive Compensation Plan for Dana Kammersgard, effective January 1, 2002.(13)                                                                                 
|10.23 |  | 2002 Executive Compensation Plan for Preston Romm, effective January 1, 2002.(13)                                                                                     
|10.24 |  | 2003 Executive Compensation Plan for James L. Lambert, effective January 1, 2003.(5)                                                                                  
|10.25 |  | 2003 Executive Compensation Plan for Dana Kammersgard, effective January 1, 2003.(5)                                                                                  
|10.26 |  | 2003 Executive Compensation Plan for Preston Romm, effective January 1, 2003.(5)                                                                                      
|10.27 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and James L. Lambert.(14)                                                                    
|10.28 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and Dana Kammersgard.(14)                                                                    
|10.29 |  | Change of Control Agreement dated August 23, 2001 between the Registrant and Preston Romm.(14)                                                                        
|10.30 |  | Securities Purchase Agreement, dated as of December 18, 2002, between the Registrant and each of the purchasers listed on the signature pages thereto.(15)             
|10.31 |  | Registration Rights Agreement, dated as of December 18, 2002, between the Registrant and each of the purchasers listed on the signature pages thereto.(15)             
|10.32 |  | Securities Purchase Agreement, dated as of March 11, 2003, between the Registrant and each of the purchasers listed on the signature pages thereto.(5)                 
|10.33 |  | Registration Rights Agreement, dated as of March 11, 2003, between the Registrant and each of the purchasers listed on the signature pages thereto.(5)                 
|10.34 |  | Registration Rights Agreement, dated as of March 4, 2003, between the Registrant and each of the individuals listed on the signature pages thereto.(5)                 
|21.1  |  | Subsidiaries of the Registrant.(5)                                                                                                                                     
|23.1  |  | Consent of Deloitte & Touche LLP.                                                                                                                                      
|24.1  |  | Power of Attorney. Reference is made to the signature page hereto.                                                                                                     
|      |  |                                                                                                                                                                        

47

---

|31.1 |  | Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------
|31.2 |  | Certification pursuant to 17 CFR 240.13a-14(a) or 17 CFR 240.15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|32.1 |  | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                      

---

48

---



INDEX TO FINANCIAL STATEMENTS

|                                                                                                                        |  | Page
|----------------------------------------------------------------------------------------------------------------------- |  | ----
|INDEPENDENT AUDITORS' REPORT                                                                                            |  | F-1 
|FINANCIAL STATEMENTS:                                                                                                   |  |     
|Consolidated balance sheets as of December 31, 2002 and 2003                                                            |  | F-2 
|Consolidated statements of operations and comprehensive operations for the years ended December 31, 2001, 2002 and 2003 |  | F-3 
|Consolidated statements of stockholders' equity for the years ended December 31, 2001, 2002 and 2003                    |  | F-4 
|Consolidated statements of cash flows for the years ended December 31, 2001, 2002 and 2003                              |  | F-5 
|Notes to consolidated financial statements for the years ended December 31, 2001, 2002 and 2003                         |  | F-7 
|Independent Auditors' Report                                                                                            |  | S-1 
|Schedule IIValuation and Qualifying Accounts                                                                           |  | S-2 

49

---



INDEPENDENT AUDITORS' REPORT

Board
of Directors and Stockholders
Dot Hill Systems Corp.

We
have audited the accompanying consolidated balance sheets of Dot Hill Systems Corp. and subsidiaries (the "Company") as of December 31, 2002 and 2003, and the related
consolidated statements of operations and comprehensive operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial
statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We
conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Dot Hill Systems Corp. and subsidiaries as of
December 31, 2002 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States of America.

/s/
DELOITTE & TOUCHE LLP

San
Diego, California
March 4, 2004

F-1

---



DOT HILL SYSTEMS CORP. AND SUBSIDIARIES        CONSOLIDATED BALANCE SHEETS        AS OF DECEMBER 31, 2002 AND 2003        (In Thousands, Except Per Share Amounts)

|                                              |                                                                                                                                                                    | 2002                                       |       | 2003     |       
|--------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ----- | -------- | ------
|ASSETS                                        |                                                                                                                                                                    |                                            |       |          |       
|CURRENT ASSETS:                               |                                                                                                                                                                    |                                            |       |          |       
|                                              | Cash and cash equivalents                                                                                                                                          |                                            | $     | 10,082   |       
|                                              | Restricted cash                                                                                                                                                    |                                            |       | 2,000    |       
|                                              | Short-term investments                                                                                                                                             |                                            |       |         |       
|                                              | Accounts receivable, net of allowance of $751 and $467                                                                                                             |                                            |       | 6,304    |       
|                                              | Inventories                                                                                                                                                        |                                            |       | 6,959    |       
|                                              | Prepaid expenses and other                                                                                                                                         |                                            |       | 1,802    |       
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total current assets                       |       |          | 27,147
|PROPERTY AND EQUIPMENT, net                   |                                                                                                                                                                    |                                            | 4,110 |          |       
|OTHER ASSETS                                  |                                                                                                                                                                    |                                            | 971   |          |       
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total assets                               |       | $        | 32,228
|                                              |                                                                                                                                                                    |                                            |       |          |       
|LIABILITIES AND STOCKHOLDERS' EQUITY          |                                                                                                                                                                    |                                            |       |          |       
|CURRENT LIABILITIES:                          |                                                                                                                                                                    |                                            |       |          |       
|                                              | Accounts payable                                                                                                                                                   |                                            | $     | 14,446   |       
|                                              | Accrued compensation                                                                                                                                               |                                            |       | 1,754    |       
|                                              | Accrued expenses                                                                                                                                                   |                                            |       | 1,614    |       
|                                              | Deferred revenue                                                                                                                                                   |                                            |       | 1,110    |       
|                                              | Income taxes payable                                                                                                                                               |                                            |       | 1,020    |       
|                                              | Short-term debt                                                                                                                                                    |                                            |       | 4,552    |       
|                                              | Current portion of restructuring accrual                                                                                                                           |                                            |       | 407      |       
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total current liabilities                  |       |          | 24,903
|RESTRUCTURING ACCRUAL, net of current portion |                                                                                                                                                                    |                                            | 1,179 |          |       
|BORROWINGS UNDER LINES OF CREDIT              |                                                                                                                                                                    |                                            | 275   |          |       
|Other long-term liabilities                   |                                                                                                                                                                    |                                            | 86    |          |       
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total liabilities                          |       |          | 26,443
|                                              |                                                                                                                                                                    |                                            |       |          |       
|COMMITMENTS AND CONTINGENCIES (Note 15)       |                                                                                                                                                                    |                                            |       |          |       
|STOCKHOLDERS' EQUITY:                         |                                                                                                                                                                    |                                            |       |          |       
|                                              | Preferred stock, $.001 par value, 10,000 shares authorized, 6 and 0 shares issued and outstanding at December 31, 2002 and December 31, 2003, respectively         |                                            |       |         |       
|                                              | Common stock, $.001 par value, 100,000 shares authorized, 25,172 and 43,307 shares issued and outstanding at December 31, 2002 and December 31, 2003, respectively |                                            |       | 25       |       
|                                              | Additional paid-in capital                                                                                                                                         |                                            |       | 109,562  |       
|                                              | Deferred compensation                                                                                                                                              |                                            |       | (48      | )     
|                                              | Accumulated other comprehensive loss                                                                                                                               |                                            |       | (318     | )     
|                                              | Accumulated deficit                                                                                                                                                |                                            |       | (103,436 | )     
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total stockholders' equity                 |       |          | 5,785 
|                                              |                                                                                                                                                                    |                                            |       |          |       
|                                              |                                                                                                                                                                    | Total liabilities and stockholders' equity |       | $        | 32,228
|                                              |                                                                                                                                                                    |                                            |       |          |       

See accompanying notes to consolidated financial statements.

F-2

---



DOT HILL SYSTEMS CORP. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS        FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003        (In
Thousands, Except Per Share Amounts)

|                                                                       |                                                       | 2001 |         | 2002    |   | 2003    |        
|---------------------------------------------------------------------- | ----------------------------------------------------- | ---- | ------- | ------- | - | ------- | -------
|NET REVENUE                                                            |                                                       | $    | 56,277  |         | $ | 46,936  |        
|COST OF GOODS SOLD                                                     |                                                       |      | 44,818  |         |   | 45,444  |        
|                                                                       |                                                       |      |         |         |   |         |        
|GROSS PROFIT                                                           |                                                       |      | 11,459  |         |   | 1,492   |        
|                                                                       |                                                       |      |         |         |   |         |        
|OPERATING EXPENSES:                                                    |                                                       |      |         |         |   |         |        
|Sales and marketing                                                    |                                                       |      | 23,717  |         |   | 22,513  |        
|Research and development                                               |                                                       |      | 6,673   |         |   | 10,043  |        
|General and administrative                                             |                                                       |      | 4,533   |         |   | 5,150   |        
|Restructuring expenses                                                 |                                                       |      | 4,905   |         |   | 1,550   |        
|                                                                       |                                                       |      |         |         |   |         |        
|                                                                       | Total operating expenses                              |      |         | 39,828  |   |         | 39,256 
|                                                                       |                                                       |      |         |         |   |         |        
|OPERATING INCOME (LOSS)                                                |                                                       |      | (28,369 | )       |   | (37,764 | )      
|                                                                       |                                                       |      |         |         |   |         |        
|OTHER INCOME (EXPENSE):                                                |                                                       |      |         |         |   |         |        
|Interest income                                                        |                                                       |      | 1,013   |         |   | 410     |        
|Interest expense                                                       |                                                       |      | (107    | )       |   | (248    | )      
|Gain on foreign currency transactions, net                             |                                                       |      | 52      |         |   | 143     |        
|Other income (expense), net                                            |                                                       |      | (657    | )       |   | 39      |        
|                                                                       |                                                       |      |         |         |   |         |        
|                                                                       | Total other income, net                               |      |         | 301     |   |         | 344    
|                                                                       |                                                       |      |         |         |   |         |        
|INCOME (LOSS) BEFORE INCOME TAXES                                      |                                                       |      | (28,068 | )       |   | (37,420 | )      
|INCOME TAX BENEFIT (EXPENSE)                                           |                                                       |      | (15,323 | )       |   | 3,117   |        
|                                                                       |                                                       |      |         |         |   |         |        
|NET INCOME (LOSS)                                                      |                                                       | $    | (43,391 | )       | $ | (34,303 | )      
|                                                                       |                                                       |      |         |         |   |         |        
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS:                 |                                                       |      |         |         |   |         |        
|Net income (loss)                                                      |                                                       | $    | (43,391 | )       | $ | (34,303 | )      
|Dividends on preferred stock                                           |                                                       |      |        |         |   | (16     | )      
|Beneficial conversion feature of preferred stock                       |                                                       |      |        |         |   | (440    | )      
|                                                                       |                                                       |      |         |         |   |         |        
|                                                                       | Net income (loss) attributable to common stockholders |      | $       | (43,391 | ) | $       | (34,759
|                                                                       |                                                       |      |         |         |   |         |        
|NET INCOME (LOSS) PER SHARE:                                           |                                                       |      |         |         |   |         |        
|Basic                                                                  |                                                       | $    | (1.76   | )       | $ | (1.39   | )      
|                                                                       |                                                       |      |         |         |   |         |        
|Diluted                                                                |                                                       | $    | (1.76   | )       | $ | (1.39   | )      
|                                                                       |                                                       |      |         |         |   |         |        
|WEIGHTED AVERAGE SHARES USED TO CALCULATE NET INCOME (LOSS) PER SHARE: |                                                       |      |         |         |   |         |        
|Basic                                                                  |                                                       |      | 24,703  |         |   | 24,953  |        
|                                                                       |                                                       |      |         |         |   |         |        
|Diluted                                                                |                                                       |      | 24,703  |         |   | 24,953  |        
|                                                                       |                                                       |      |         |         |   |         |        
|COMPREHENSIVE OPERATIONS:                                              |                                                       |      |         |         |   |         |        
|Net income (loss)                                                      |                                                       | $    | (43,391 | )       | $ | (34,303 | )      
|Foreign currency translation adjustments                               |                                                       |      | (138    | )       |   | 36      |        
|Net unrealized gain (loss) on short-term investments                   |                                                       |      | 150     |         |   | (150    | )      
|                                                                       |                                                       |      |         |         |   |         |        
|                                                                       | Comprehensive income (loss)                           |      | $       | (43,379 | ) | $       | (34,417
|                                                                       |                                                       |      |         |         |   |         |        

See
accompanying notes to consolidated financial statements.

F-3

---



DOT HILL SYSTEMS CORP. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003        (In Thousands)

|                                                                      |  | Preferred
Stock |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|--------------------------------------------------------------------- |  | --------------- | - | - | - |  | ------ |  | - | ---- | - | - | ------- | - | - | --- | -
|
|
|
|Balance, January 1, 2001                                              |  |                |   | $ |  |  | 24,608 |  | $ | 246  |   | $ | 99,026  |   | $ |    |  
|Adjustment for change in par value of common stock                    |  |                 |   |   |   |  |        |  |   | (223 | ) |   | 223     |   |   |     |  
|Exercise of stock options                                             |  |                 |   |   |   |  | 64     |  |   | 1    |   |   | 57      |   |   |     |  
|Sale of common stock under employee stock purchase plan               |  |                 |   |   |   |  | 119    |  |   | 1    |   |   | 161     |   |   |     |  
|Foreign currency translation adjustment                               |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Unrealized gain on short-term investments                             |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Net loss                                                              |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|                                                                      |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Balance, December 31, 2001                                            |  |                |   |   |  |  | 24,791 |  |   | 25   |   |   | 99,467  |   |   |    |  
|Issuance of stock warrant                                             |  |                 |   |   |   |  |        |  |   |      |   |   | 3,647   |   |   |     |  
|Issuance of stock under deferred compensation arrangement             |  |                 |   |   |   |  | 15     |  |   |      |   |   | 60      |   |   | (60 | )
|Amortization of deferred compensation                                 |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   | 12  |  
|Issuance of stock options to non-employees                            |  |                 |   |   |   |  |        |  |   |      |   |   | 25      |   |   |     |  
|Issuance of preferred stock and stock warrants, net of issuance costs |  | 6               |   |   |   |  |        |  |   |      |   |   | 5,406   |   |   |     |  
|Beneficial conversion feature of preferred stock                      |  |                 |   |   |   |  |        |  |   |      |   |   | 440     |   |   |     |  
|Dividends on preferred stock                                          |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Exercise of stock options                                             |  |                 |   |   |   |  | 21     |  |   |      |   |   | 40      |   |   |     |  
|Sale of common stock under employee stock purchase plan               |  |                 |   |   |   |  | 345    |  |   |      |   |   | 477     |   |   |     |  
|Foreign currency translation adjustment                               |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Unrealized loss on short-term investments                             |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Net loss                                                              |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|                                                                      |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Balance, December 31, 2002                                            |  | 6               |   |   |  |  | 25,172 |  |   | 25   |   |   | 109,562 |   |   | (48 | )
|Conversion of preferred stock to common stock                         |  | (6              | ) |   |  |  | 1,846  |  |   | 2    |   |   | (2      | ) |   |     |  
|Issuance of common stock and stock warrant, net of issuance costs     |  |                 |   |   |   |  | 14,654 |  |   | 15   |   |   | 161,268 |   |   |     |  
|Amortization of deferred compensation                                 |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   | 20  |  
|Dividends on preferred stock                                          |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Exercise of stock options and warrant                                 |  |                 |   |   |   |  | 1,111  |  |   | 1    |   |   | 4,240   |   |   |     |  
|Sale of common stock under employee stock purchase plan               |  |                 |   |   |   |  | 524    |  |   |      |   |   | 759     |   |   |     |  
|Foreign currency translation adjustment                               |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Net unrealized gain on short-term investments                         |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Net income                                                            |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|                                                                      |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  
|Balance, December 31, 2003                                            |  |                |   | $ |  |  | 43,307 |  | $ | 43   |   | $ | 275,827 |   | $ | (28 | )
|                                                                      |  |                 |   |   |   |  |        |  |   |      |   |   |         |   |   |     |  

See accompanying notes to consolidated financial statements.

F-4

---



DOT HILL SYSTEMS CORP. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF CASH FLOWS        FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003        (In Thousands)

|                                                                                                   |                                                                                     | 2001 |         | 2002    |   | 2003    |        
|-------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ---- | ------- | ------- | - | ------- | -------
|Cash Flow From Operating Activities:                                                               |                                                                                     |      |         |         |   |         |        
|Net income (loss)                                                                                  |                                                                                     | $    | (43,391 | )       | $ | (34,303 | )      
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |                                                                                     |      |         |         |   |         |        
|                                                                                                   | Depreciation and amortization                                                       |      |         | 1,550   |   |         | 1,463  
|                                                                                                   | Loss on disposal of property and equipment                                          |      |         |        |   |         | 329    
|                                                                                                   | Impairment of property and equipment                                                |      |         | 1,357   |   |         |       
|                                                                                                   | Provision for doubtful accounts and note receivable                                 |      |         | (151    | ) |         | 1,018  
|                                                                                                   | Deferred income taxes                                                               |      |         | 18,423  |   |         |       
|                                                                                                   | Stock-based sales and marketing expenses                                            |      |         |        |   |         | 3,647  
|                                                                                                   | Stock-based compensation expenses                                                   |      |         |        |   |         | 25     
|                                                                                                   | Amortization of deferred compensation                                               |      |         |        |   |         | 12     
|                                                                                                   | (Gain) loss on sale of short-term investments                                       |      |         |        |   |         | (71    
|Changes in operating assets and liabilities:                                                       |                                                                                     |      |         |         |   |         |        
|                                                                                                   | Accounts receivable                                                                 |      |         | 11,294  |   |         | 1,973  
|                                                                                                   | Inventories                                                                         |      |         | 10,233  |   |         | 6,917  
|                                                                                                   | Prepaid expenses and other assets                                                   |      |         | (504    | ) |         | 161    
|                                                                                                   | Note receivable                                                                     |      |         | (1,242  | ) |         | 115    
|                                                                                                   | Accounts payable                                                                    |      |         | (12,582 | ) |         | 9,225  
|                                                                                                   | Accrued compensation and other expenses                                             |      |         | (638    | ) |         | (616   
|                                                                                                   | Deferred revenue                                                                    |      |         | (1,425  | ) |         | (331   
|                                                                                                   | Income taxes payable                                                                |      |         | (123    | ) |         | (2,246 
|                                                                                                   | Restructuring accrual                                                               |      |         | 1,241   |   |         | 345    
|                                                                                                   | Other liabilities                                                                   |      |         | (146    | ) |         | (27    
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|Net cash provided by (used in) operating activities                                                |                                                                                     |      | (16,104 | )       |   | (12,364 | )      
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|Cash Flows From Investing Activities:                                                              |                                                                                     |      |         |         |   |         |        
|                                                                                                   | Purchases of property and equipment                                                 |      |         | (1,468  | ) |         | (2,388 
|                                                                                                   | Proceeds from sale of property and equipment                                        |      |         |        |   |         |       
|                                                                                                   | Sales of short-term investments                                                     |      |         |        |   |         | 8,637  
|                                                                                                   | Purchases of short-term investments                                                 |      |         | (8,522  | ) |         | (44    
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|Net cash provided by (used in) investing activities                                                |                                                                                     |      | (9,990  | )       |   | 6,205   |        
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|Cash Flows From Financing Activities:                                                              |                                                                                     |      |         |         |   |         |        
|                                                                                                   | Proceeds from exercise of stock options and warrants                                |      |         | 58      |   |         | 40     
|                                                                                                   | Proceeds from sale of stock to employees                                            |      |         | 162     |   |         | 477    
|                                                                                                   | Proceeds from bank and other borrowings                                             |      |         | 11,531  |   |         | 35,505 
|                                                                                                   | Payments on bank and other borrowings                                               |      |         | (11,387 | ) |         | (31,008
|                                                                                                   | (Increase) decrease in restricted cash                                              |      |         |        |   |         | (2,000 
|                                                                                                   | Proceeds from issuance of common stock and stock warrant, net of issuance costs     |      |         |        |   |         |       
|                                                                                                   | Proceeds from issuance of preferred stock and stock warrants, net of issuance costs |      |         |        |   |         | 5,406  
|                                                                                                   | Dividends paid to preferred stockholders                                            |      |         |        |   |         |       
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|Net cash provided by financing activities                                                          |                                                                                     |      | 364     |         |   | 8,420   |        
|                                                                                                   |                                                                                     |      |         |         |   |         |        
|                                                                                                   |                                                                                     |      |         |         |   |         |        

F-5

---

|Effect of Exchange Rate Changes on Cash                    |                                                              |   | (138    | )  |   | 36     |     |   | 30      |   
|---------------------------------------------------------- | ------------------------------------------------------------ | - | ------- | -- | - | ------ | --- | - | ------- | --
|                                                           |                                                              |   |         |    |   |        |    
|Net Increase (Decrease) in Cash and Cash Equivalents       |                                                              |   | (25,868 | )  |   | 2,297  |     |   | 128,481 |   
|Cash and Cash Equivalents, beginning of year               |                                                              |   | 33,653  |    |   | 7,785  |     |   | 10,082  |   
|                                                           |                                                              |   |         |    |   |        |    
|Cash and Cash Equivalents, end of year                     |                                                              | $ | 7,785   |    | $ | 10,082 |     | $ | 138,563 |   
|                                                           |                                                              |   |         |    |   |        |    
|Supplemental Disclosures of Cash Flow Information:         |                                                              |   |         |    |   |        |     |   |         |   
|                                                           | Cash paid for interest                                       |   | $       | 65 |   | $      | 194 |   | $       | 91
|                                                           |                                                              |   |         |    |   |        |    
|                                                           | Cash paid for income taxes                                   |   | $       | 28 |   | $      | 107 |   | $       | 99
|                                                           |                                                              |   |         |    |   |        |    
|Supplemental Disclosures of Non-Cash Financing Activities: |                                                              |   |         |    |   |        |     |   |         |   
|                                                           | Dividends payable on preferred stock                         |   | $       |   |   | $      | 16  |   | $       |  
|                                                           |                                                              |   |         |    |   |        |    
|                                                           | Value of conversion discount for convertible preferred stock |   | $       |   |   | $      | 440 |   | $       |  
|                                                           |                                                              |   |         |    |   |        |    
|                                                           | Stock issued under deferred compensation arrangement         |   | $       |   |   | $      | 60  |   | $       |  
|                                                           |                                                              |   |         |    |   |        |    
|                                                           | Conversion of preferred stock to common stock                |   | $       |   |   | $      |    |   | $       | 2 
|                                                           |                                                              |   |         |    |   |        |    

See accompanying notes to consolidated financial statements.

F-6

---



DOT HILL SYSTEMS CORP.        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 and 2003

1. Background and Summary of Significant Accounting Policies

Background

Dot Hill Systems Corp. ("we," "our" or "us") is a provider of enterprise storage for organizations requiring high reliability, high performance networked storage
and data management solutions in an open systems architecture. Our storage solutions consist of integrated hardware and software products employing a modular, building block approach to meet customer
needs. Our broad range of products, from medium capacity stand-alone storage units to complete turn-key, multi-terabyte storage area networks, provides end-users with a
cost-effective means of addressing increasing storage demands without sacrificing carrier class performance. Our integrated technology has been distinguished by certification as NEBS Level
3 and is MIL STD-810F compliant based on its ruggedness and reliability.

Historically,
we relied mainly on direct sales to customers in an array of markets, including the government and telecommunications. Beginning in 2001, we shifted our sales and marketing
efforts away from direct sales toward indirect sales through channel partners. These channel partners either incorporate our products into their own, private-label products or sell our products off
the shelf. During 2002, we began outsourcing the manufacturing of our next-generation family of
disk systemsSANnet II. We also have sales offices in the United States, Germany, Japan, the Netherlands, Singapore and the United Kingdom.

Basis of Presentation

On August 2, 1999, Box Hill Systems Corp. and Artecon, Inc. completed a merger, or the Merger, in which the two companies were merged in a
tax-free, stock-for-stock transaction. The merger was accounted for using the pooling-of-interests method. We are the result of that merger.
Subsequent to the merger, we changed our name to Dot Hill Systems Corp.

Principles of Consolidation

The accompanying consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries. All significant intercompany
transactions and balances have been eliminated in consolidation.

Use of Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents

Cash and cash equivalents include highly liquid investments purchased with an original maturity of three months or less. Cash equivalents consist principally of
money market funds, market auction rate securities, and repurchase agreements.

F-7

---

Short-term Investments

We account for investments in accordance with Statement of Financial Accounting Standards, or SFAS, No. 115,Accounting for Certain
Investments in Debt and Equity Securities. Short-term investments have been categorized as available for sale and, as a result, are stated at fair value. Unrealized
gains and losses on available-for-sale securities are included as a separate component of stockholders' equity.

Accounts Receivable

The allowance for doubtful accounts receivable represents management's estimate of potential loss on the accounts receivable balance. The estimate for accounts
receivable is calculated using a percentage based on historical write-offs and recoveries. In addition, we also estimate potential losses for specific accounts.

Inventories

Inventories are comprised of purchased parts and assemblies, which include direct labor and overhead, and are valued at the lower of cost (first-in,
first-out) or market value. We perform periodic valuation assessments based on projected sales forecasts and analyzing upcoming changes in future configurations of our products and record
inventory reserves for excess and obsolete inventory. We use certain of our inventory items internally and also provide select customers with the use of certain inventory items on a temporary test
basis. The carrying value of these items is reduced to market through a monthly charge to expense until they are returned to inventory, which is generally within twelve months.

Property and Equipment

Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets
(two to seven years). Leasehold improvements are amortized on a straight-line basis over the lesser of the remaining term of the lease or the estimated useful life of the asset.
Significant improvements are capitalized and expenditures for maintenance and repairs are charged to expense as incurred.

Deferred Compensation

Deferred compensation represents the unearned value of a common stock bonus given to an employee. In accordance with Accounting Principles Board, or APB, Opinion
No. 25, we recorded deferred compensation for the value of the common stock at the date of issuance and are amortizing the balance over the vesting period of the award, which is three years.

Fair Value of Financial Instruments

Pursuant to SFAS No. 107,Disclosure About Fair Value of Financial Instruments, we are required to estimate
the fair value of all financial instruments included on our balance sheets. We consider the carrying value of our financial instruments, including cash and cash equivalents, restricted cash,
short-term investments, accounts receivable, accounts payable, accrued expenses and short-term debt to approximate their fair value due to the relatively short period of time
between origination of the

F-8

---

instruments
and their expected realization. The carrying value of the lines of credit approximate their fair value based on the terms and rates available to us for similar instruments.

Long-Lived Assets

We account for the impairment and disposition of long-lived assets in accordance with SFAS No. 144,Accounting for the
Impairment or Disposal of Long-Lived Assets.We periodically review the recoverability of the carrying value of long-lived assets for impairment
whenever events or changes in circumstances indicate that their carrying value may not be recoverable. Recoverability of these assets is determined by analysis of the assets' fair value by comparing
the forecasted future undiscounted net cash flows from operations to which the assets relate, based on our best estimates using the appropriate assumptions and projections at the time, to the carrying
amount of the assets. If the carrying value is determined not to be recoverable from future operating cash flows, the assets are deemed impaired and an impairment loss is recognized equal to the
amount by which the carrying amount exceeds the estimated fair value of the assets. During the year ended December 31, 2001, we recognized an impairment of certain long-lived assets
in connection with restructuring activities (Note 4). Based on our most recent analysis, we believe that no additional impairment exists at December 31, 2003.

Revenue Recognition

We recognize revenue for non-software product sales upon transfer of title to the customer. Reductions to revenue for estimated sales returns are also
recorded at that time. These estimates are based on historical sales returns, changes in customer demand and other factors. If actual future returns and allowances differ from past experience,
additional allowances may be required. Certain of our sales arrangements include multiple elements. Generally, these arrangements include delivery of the product, installation, training and product
maintenance. Maintenance related to product sales entitles the customer to basic product support and significantly greater response time in resolving warranty related issues. We allocate revenue to
each element of the arrangement based on its relative fair value. For maintenance contracts this is typically the price charged when such contracts are sold separately or renewed. Because professional
services related to installation and training can be provided by other third party organizations, we allocate revenue related to professional services based on rates that are consistent with other
like companies providing similar services, i.e., the market rate for such services. Revenue from product maintenance contracts is deferred and recognized ratably over the contract term, generally
twelve months. Revenue from installation, training and consulting is recognized as the services are performed.

For
software sales, we apply Statement of Position No. 97-2,Software Revenue Recognition, whereby revenue is
recognized from software licenses at the time the product is delivered, provided we have no significant obligations related to the sale, the resulting receivable is deemed collectible and there is
vendor-specific objective evidence supporting the value of the separate contract elements. For arrangements with multiple elements, we allocate revenue to each element using the residual method based
on vendor specific objective evidence of the undelivered items. A portion of the arrangement fee equal to the fair value of the undelivered elements, typically software maintenance contracts, is
deferred and recognized ratably over the contract term, generally twelve months. Vendor specific

F-9

---

objective
evidence is based on the price charged when the element is sold separately. A typical arrangement includes a software licensing fee and maintenance agreement.

The
cost of maintenance contracts entered into with third parties is deferred and recognized as expense over the contract term. At December 31, 2002 and 2003, the balance of
deferred costs for maintenance contracts was $0.7 million and $0.1 million, respectively, and is included in prepaid expenses and other current assets.

Product Warranties

We generally extend to our customers the warranties provided to us by our suppliers and, accordingly, the majority of our warranty obligations to customers are
covered by supplier warranties. For warranty costs not covered by our suppliers, we provide for estimated warranty costs in the period the revenue is recognized. There can be no assurance that our
suppliers will continue to provide such warranties to us in the future, which could have a material adverse effect on our operating results and financial condition. Our warranty cost activity for the
years ended December 31 is as follows:

|Accrued Warranty Costs |  | Balance at
Beginning of
Year |     | Charged to
Operations |   | Deductions for
Costs Incurred |  | Deductions for
Change in
Estimates |        | Balance at
End of Year
|---------------------- |  | ---------------------------- | --- | --------------------- | - | ----------------------------- |  | ---------------------------------- | ------ | ----------------------
|
|2003                   |  | $                            | 336 |                       | $ | 876                           |  | $                                  | (876   | )                     
|2002                   |  |                              | 316 |                       |   | 1,202                         |  |                                    | (1,182 | )                     
|2001                   |  |                              | 316 |                       |   | 1,221                         |  |                                    | (1,221 | )                     

Advertising Costs

We expense advertising costs as incurred. For the years ended December 31, 2001, 2002 and 2003, advertising expenses were $1.5 million,
$1.2 million and $0.3 million, respectively.

Research and Development

Research and development costs are expensed as incurred. In conjunction with the development of our products, we incur certain software development costs. No
costs have been capitalized pursuant to SFAS No. 86,Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,
because the period between achieving technological feasibility and completion of such software is relatively short and software development costs qualifying for capitalization have been insignificant.

Stock-Based Compensation

We have two stock-based compensation plans, which are described more fully in Note 12. SFAS No. 123,Accounting for
Stock-Based Compensation,encourages, but does not require us to record compensation cost for stock-based employee compensation plans at fair value. We have chosen to continue
to account for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25,Accounting for Stock Issued to
Employees,and related interpretations for all periods presented. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of our
stock at the date of grant over the amount an employee must pay to acquire the stock.

F-10

---

Had
compensation cost for our stock option awards been determined based upon the fair value at the date of grant, in accordance with SFAS No. 123, our net income (loss) and basic
and diluted net income (loss) per share would have been adjusted to the following amounts for the years ended December 31:

2001

2002

2003(net income (loss) amounts in thousands)Net income (loss) attributable to common stockholders as reported

$
(43,391
)
$
(34,759
)
$
11,990Total stock-based employee compensation expense determined under fair value based method for all awards


(2,351
)

(2,201
)

(7,047
)Pro forma net income (loss) attributable to common stockholders

$
(45,742
)
$
(36,960
)
$
4,943Basic net income (loss) per share:As reported

$
(1.76
)
$
(1.39
)
$
0.35Pro forma

$
(1.85
)
$
(1.48
)
$
0.15Diluted net income (loss) per share:As reported

$
(1.76
)
$
(1.39
)
$
0.31Pro forma

$
(1.85
)
$
(1.48
)
$
0.13


We
account for stock options granted to non-employees using the fair value method. Compensation expense for options granted to non-employees has been determined
in accordance with Emerging Issues Task Force, or EITF, No. 96-18,Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services,as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more
reliably measured. Compensation expense for options granted to non-employees is periodically remeasured as the underlying options vest and is recorded as expense and deferred compensation
in the financial statements.

Foreign Currency Transactions and Translation

A portion of our international business is presently conducted in currencies other than the U.S. dollar. Foreign currency transaction gains and losses arising
from normal business operations are included in current period earnings. As a result, fluctuations in the value of the currencies in which we conduct our
business relative to the U.S. dollar will cause currency transaction gains and losses, which we have experienced in the past and continue to experience. Due to the substantial volatility of currency
exchange rates, among other factors, we cannot predict the effect of exchange rate fluctuations upon future operating results. We have not previously undertaken hedging transactions to cover currency
exposure and do not intend to engage in hedging activities in the future.

The
functional currency of each of our foreign subsidiaries is the local currency and accordingly, assets and liabilities are translated into U.S. dollars at year-end
exchange rates; revenues and expenses,

F-11

---

and
gains and losses are translated at rates of exchange that approximate the rates in effect on the transaction date. Resulting remeasurement gains and losses are recognized as a component of other
comprehensive income.

Income Taxes

We record deferred income taxes to reflect temporary differences between the reporting of income for financial statement and tax reporting purposes. Measurement
of the deferred income tax items is based on enacted tax laws and rates. In the event the future consequences of differences between financial reporting bases and tax bases of our assets and
liabilities result in a deferred income tax asset, an evaluation is performed to determine the probability we will be able to realize the future benefits of such asset. A valuation allowance related
to a deferred income tax asset is recorded when it is considered more likely than not that some portion or all of the deferred income tax asset will not be realized.

Net Income (Loss) Per Share

Basic net income (loss) per share is calculated by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares
outstanding during the period.

Diluted
net income (loss) per share reflects the potential dilution of securities by including common stock equivalents, such as stock options, stock warrants and convertible preferred
stock, in the weighted average number of common shares outstanding for a period, if dilutive.

The
following table sets forth a reconciliation of the basic and diluted number of weighted average shares outstanding used in the calculation of net income (loss) per share for the
years ended December 31:

2001

2002

2003(in thousands)Weighted average shares used to calculate basic net income (loss) per share

24,703

24,953

33,856Dilutive effect of stock options and stock warrants





3,696Dilutive effect of convertible preferred stock





612Weighted average shares used to calculate diluted net income (loss) per share

24,703

24,953

38,164


As
of December 31, 2001, options to purchase 3,285,293 shares of common stock with exercise prices ranging from $0.50 to $15.94 per share were outstanding, but were not included
in the calculation of diluted net loss per share because their effect was antidilutive.

As
of December 31, 2002, options to purchase 3,670,843 shares of common stock with exercise prices ranging from $0.50 to $15.94 per share and warrants to purchase 1,727,568 shares
of common stock with exercise prices ranging from $2.97 to $3.25 per share were outstanding, but were not included in the calculation of diluted net loss per share because their effect was
antidilutive.

F-12

---

Additionally,
preferred stock convertible into 1,846,152 shares of common stock has also been excluded from the calculation of diluted net loss per share because its effect was antidilutive.

As
of December 31, 2003, options to purchase 100,716 shares of common stock with exercise prices ranging from $11.30 to $16.46 per share were outstanding, but were not included in
the calculation of diluted net income per share because their effect was antidilutive.

Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force, or EITF, reached a consensus on Issue 00-21,Revenue Arrangements
with Multiple Deliverables. EITF Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products,
services and/or rights to use assets. The provisions of EITF Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not
expect the adoption of this statement, effective January 1, 2004, to have a significant effect on our financial statements.

In
May 2003, the Financial Accounting Standards Board, or FASB, issued SFAS No. 150,Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the first
interim period beginning after June 15, 2003, with certain exceptions. The adoption of this statement, effective July 1, 2003, had no effect on our financial statements.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

2. Risks and Uncertainties

General Business Risks and Uncertainties

Our future results of operations involve a number of risks and uncertainties. Management believes the factors that could affect our future operating results and
cause actual results to differ materially from expectations include, but are not limited to, dependence on new products, dependence on a limited number of suppliers of high quality components,
reliance on a limited number of principal customers, dependence on a third party manufacturer, the integration of the business and technology of Chaparral Network Storage, Inc., or Chaparral,
recently acquired by us, a recent shift in our sales and marketing strategy from direct sales to indirect sales through channel partners, difficulties in managing growth, difficulties in attracting
and retaining qualified personnel, competition, competitive pricing, dependence on key personnel, enforcement of our intellectual property rights, intellectual property claims made by third parties
upon us, dependence on a limited number of production facilities, global economic conditions, the lengthening of sales cycles, and an uneven pattern of quarterly results.

F-13

---

Concentration of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of trade accounts receivable. We do not require collateral or
other securities to support customer receivables. A majority of our net revenue is derived from a limited number of customers. For the year ended December 31, 2001, sales to one customer
accounted for approximately 15%. For the years ended 2002 and 2003, sales to another customer accounted for approximately 25%, and 83%, respectively. For the year ended December 31, 2001, our
accounts receivable from one customer was approximately 16%. For the year ended December 31, 2002, our accounts receivable from two customers were approximately 11% and 43%. For the year ended
December 31, 2003, our accounts receivable from two customers were 12% and 56%. Generally, our customers have no minimum purchase requirements and have certain rights to extend, delay or cancel
shipment of their orders without penalty.

Cash and Cash Equivalents Concentrations

The Federal Deposit Insurance Corporation, or FDIC, insures a corporation's funds deposited in a bank up to a maximum of $0.1 million in the event of a
bank failure. As of December 31, 2003, our cash and cash equivalents held exceeded the FDIC insured amount by approximately $138.5 million. We have not experienced any losses in relation
to cash and cash equivalents in excess of FDIC insurance limits.

Foreign Sales

The following table summarizes foreign sales by geographic region as a percentage of net revenue for the years ended December 31:

2001

2002

2003Europe

22.2
%
18.4
%
4.9
%Asia

7.9

6.5

1.7Other

0.5

1.8

.3Total foreign sales

30.6
%
26.7
%
6.9
%


Dependence on Suppliers

We rely on other companies to supply certain key components of our products and products that we resell. Many of these components and third-party products are
available only from limited sources in the quantities and quality demanded by us. Our third party contract manufacturers are responsible for purchasing and obtaining supplies.

We
have outsourced the manufacture of substantially all of our products to a single manufacturer. Approximately 32% and 93% of our total raw material purchases for the years ended
December 31, 2002 and 2003, respectively, were from this manufacturer. If our relationship with this manufacturer terminates, it could take several months to establish alternative manufacturing
for these products and we may not be able to fulfill orders for these products in a timely manner, which would have a material

F-14

---

adverse
effect on our financial condition and operating results. Under an OEM agreement with a significant customer, this customer has the right to require that we use a third party to manufacture
product. Such an external manufacturer must meet this customer's engineering, qualification and logistics requirements. If our relationship with the current manufacturer terminates, we may be unable
to find another suitable external manufacturer, which would have a material adverse effect on our financial condition and operating results.

With
respect to certain components, such as disk drives and controllers, if our third party manufacturer had to seek alternative sources of supply, the incorporation of such components
from alternative suppliers and the manufacture and shipment of product could be delayed while modifications to such products and the accompanying software were made to accommodate the introduction of
the alternative suppliers' components. We estimate that replacing the controllers that we currently use with those of another supplier would involve several months of hardware and software
modification, which would have a material adverse effect on our financial condition and operating results.

3. Comprehensive Operations

Our accumulated other comprehensive loss balance consists of foreign currency translation adjustments and unrealized gains and losses on securities. Changes in
the accumulated other comprehensive loss balance for the years ended December 31, 2001, 2002 and 2003 are detailed as follows:

(in thousands)Balance, January 1, 2001

$
(216
)Foreign currency translation adjustment


(138
)Unrealized gain on short-term investments


150Balance, December 31, 2001


(204
)Foreign currency translation adjustment


36Unrealized loss on short-term investments


(150
)Balance, December 31, 2002


(318
)Foreign currency translation adjustment


30Net unrealized gain on short-term investments


25Balance, December 31, 2003

$
(263
)


4. Restructuring Costs and Asset Writedowns

In March 2001, we announced plans to reduce our full-time workforce by up to 30% and reduce other expenses in response to delays in customer
orders, lower than expected revenues and slowing global market conditions. The cost reduction actions were designed to reduce our breakeven point in light of an economic downturn. The cost reductions
resulted in a charge for employee severance, lease

F-15

---

termination
costs and other office closure expenses related to the consolidation of excess facilities. We recorded restructuring expenses in the first quarter of 2001 of approximately
$2.9 million, as follows:

(in thousands)Employee termination costs

$
1,271Impairment of property and equipment


1,007Facility closures and related costs


637Professional fees and other


20Total

$
2,935


In
June 2001, we announced plans to further reduce our full-time workforce by up to 17% and reduce other expenses in response to a continuing economic downturn and
overall decrease in revenue. As a result of these additional restructuring actions, we recorded additional restructuring expenses during the second quarter of 2001 of approximately
$1.5 million, as follows:

(in thousands)Employee termination costs

$
259Impairment of property and equipment


350Facility closures and related costs


861Total

$
1,470


Employee
termination costs consist primarily of severance payments for 180 employees. Impairment of property and equipment consists of the write-down of certain fixed assets
associated with
facility closures. The facility closures and related costs consist of lease termination costs for five sales offices and closure of our New York City office.

During
the fourth quarter of 2001, we increased our March 2001 related restructuring accrual by approximately $0.2 million and our June 2001 Restructuring accrual by
approximately $0.3 million restructuring accrual due to the continuing deterioration of various real estate markets and the inability to sublet excess space in our Carlsbad and New York City
facilities.

During
the fourth quarter of 2002, we again increased our March 2001 related restructuring accrual by approximately $0.7 million and our June 2001 Restructuring
accrual by approximately $0.9 million to reflect additional deterioration of real estate markets in Carlsbad and New York City, as well as the effects of lease buyouts negotiated on several
other facilities and a sublease arrangement reached on another facility.

F-16

---

The
following is a summary of restructuring activity recorded during the years ended December 31, 2002 and 2003:

March 2001 Restructuring

|                                     |  | Restructuring
Expenses in
2001 |       | Amounts
Utilized
in
2001 |   | Accrued
Restructuring
Expenses at
December 31,
2001 |   | Additional
Restructuring
Expenses in
2002 |     | Amounts
Utilized
in
2002 |   | Accrued
Restructuring
Expenses at
December 31,
2002 |  | Amounts
Utilized
in
2003 |      | Accrued
Restructuring
Expenses at
December 31,
2003
|------------------------------------ |  | ------------------------------ | ----- | ------------------------ | - | --------------------------------------------------- | - | ----------------------------------------- | --- | ------------------------ | - | --------------------------------------------------- |  | ------------------------ | ---- | ---------------------------------------------------
|
|Employee termination costs           |  | $                              | 1,271 |                          | $ | (1,269                                              | ) | $                                         | 2   |                          | $ |                                                    |  | $                        | (2   | )                                                  
|Impairment of property and equipment |  |                                | 1,007 |                          |   | (1,007                                              | ) |                                           |    |                          |   |                                                    |  |                          |     |                                                    
|Facility closures and related costs  |  |                                | 792   |                          |   | (398                                                | ) |                                           | 394 |                          |   | 693                                                 |  |                          | (426 | )                                                  
|Professional fees and other          |  |                                | 20    |                          |   | (20                                                 | ) |                                           |    |                          |   |                                                    |  |                          |     |                                                    
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                     |  |                          |      |                                                    
|Total                                |  | $                              | 3,090 |                          | $ | (2,694                                              | ) | $                                         | 396 |                          | $ | 693                                                 |  | $                        | (428 | )                                                  
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                     |  |                          |      |                                                    

June 2001 Restructuring

|                                     |  | Restructuring
Expenses in
2001 |       | Amounts
Utilized
in
2001 |   | Accrued
Restructuring
Expenses at
December 31,
2001 |   | Additional
Restructuring
Expenses in
2002 |     | Amounts
Utilized
in
2002 |   | Accrued
Restructuring
Expenses at
December 31,
2002 |  | Amounts
Utilized
in
2003 |      | Accrued
Restructuring
Expenses at
December 31,
2003
|------------------------------------ |  | ------------------------------ | ----- | ------------------------ | - | --------------------------------------------------- | - | ----------------------------------------- | --- | ------------------------ | - | --------------------------------------------------- |  | ------------------------ | ---- | ---------------------------------------------------
|
|Employee termination costs           |  | $                              | 259   |                          | $ | (259                                                | ) | $                                         |    |                          | $ |                                                    |  | $                        |     |                                                    
|Impairment of property and equipment |  |                                | 350   |                          |   | (350                                                | ) |                                           |    |                          |   |                                                    |  |                          |     |                                                    
|Facility closures and related costs  |  |                                | 1,206 |                          |   | (361                                                | ) |                                           | 845 |                          |   | 857                                                 |  |                          | (777 | )                                                  
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                     |  |                          |      |                                                    
|Total                                |  | $                              | 1,815 |                          | $ | (970                                                | ) | $                                         | 845 |                          | $ | 857                                                 |  | $                        | (777 | )                                                  
|                                     |  |                                |       |                          |   |                                                     |   |                                           |     |                          |   |                                                     |  |                          |      |                                                    

We believe that there are no unresolved issues or additional liabilities that may result in a significant adjustment to restructuring expenses
accrued as of December 31, 2003.

5. Short-Term Investments and Restricted Cash

As of December 31, 2002, restricted cash consisted entirely of a $2.0 million letter of credit that expired on January 31, 2003.

F-17

---

The
following table summarizes our short-term investments as of December 31, 2003:

Cost

Net
Unrealized
Losses

Net
Unrealized
Gains

Fair
Value(in thousands)U.S. Government securities

$
37,286

$
71

$
49

$
37,264Municipal securities and private debt obligation


5,200





5


5,205Commercial paper


10,471





42


10,513$
52,957

$
71

$
96

$
52,982


The
cost and fair value of short-term investments at December 31, 2003 by contractual maturity are shown below. Expected maturities will differ from contractual
maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.

Cost

Fair Value(in thousands)Due in one year or less

$
25,441

$
25,425Due after one year through five years


22,316


22,352Due after five years through ten years





Due after ten years


5,200


5,205$
52,957

$
52,982


As
of December 31, 2002, we did not have any securities classified as short-term investments.

F-18

---



6. Inventories

Inventories consist of the following at December 31:

2002

2003(in thousands)Purchased parts and materials

$
4,509

$
1,706Work-in-process


120


24Finished goods


2,330


1,428Total inventory

$
6,959

$
3,158


7. Property and Equipment

Property and equipment consist of the following at December 31:

2002

2003(in thousands)Machinery and equipment

$
7,395

$
10,016Furniture, fixtures, and computer equipment


668


753Leasehold improvements


603


560Total property and equipment, at cost


8,666


11,329Less accumulated depreciation


(4,556
)

(6,538
)Total property and equipment, net

$
4,110

$
4,791


Depreciation
expense was $1.4 million, $1.5 million and $2.0 million for the years ended December 31, 2001, 2002 and 2003, respectively.

8. Credit Facilities

Japanese Yen Facilities

Our Japanese subsidiary has two lines of credit with Tokyo Mitsubishi Bank, a Japanese bank, and one line of credit with National Life Finance Corporation in
Japan, for borrowings up to an aggregate of 45 million Yen (approximately US $0.4 million at December 31, 2003). At December 31, 2002 and 2003, 33 million Yen
(approximately US $0.3 million) and 26.5 million Yen (approximately US $0.2 million), respectively, were outstanding under these lines of credit. Borrowings under these lines of
credit incur interest at a fixed rate ranging from 1.8% to 2.6% and 1.7% to 1.8% as of December 31, 2002 and 2003, respectively. Interest is due monthly, with the principal due on various dates
through August 2008. Borrowings under these lines of credit are collateralized by inventories of the Japanese subsidiary.

Line of Credit

We have an agreement with Wells Fargo Bank, National Association which provides for borrowings of up to $15.0 million under a revolving line of credit that
expires on May 1, 2004. The maximum amount we may borrow under the line of credit is limited by the amount of our cash and investment balances held at the bank at any given time and may be
reduced by the amount of any outstanding

F-19

---

letters
of credit with the bank. Borrowings under the facility are collateralized by a pledge of our deposits held at the bank. As of December 31, 2003, the amount available under this facility
was $15.0 million. Borrowings under the line of credit incur interest at the bank's prime rate or 50 basis points above LIBOR, at our option. Interest on outstanding borrowings is due monthly,
with the principal due at maturity. As of December 31, 2002 and 2003, there was no balance outstanding under this line of credit.

Short-Term Debt

On October 24, 2002, we entered into a loan and security agreement with a customer, pursuant to which this customer loaned us approximately
$4.5 million. The loan was secured by all of our assets. The funds were to enable us to design and deliver storage products under an OEM agreement, and for other working capital and general
corporate purposes, subject to certain limitations. The loan carries an interest rate of 2% per annum, compounded daily. As of December 31, 2002, there was approximately $4.5 million
outstanding under this agreement. The amount outstanding was fully repaid during 2003 and the loan and security agreement was terminated.

In
accordance with this loan and security agreement, we agreed to obtain the consent of the customer prior to entering into any private equity issuances. Prior to the 2002 sale of the
convertible preferred stock (see Note 11), we obtained the consent of the customer by issuing them a warrant to purchase 154,752 shares of our common stock at a price of $3.25 per share.

9. Income Taxes

Components of the income tax benefit (provision) are as follows for the years ended December 31:

2001

2002

2003(in thousands)Current:Federal

$
3,178

$
3,531

$
(60
)State, local and foreign


(101
)

(423
)

(28
)3,077


3,108


(88
)Deferred:Federal


5,922


7,778


3,306State, local and foreign


2,322


3,294


(2,546
)8,244


11,072


760Increases in deferred income tax asset valuation allowance


(26,644
)

(11,063
)

(760
)Total income tax benefit (provision)

$
(15,323
)
$
3,117

$
(88
)


F-20

---

A
reconciliation of the federal statutory income tax rate and the effective income tax rate is as follows for the years ended December 31:

2001

2002

2003Federal statutory rate

(35.0
)%
(35.0
)%
35.0
%Increase (decrease) in deferred income tax asset valuation allowance

95.0

29.6

(38.7
)State and local income taxes, net of federal effect

(5.0
)
(5.3
)
5.8Foreign taxes

0.9

1.4

(1.2
)Tax credit carryforwards and other

(1.3
)
1.0

(0.2
)Effective income tax rate

54.6
%
(8.3
)%
0.7
%


The
income tax effect of temporary differences that give rise to deferred income taxes are as follows at December 31:

2002

2003(in thousands)Deferred income tax assets:Net operating loss and tax credit carryforwards

$
32,218

$
36,405Inventory reserve and uniform capitalization


6,197


2,754Stock warrants


1,605


1,532Restructuring accrual


698


388In-process research and development


552


472Acquisition costs


365


128Allowance for bad debts


327


113Vacation accrual


213


233Acquired intangibles


189


162Warranty accrual


147


110Other accruals and reserves





227Total deferred income tax assets


42,511


42,524Deferred income tax liabilities:State taxes


(3,459
)

(2,593
)Depreciation and amortization


(435
)

(717
)Other


(421
)

(258
)Total deferred income tax liabilities


(4,315
)

(3,568
)Deferred income tax asset valuation allowance


(38,196
)

(38,956
)Net deferred income tax balance

$


$



As
of December 31, 2003, a valuation allowance of approximately $39.0 million has been provided based upon our assessment of the future realizability of our deferred income
tax assets, as it is more likely than not that sufficient taxable income will not be generated to realize these temporary differences.

F-21

---

Additionally,
at December 31, 2003, approximately $4.2 million of the valuation allowance is attributable to the potential tax benefit of stock option transactions that
will be credited directly to common stock, if realized.

As
of December 31, 2003, we have federal and state net operating loss carryforwards of approximately $80.7 million and $53.8 million, which begin to expire in 2009
and 2004, respectively. In addition, we have federal tax credit carryforwards of approximately $2.4 million, of which $0.2 million can be carried forward indefinitely to offset future
taxable income, and the remaining $2.2 million will begin to expire in 2008. We also have state tax credit carryforwards of $2.3 million, of which $2.1 million can be carried
forward indefinitely to offset future taxable income, and the remaining $0.2 million will begin to expire in 2006.

As
a result of our equity transactions, an ownership change, within the meaning of Internal Revenue Code, or IRC, Section 382, occurred on September 18, 2003. As a result,
annual use of our federal net operating loss and credit carry forwards is limited to (i) the aggregate fair market value of Artecon immediately before the ownership change multiplied by
(ii) the long-term tax-exempt rate (within the meaning of IRC Section 382 (f)) in effect at that time. The annual limitation is cumulative and, therefore, if not
fully utilized in a year, can be utilized in future years in addition to the Section 382 limitation for those years.

We
have not provided for any residual U.S. income taxes on the earnings from our foreign subsidiaries because such earnings are intended to be indefinitely reinvested. Such residual U.S.
income taxes, if any, would be insignificant.

10. Stockholders' Equity

Increase in Authorized Common Shares

In May 2002, our board of directors authorized an increase of 573,505 shares of our common stock issuable pursuant to our 2000 Amended and Restated Equity
Incentive Plan and 100,000 shares of our common stock issuable pursuant to our 2000 Amended and Restated Employee Stock Purchase Plan. This increase in shares became effective on the date of the 2002
Annual Stockholders Meeting, which was held May 14, 2002.

In
May 2003, our board of directors authorized an increase of 758,029 shares of our common stock issuable pursuant to our 2000 Amended and Restated Equity Incentive Plan and
100,000 shares of our common stock issuable pursuant to our 2000 Amended and Restated Employee Stock Purchase Plan. This increase in shares became effective on the date of the 2003 Annual Stockholders
Meeting, which was held May 6, 2003.

Common Stock Issuances

During March 2003, we raised net proceeds of approximately $16.5 million in a private placement of 4,750,000 shares of our common stock at a price
of $3.75 per share. The shares in the private placement were sold at a price per share that was approximately 14% less than the five-day volume weighted average price of our common stock.
We agreed to sell the shares in the private placement at a discount to the market price because the purchasers could not resell the shares to the public until the

F-22

---

resale
was registered. In connection with the private placement, we granted a warrant to the placement agent to purchase 183,000 shares of our common stock for $4.50 per share. The warrant was
recorded as a cost of the stock issuance.

During
September 2003 we received net proceeds of approximately $144.8 million from a secondary public offering of 9,904,000 shares of our common stock at a price of $15.50
per share.

Stockholders Rights Plan

On May 19, 2003 we adopted a plan to provide certain rights to our stockholders, or a rights plan. Terms of the rights plan provide for a dividend
distribution of one preferred share purchase right for each outstanding share of our common stock. The dividend was payable on May 30, 2003 to our stockholders of record on that date. Each such
purchase right entitles the registered holder to purchase one one-hundredth of a share of our Series A Junior Participating Preferred Stock at a price of $50.00, subject to
adjustment. Each one one-hundredth of a share of this series of preferred stock has designations and powers, preferences and rights, and qualifications, limitations and restrictions that
make its value approximately equal to the value of one share of our common stock.

11. Preferred Stock

On December 18, 2002, we received gross proceeds of $6.0 million from the sale of 6,000 shares of preferred stock and warrants in a private
placement. The preferred stock carried a 7% cumulative dividend. On May 2, 2003, we converted all of the outstanding shares of preferred stock into 1,846,152 shares of our common stock at a per
share price of $3.25. The warrants granted to the holders of the preferred stock entitle them to purchase an aggregate of 369,229 shares of our common stock at a per share price of $3.25. The warrants
terminate upon the earlier of December 19, 2007 or our consummation of certain acquisition transactions.

The
warrants issued to the purchasers of the preferred stock were assigned a value of $845,902 using the Black Scholes valuation model. The remaining gross proceeds of $5,154,098 were
allocated to the preferred stock. Based on the amount allocated to the preferred stock, a beneficial conversion amount of $439,748 resulted, which has been recorded as a dividend.

In
connection with the sale of the preferred stock, we issued a warrant, to the placement agent in the transaction, to purchase up to 118,812 shares of our common stock for $3.25 per
share. The warrant was recorded as a cost of the stock issuance.

12. Stock Options and Warrants

Stock Incentive Plan

Our 2000 Amended and Restated Equity Incentive Plan, or Incentive Plan, provides for the granting of incentive and nonqualified stock options to employees. Our
2000 Non-Employee Stock Option Plan, or Directors' Plan, adopted in March 2000 provides for the granting of nonqualified stock options to non-employee directors. We
currently have reserved 6,266,938 and 500,000 shares of common stock for issuance pursuant to the Incentive Plan and the Directors' Plan, respectively. The

F-23

---

terms
and conditions of grants of stock options are determined by our board of directors in accordance with the terms of the Incentive Plan and Directors' Plan.

Information
with respect to options under the Incentive Plan and Directors' Plan, as restated for the combination with Artecon's stock option plan, is as follows:

Number of
Shares

Weighted Average
Exercise PriceBALANCE, January 1, 2001

2,767,938

$
5.49Grants

1,580,200


2.26Forfeitures

(998,947
)

5.26Exercises

(63,898
)

0.91BALANCE, December 31, 2001

3,285,293


4.09Grants

868,996


2.79Forfeitures

(462,269
)

3.58Exercises

(21,177
)

1.89BALANCE, December 31, 2002

3,670,843


3.86Grants

961,000


7.81Forfeitures

(296,280
)

3.35Exercises

(1,079,836
)

3.83BALANCE, December 31, 2003

3,255,727

$
5.08


The
options generally vest ratably over a four or five year period and are exercisable over a period of ten years from the date of grant.

Information
with respect to options outstanding under the Incentive Plan and Directors' Plan at December 31, 2003 is as follows:

|                |  | Options Outstanding |  |      |  |  
|--------------- |  | ------------------- |  | ---- |  | -
|
|
|
|$0.75 - $  1.75 |  | 183,144             |  | 7.67 |  | $
|$1.89 - $  2.10 |  | 524,440             |  | 7.56 |  |  
|$2.25 - $  2.95 |  | 924,058             |  | 8.73 |  |  
|$3.15 - $  5.38 |  | 516,442             |  | 7.17 |  |  
|$5.40 - $  5.50 |  | 248,260             |  | 5.84 |  |  
|$6.00 - $16.46  |  | 859,383             |  | 7.83 |  |  
|                |  |                     |  |      |  |  
|                |  | 3,255,727           |  | 7.77 |  | $
|                |  |                     |  |      |  |  

As
of December 31, 2001 and 2002, approximately 896,000 and 1,598,000 options were exercisable at a weighted average exercise price of $5.98 and $4.98 respectively.

F-24

---

The
pro forma compensation costs presented in Note 1 were determined using the weighted average fair values, at the date of grant, for options granted during the years ended
December 31, 2001, 2002 and 2003 of $1.93, $2.40 and $5.87 per share, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing
model with the following weighted average assumptions for the years ended December 31:

2001

2002

2003Risk free interest

4.5%

3.0%

2.9%Expected dividend yield





Expected life

5 years

5 years

5 yearsExpected volatility

100%

105%

82%


Warrants

As of December 31, 2003, there were outstanding warrants to purchase 2,034,551 shares of our common stock. The warrants have exercise prices ranging from
$2.97 to $4.50 per share and expire at various dates through March 14, 2008.

On
May 24, 2002, we granted an OEM customer a warrant to purchase 1,239,527 shares of our common stock at $2.97 per share in connection with the signing of a product supply
agreement. The warrant was fully vested upon issuance and became exercisable for 413,175 shares at signing, becomes exercisable for 413,176 additional shares on May 24, 2003 and 2004 and
expires on May 24, 2007. The fair value of the warrant, determined using the Black-Scholes option pricing model, was $3.7 million. The warrant was issued to induce the customer to
purchase our products in the future and was not issued in consideration of any past transactions. As we received no consideration for the issuance of the warrant and the customer has no requirement to
purchase any products from us, the $3.7 million value of the warrant was included in sales and marketing expense during the year ended December 31, 2002.

13. Related Party Transactions

Revenues from sales to affiliated companies for the years ended December 31, 2001, 2002 and 2003 were approximately $1,000, $0 and $0, respectively.
Purchases from affiliated companies for the years ended December 31, 2001, 2002 and 2003 were approximately $19,000, $0 and $15,000, respectively.

14. Employee Benefit Plans

Dot Hill Retirement Savings Plan

Effective December 1, 2000, we adopted a new retirement savings plan titled the Dot Hill Retirement Savings Plan, which combined and replaced the Box Hill
and Artecon retirement savings plans. This plan, which qualifies under Section 401(k) of the Internal Revenue Code, is open to eligible employees over 21 years of age. Under the plan,
participating U.S. employees may defer up to 20% of their pretax salary, but not more than statutory limits. We may match 50% of participating employees' contributions up to a specified limit
($1,000). Our matching contributions vest to employees as a percentage based on years of employment from one to five years, and matching contributions are fully

F-25

---

vested
to employees after five years of employment. Our matching contributions to the new retirement savings plan for the years ended December 31, 2001, 2002 and 2003 were approximately
$0.1 million, $0, and $0.1 million, respectively.

Employee Stock Purchase Plan

Our Employee Stock Purchase Plan (the "Purchase Plan") was adopted in August 1997, and amended and restated in March 2000. The Purchase Plan
qualifies under the provisions of Section 423 of the Internal Revenue Code and provides our eligible employees, as defined in the Purchase Plan with an opportunity to purchase shares of our
common stock at 85% of fair market value, as defined. We have reserved 1,050,000 shares of common stock for issuance pursuant to the Purchase Plan. During the years ended December 31, 2001,
2002 and 2003 approximately 119,000, 345,000 and 524,000 shares, respectively, were issued under the Purchase Plan.

15. Commitments and Contingencies

Operating Leases

We lease office space and equipment under noncancelable operating leases, which expire at various dates through September 2009. Rent expense for the years
ended December 31, 2001, 2002 and 2003 was $1.5 million, $1.0 million and $0.9 million, respectively.

Future
minimum lease payments due under all noncancelable operating leases as of December 31, 2003 are as follows (in thousands):

2004

$
1,6772005


1,5592006


7472007


4892008


40Thereafter


41Total minimum lease payments

$
4,553


The
above minimum lease payments include minimum rental commitments totaling $3.1 million that have been included in the restructuring accrual as of December 31, 2003.
Minimum payments for operating leases have not been reduced by minimum sublease rentals of $2.9 million due in the future under non-cancelable subleases.

Employment Agreements

In connection with the Merger, effective August 2, 1999 we adopted employment contracts with two of our executive officers. These contracts provide for
base salaries totaling $600,000 per year. In addition, each executive was eligible to receive, at the discretion of our board of directors, a cash bonus of up to 50% of such executives' then annual
base salary. The employment contracts may be terminated at our option or at the executive's option "for cause," or, upon 30 days written notice, for convenience and "without cause." If we
terminate for convenience, the executive is entitled to a severance payment

F-26

---

equal
to their then-current annual base salary. Following termination of employment other than due to death or disability, we may hire the executive as a consultant for a period of one
year at a cost of 25% of the executive's then current annual base salary.

In
August 2001, the Company entered into change of control agreements with three of its executive officers. Under one of the agreements, in the event of an acquisition of the
Company or similar corporate event, referred to hereafter as a change of control, the executive officer's remaining stock options will become fully vested and the executive officer will be entitled to
a lump sum cash payment equal to 150% of annual base salary then in effect. Under the second agreement, if the executive officer's employment is terminated other than for cause in connection with a
change of control, the remaining unvested stock options will become fully vested and the executive officer will be entitled to a lump sum cash payment of 125% of annual base salary then in effect.
Under the third agreement, in the event of a change of control, the executive officer's remaining unvested stock options will become fully vested and the executive officer will be entitled to a lump
sum cash payment equal to 125% of annual base salary then in effect.

Effective
April 1, 2002, we entered into a change of control agreement with an additional executive. Under the agreement, in the event of a change of control, the executive's
remaining unvested stock options will become fully vested and the executive will be entitled to a lump sum cash payment equal to 125% of annual base salary then in effect.

Effective
January 1, 2003, we adopted the Executive Compensation Plan 2003 (the "Plan") for four of our executives. The terms of the Plan are in addition to the terms of these
executive's employment contracts. The Plan provides for annual performance bonus potential of 50% of base salary for three of the executives and 75% of base salary for the remaining executive. The
formula for the annual bonus calculation is as follows: 70% of bonus potential is tied to our annual operating plan. Of this 70% bonus potential, half is based on meeting revenue goals and half is
based on meeting certain net income goals. If we attain less than 85% of revenue and net income goals, this 70% bonus potential will not be paid. For each 1% increase above 85% of the revenue and net
income goals, a bonus equal to 3.3% of the annual performance bonus potential will be paid, with no cap. The remaining 30% of bonus potential is subjective, with 20% being tied to individual goals and
performance and 10% being based on our performance with respect to the management of our working capital and cash flow. For
the year ended December 31, 2003, the bonus payable under the Plan is approximately $2.8 million and is included in accrued compensation at December 31, 2003. The executive compensation
plan for 2004 has not yet been completed.

Celtic Capital Corporation Litigation

We were subject to a legal action first filed by Celtic Capital Corporation, or Celtic, against us on April 24, 2001 in the Superior Court of the State of
California and later amended. The plaintiffs alleged violations of the California Commercial Code and breach of contract among other commercial claims. We responded to the action by asserting numerous
defenses and by filing a cross-complaint against National Manufacturing Technology, Inc. and affiliates (Celtic's assignors) and Epitech, Inc., or the Cross-Defendants, asserting various
commercial claims including breach of contract. Defense costs, and other amounts incurred in connection with the Celtic litigation, were expensed as incurred.

F-27

---

On
April 3, 2002, the parties reached a settlement agreement in the Celtic litigation. Under the settlement agreement, we paid Celtic $350,000 on April 5, 2002 and made
payments of $60,000 per month from May 1, 2002 through September 1, 2002. The final payment of $75,000 was made on October 1, 2002 and the action has now been finalized. We
recorded the expense related to this settlement agreement, totaling $725,000, in other expenses for the year ended December 31, 2001. In exchange for the foregoing, Celtic completely released
us from all claims and causes of action related to the complaint. We also received from the Cross-Defendants a global release of all claims, and all goods, work-in-process and
inventory in the possession of the Cross-Defendants, which was in any way related to our purchase orders. In exchange, we released the Cross-Defendants from all claims and causes of action related to
the cross-complaint.

Crossroads Systems Litigation

On October 17, 2003, Crossroads Systems, or Crossroads, filed a lawsuit against us in the United States District Court in Austin, Texas, alleging that our
products infringe two United States patents assigned to Crossroads, Patent Numbers 5,941,972 and 6,425,035. We were served with the lawsuit on October 27, 2003. Chaparral was added as a party
to the lawsuit in March 2004. The patents involve storage routers and methods for providing virtual local storage. Patent Number 5,941,972 involves the interface of SCSI storage devices and the
Fibre Channel protocol and Patent Number 6,425,035 involves the interface of any one transport medium and a second transport medium. We believe that we have meritorious defenses to Crossroads' claims
and are in the process of vigorously defending against them. We believe that the outcome will not have a material adverse effect on our financial condition or operating results. However, we expect to
incur significant legal expenses in connection with this litigation. These defense
costs, and other expenses related to this litigation, will be expensed as incurred and will negatively affect our operating results.

Other Litigation

We are involved in certain other legal actions and claims arising in the ordinary course of business. Management believes that the outcome of such other
litigation and claims will not have a material adverse effect on our financial condition or operating results.

16. Segment and Geographic Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief
operating decision-maker in deciding how to allocate resources and in assessing performance. Our chief operating decision-maker is the Chief Executive Officer. Our operating segments are managed
separately because each segment represents a strategic business unit that offers different products or services.

Our
operating segments are organized on the basis of products and services. We have identified operating segments that consist of our SANnet family of systems, legacy and other systems
and services. We currently evaluate performance based on stand-alone segment revenue and gross margin. Because we do not currently maintain information regarding operating income at the operating
segment level, such information is not presented.

F-28

---

We
previously also maintained and disclosed information by market segment, which consisted of e-commerce, telecommunications and service providers; government; and commercial
and other customers. In 2001, we began to focus on indirect sales through channel partners regardless of the market segment served by those channel partners. In May 2002, we signed a key
agreement with a particular channel partner, which partner began to ship product to its own customers during October 2002. Sales to that channel partner accounted for approximately 62% of our
net revenue during the fourth quarter of 2002 and approximately 83% of our net revenue for the year ended December 31, 2003. We have limited visibility into the type of market segments to which
that channel partner, and many other channel partners, sell, and therefore we have no way to identify or track net revenue generated by those channel partners by market segment. Going forward, we
expect sales to channel partners to increase. Therefore, we have ceased to disclose information by market segment.

Information
concerning revenue by product and service is as follows:

|                              |  | SANet Families |         | Legacy and
Other |   | Services |   | Total
|----------------------------- |  | -------------- | ------- | ---------------- | - | -------- | - | -----
|
|Year ended December 31, 2001: |  |                |         |                  |   |          |   |      
|Net revenue                   |  | $              | 27,494  |                  | $ | 23,475   |   | $    
|                              |  |                |         |                  |   |          |   |      
|Gross profit                  |  | $              | 4,042   |                  | $ | 6,102    |   | $    
|                              |  |                |         |                  |   |          |   |      
|Year ended December 31, 2002: |  |                |         |                  |   |          |   |      
|Net revenue                   |  | $              | 35,328  |                  | $ | 8,503    |   | $    
|                              |  |                |         |                  |   |          |   |      
|Gross profit (loss)           |  | $              | (1,895  | )                | $ | 2,861    |   | $    
|                              |  |                |         |                  |   |          |   |      
|Year ended December 31, 2003: |  |                |         |                  |   |          |   |      
|Net revenue                   |  | $              | 179,061 |                  | $ | 5,044    |   | $    
|                              |  |                |         |                  |   |          |   |      
|Gross profit (loss)           |  | $              | 47,379  |                  | $ | (3,467   | ) | $    
|                              |  |                |         |                  |   |          |   |      

Information
concerning operating assets by product and service, derived by specific identification for assets related to specific segments and an allocation based on segment volume for
assets related to multiple segments, is as follows:

|       |                   | SANnet
Families |   | Legacy and
Other |  | Services |       | Total
|------ | ----------------- | --------------- | - | ---------------- |  | -------- | ----- | -----
|
|As of: |                   |                 |   |                  |  |          |       |      
|       | December 31, 2003 |                 | $ | 207,686          |  | $        | 6,553 |      
|       |                   |                 |   |                  |  |          |       |      
|       | December 31, 2002 |                 | $ | 23,590           |  | $        | 3,033 |      
|       |                   |                 |   |                  |  |          |       |      

F-29

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Information
concerning principal geographic areas in which we operate is as follows:

As of and for the Year Ended December 31,2001

2002

2003(in thousands)Net revenue:United States

$
39,332

$
35,268

$
175,233Europe


12,511


8,615


9,120Asia


4,434


3,053


3,095$
56,277

$
46,936

$
187,448Income (loss) before income taxes:United States

$
(26,425
)
$
(36,575
)
$
11,022Europe


(1,634
)

(528
)

943Asia


(9
)

(317
)

254$
(28,068
)
$
(37,420
)
$
12,219Assets:United States




$
29,453

$
213,027Europe





2,123


4,196Asia





652


1,220$
32,228

$
218,443


Net
revenue is recorded in the geographic area in which the sale is originated.

F-30

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17. Quarterly Financial Information (Unaudited)

The information presented below reflects all adjustments, which, in the opinion of management, are of a normal and recurring nature, except per share amounts,
necessary to present fairly the results of operations for the periods presented.

|                                                      |  | First
Quarter |        | Second
Quarter |   | Third
Quarter |   | Fourth
Quarter |       
|----------------------------------------------------- |  | ------------- | ------ | -------------- | - | ------------- | - | -------------- | ------
|
|Year Ended December 31, 2002:                         |  |               |        |                |   |               |   |                |       
|Net revenue                                           |  | $             | 10,890 |                | $ | 11,206        |   | $              | 8,584 
|Gross profit (loss)                                   |  |               | 2,364  |                |   | 273           |   |                | 868   
|Loss before income taxes                              |  |               | (6,180 | )              |   | (12,182       | ) |                | (7,282
|Net loss                                              |  |               | (6,180 | )              |   | (8,882        | ) |                | (7,280
|Net loss attributable to common stockholders          |  |               | (6,180 | )              |   | (8,882        | ) |                | (7,280
|Basic and diluted net loss per share                  |  |               | (0.25  | )              |   | (0.36         | ) |                | (0.29 
|Year Ended December 31, 2003:                         |  |               |        |                |   |               |   |                |       
|Net revenue                                           |  | $             | 30,522 |                | $ | 48,428        |   | $              | 50,979
|Gross profit                                          |  |               | 5,537  |                |   | 10,013        |   |                | 12,213
|Income (loss) before income taxes                     |  |               | (1,464 | )              |   | 2,571         |   |                | 4,306 
|Net income (loss)                                     |  |               | (1,464 | )              |   | 2,560         |   |                | 4,269 
|Net income (loss) attributable to common stockholders |  |               | (1,569 | )              |   | 2,524         |   |                | 4,269 
|Basic net income (loss) per share                     |  |               | (0.06  | )              |   | 0.08          |   |                | 0.13  
|Diluted net income (loss) per share                   |  |               | (0.06  | )              |   | 0.07          |   |                | 0.11  

18. Subsequent Events

On February 23, 2004, we completed an acquisition of Chaparral. The aggregate acquisition price consisted of approximately $62 million in cash and
the assumption of approximately $4.1 million in liabilities. Chaparral is a developer of specialized storage appliances as well as high-performance, mid-range RAID
controllers and data routers. The acquisition of Chaparral will enable us to increase the amount of proprietary technology within our storage systems, broaden our product line and diversify our
customer base.

F-31

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INDEPENDENT AUDITORS' REPORT

Board
of Directors and Stockholders
Dot Hill Systems Corp.

We
have audited the consolidated financial statements of Dot Hill Systems Corp. and subsidiaries (the "Company") as of December 31, 2002 and 2003, and for each of the three years
in the period ended December 31, 2003, and have issued our report thereon dated March 4, 2004; such report is included elsewhere in this Form 10-K. Our audits also
included the consolidated financial statement schedule of the Company, listed in Item 15(a)(2). This financial statement schedule is the responsibility of the Company's management. Our responsibility
is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.

/s/DELOITTE & TOUCHE LLP

San
Diego, California
March 4, 2004

S-1

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DOT HILL SYSTEMS CORP. AND SUBSIDIARIES  SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS  FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003  (IN THOUSANDS)

|                                                         |  | Balance at
Beginning of
Year |        | Charged to
Costs and
Expenses |   | Deductions |   | Balance at End of
Year
|-------------------------------------------------------- |  | ---------------------------- | ------ | ----------------------------- | - | ---------- | - | ----------------------
|Allowance for doubtful note, accounts and sales returns: |  |                              |        |                               |   |            |   |                       
|Year ended December 31, 2001                             |  | $                            | 1,593  |                               | $ | (151       | ) | $                     
|Year ended December 31, 2002                             |  |                              | 1,113  |                               |   | 1,018      |   |                       
|Year ended December 31, 2003                             |  |                              | 1,848  |                               |   | (284       | ) |                       
|Reserve for excess and obsolete inventories:             |  |                              |        |                               |   |            |   |                       
|Year ended December 31, 2001                             |  | $                            | 7,647  |                               | $ | 5,795      |   | $                     
|Year ended December 31, 2002                             |  |                              | 5,240  |                               |   | 8,280      |   |                       
|Year ended December 31, 2003                             |  |                              | 13,144 |                               |   | 1,705      |   |                       

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S-2

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