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                          SECURITIES AND EXCHANGE COMMISSION
                               WASHINGTON, D.C. 20549

                                     -----------

                                     FORM 10-K
                    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                        OF THE SECURITIES EXCHANGE ACT OF 1934

                     FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

                           COMMISSION FILE NUMBER 0-23107

                                     -----------

                                   FAROUDJA, INC.
                (Exact name of registrant as specified in its charter)

          DELAWARE                                     77-0444978
(State or other jurisdiction of         (I.R.S. Employer Identification No.)
incorporation and organization)                          


                      750 PALOMAR AVENUE, SUNNYVALE, CA 94086
             (Address of principal executive offices, including zip code)

                                   (408) 735-1492
                          (Registrant's telephone number)
                                          
            Securities registered pursuant to Section 12(b) of the Act:
                                          
                                        NONE
                                          
            Securities registered pursuant to Section 12(g) of the Act:
                                          
                      COMMON STOCK, PAR VALUE $.001 PER SHARE
                                   (Title of class)

                                     -----------

     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  X  No

     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.  X

     The aggregate market value of the voting stock held by non-affiliates of 
the Registrant, based on the closing price of the Common Stock on March 1, 
1999, as reported on the NASDAQ National Market, was approximately $14.8 
million. Shares of Common Stock held by each officer and director and by each 
person who owns 5% or more of the outstanding Common Stock have been excluded 
from this computation in that such persons may be deemed to be affiliates.  
This determination of affiliate status is not necessarily a conclusive 
determination for other purposes. 

     As of March 1, 1999 the Registrant had outstanding 12,242,597 shares of 
Common Stock.

                         DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Registrant's Proxy Statement for the Annual Meeting of 
Stockholders to be held on June 10, 1999 are incorporated by reference into 
Part III of this Form 10-K Report. 

                                       -1-

<PAGE>

                                    FAROUDJA, INC.

                                      FORM 10-K

                                  DECEMBER 31, 1998

                                        INDEX


<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            NO.
                                                                           ------
<S>         <C>                                                             <C>
PART I

Item 1.     BUSINESS . . . . . . . . . . . . . . . . . . . . . . . . . . . .  3

            EXECUTIVE OFFICERS OF THE COMPANY. . . . . . . . . . . . . . . . 18

Item 2.     PROPERTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Item 3.     LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . . . . . . . 19

Item 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. . . . . . . 19

PART II

Item 5.     MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
            MATTERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Item 6.     SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . . . . . . . 20

Item 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 
            AND RESULTS OF OPERATIONS. . . . . . . . . . . . . . . . . . . . 21

Item 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK . . . 26

Item 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. . . . . . . . . . . 27

Item 9.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING 
            AND FINANCIAL DISCLOSURE . . . . . . . . . . . . . . . . . . . . 42

PART III

Item 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT . . . . . . . 42

Item 11.    EXECUTIVE COMPENSATION . . . . . . . . . . . . . . . . . . . . . 42

Item 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT . 42

Item 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS . . . . . . . . . 42

PART IV

Item 14.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON 
            FORM 8-K . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

SIGNATURES   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
</TABLE>

                                       -2-

<PAGE>


     THIS FORM 10-K CONTAINS FORWARD LOOKING STATEMENTS WITHIN THE MEANING OF 
THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CONCERNING THE COMPANY'S 
FUTURE PRODUCTS, EXPENSES, REVENUE, LIQUIDITY AND CASH NEEDS AS WELL AS THE 
COMPANY'S PLANS AND STRATEGIES.   SUCH FORWARD-LOOKING STATEMENTS INVOLVE 
KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES. THESE FORWARD-LOOKING STATEMENTS 
ARE BASED ON CURRENT EXPECTATIONS.  THE COMPANY'S ACTUAL RESULTS AND TIMING 
OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THE DESCRIPTIONS IN THESE 
FORWARD-LOOKING STATEMENTS. FOR A DISCUSSION OF VARIOUS RISKS AND 
UNCERTAINTIES AFFECTING THE COMPANY'S FUTURE OPERATIONS SEE "FACTORS 
AFFECTING FUTURE OPERATING RESULTS." THE COMPANY UNDERTAKES NO OBLIGATION TO 
PUBLICLY UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT 
OF NEW INFORMATION, FUTURE EVENTS, OR OTHERWISE.

                                        PART I

ITEM 1.  BUSINESS

GENERAL

     Faroudja Inc. (the "Company") designs, develops and markets a range of 
video image enhancement products for the home theater and industrial markets 
and the broadcast market.  The Company is currently seeking to apply its 
technologies and experience to address opportunities in the emerging digital 
television ("DTV") and high definition television ("HDTV") broadcast market, 
to markets for new video display devices, and to markets resulting from new 
applications such as the convergence of the personal computer ("PC") and the 
TV. 

     The Company began operations in 1971 through two related companies, 
Faroudja Laboratories, Inc. ("FLI") and later Faroudja Research Enterprises, 
Inc. ("FRE"). The Company was incorporated in December 1996 under the laws of 
the state of Delaware to succeed to the business of FLI and FRE. Thereafter, 
FRE was merged into FLI with FLI surviving the merger.  FLI was subsequently 
merged into a newly-formed, wholly-owned subsidiary of the Company. 

BACKGROUND

     Video images are pervasive in today's society as sources of 
entertainment and information.  These video images are displayed on a variety 
of electronic media including color TVs, projection TV systems and PCs.  
Historically, there has been a substantial difference in the quality of these 
various media, ranging from low quality TV pictures to very high quality 
cinema pictures.  This difference resulted from a host of technical issues 
related to the capture, transmission and display of video images.  Current 
technologies make it possible to replicate cinema quality on TVs, projection 
systems and PCs. 

     With U.S. households owning approximately 250 million television sets, 
TV is the dominant medium for viewing video images. While TV is an integral 
part of modern life, it is optimized around image production, transmission 
and display technology created more than 40 years ago. TV signals are 
produced in accordance with the NTSC standard developed in the 1940s for 
black and white programs. This standard was last modified in the 1950s to 
make possible the compatible transmission of black and white and color 
programs. Technical compromises required to achieve compatibility introduce 
image degrading imperfections, known as artifacts. Additionally, analog 
transmission introduces noise in the TV image. While always present, these 
imperfections are less evident on smaller TV screens than on screens 25 
inches in size and larger. Over the last decade, consumer interest in larger 
screen TVs has increased dramatically, fueled by decreasing equipment prices 
and an expanding universe of movies, sporting events and other programming 
available via cable TV, video cassette, direct broadcast satellite, laser 
disc and, most recently, digital video disc ("DVD"). As TV screen sizes 
increase, impairments in the image, such as low resolution, artifacts and 
noise, have become more apparent. The better quality images produced by DVDs, 
digital satellite transmission and high-resolution computer monitors have 
made viewers more discriminating and have elevated their image quality 
expectations. 

     The Company believes that this trend will accelerate with the recent 
introduction of HDTV.  HDTV images are expected to incorporate cinema-like 
image quality in a wider screen format. The Federal Communications Commission 
("FCC") has established standards for DTV broadcasting in the United States 
and adopted rules mandating the gradual introduction of DTV broadcasting. The 
FCC has targeted the eventual phase-out of analog (NTSC) broadcasting by the 
year 2006. Current analog broadcasting equipment is not compatible with the 
new DTV standards. In order to transmit digital signals in accordance with 
the new DTV standards, broadcasters will need to acquire new equipment, 
including digital transmission equipment, at costs estimated to range from $2 
million per station to as high as $10 million per station. Broadcasters are 
seeking to reduce the costs of transitioning from analog to digital 
broadcasting through strategies which will allow them to continue to use much 
of their existing equipment. 

     Advances in microprocessors, the availability of low cost memory and
storage, high quality displays, sophisticated software and the emergence of the
World Wide Web have fueled the growth in multimedia applications on the PC. The
PC is increasingly being used to view video stored on hard disk, CD-ROM, DVD and
laser disc, as well as video over the Internet. The Company believes that the
use of the PC as an entertainment device in the future will depend in large part
on the PC's ability to display high quality TV images. Since TV 

                                       -3-

<PAGE>

signals use an interlaced format while PCs use a progressive scanning display 
format, a TV signal must be converted before being displayed on a PC. The 
interlace/progressive conversion, along with other steps in the conversion of 
the TV signal, have caused color distortion, motion artifacts, noise and 
other imperfections, resulting in poor video quality on the PC.  Image 
problems become even more apparent when TV signals are viewed on a PC, as PC 
users sit relatively close to their screens and PC monitors have higher 
resolution than most TVs. 

FAROUDJA SOLUTIONS

     The Company designs, develops and markets video image enhancement 
products, that dramatically improve image quality, producing cinema quality 
images on a wide variety of displays. 

     The Company's products for the TV market substantially reduce the 
imperfections inherent in analog NTSC signals, which become increasingly 
apparent on large screen TV displays. The Company's technology improves 
picture quality by removing artifacts and noise, detecting and compensating 
for motion, enhancing resolution, and multiplying the number of lines 
displayed. Faroudja's product sales for the TV market include sales of stand 
alone products to home and industrial customers, and sales of both board 
level and application specific integrated circuit ("ASIC") products to 
original equipment manufacturer ("OEM") customers. 

     The Company has also developed products that support the transition from 
analog to DTV/HDTV broadcasting. As broadcasters make significant investments 
to satisfy regulatory requirements, the Company believes that product 
solutions which interface with current studio equipment will help 
broadcasters minimize transition costs and maintain flexibility in responding 
to evolving regulatory and market requirements. The Company believes that its 
Digital Format Translator-TM- ("DFT") upconversion products will enable 
broadcasters to use much of the equipment present in their existing studios 
to produce programming in various DTV/HDTV video formats. 

STRATEGY

     The Company's objective is to maintain and expand its position as the 
industry standard of excellence for video image quality. Key elements of the 
Company's strategy to achieve this objective include: 

MAINTAIN AND EXTEND TECHNOLOGY LEADERSHIP.  The Company intends to build upon 
its technology leadership in video image processing by increasing its 
investment in research and development. These efforts will focus on 
developing patentable technologies and innovative products for the video 
display and broadcast markets. The Company intends to leverage its image 
enhancement expertise in TV into broadcast, DTV and other new displays, and 
PC products and applications.

PENETRATE BROADER MARKET SEGMENTS.  The Company has historically sold 
products that address the needs of the industrial and home theater markets. 
The Company is seeking product opportunities in new and broader market 
segments, such as the converging PC and TV markets and the emerging DTV/HDTV 
broadcast and new digital display markets. 

BUILD AND LEVERAGE STRATEGIC RELATIONSHIPS.  The Company intends to establish 
and maintain strategic relationships with companies whose technology, 
products and distribution strategies complement those of the Company. Through 
selective licensing of its patented technologies, the Company intends to 
increase penetration and recognition of its capabilities in markets currently 
served and to facilitate migration into new markets.

INCREASE BRAND NAME AWARENESS.  The Company has established a reputation for 
excellence in video processing and video image enhancement in the commercial 
broadcast, industrial and home theater markets. The Company intends to 
increase brand name awareness through advertising, the marketing of stand 
alone image enhancement and display products carrying the Company's 
trademarks, co-branding agreements with OEM customers and greater emphasis on 
Internet marketing through its web site. The distribution of Company-branded 
and co-branded products in new and broader market segments is also intended 
to increase Faroudja-Registered Trademark- brand awareness. 

PRODUCTS

     Faroudja designs, develops and markets a range of video image 
enhancement products for the TV and broadcast markets. The following table 
sets forth certain information regarding the Company's current stand alone 
home theater and industrial products and products for the broadcast market: 

                                       -4-

<PAGE>


<TABLE>
<CAPTION>
MARKET                  PRODUCT      DESCRIPTION
------                  -------      -----------
<S>                     <C>          <C>
TV-Image                VP401        Line quadrupler and video processor for large screen high resolution video projection system
Enhancement/
Line Multiplying        VP301        Line tripler and video processor for large screen high resolution video projection system

                        VP251        Line doubler and video processor for large screen high resolution video projection system

                        VS50         NTSC/PAL low noise video decoder, frame synchronizer and image processor for large screen
                                     standard resolution displays and video production

Large Screen            RP5800       HDTV rear screen multimedia projection system with line doubler and video processor
Multimedia Display
Systems                 LS700        LCD-based front projection system with line doubler and video processor

Broadcast               DFD U        NTSC/PAL video decoder/frame synchronizer with 10-bit processing, time base correction,
                                     patented 2D adaptive comb filter produces artifact-free digital D1 parallel and serial
                                     outputs 

                        A2D1F        Low noise video decoder/frame synchronizer with video adjustments and D1 output

                        DFT-3        Base format translator for upconverting NTSC serial digital input to ATSC 720p or 1080i HDTV
                                     video formats, includes multiple preset aspect ratios, standard and high definition frame
                                     synchronization, digital color correction and HD-SDI outputs

                        DFT-3S       DFT-3 format translator for upconverting NTSC serial digital input to ATSC 720p or 1080i HDTV
                                     video formats, includes multiple preset aspect ratios, standard and high definition frame
                                     synchronization, digital color correction, advanced video enhancement, HD-SDI outputs and
                                     System Control Software 

                        DFT-3A       Fully featured format translator for upconverting a full range of NTSC signals through
                                     patented 2D decoding, analog component and serial digital inputs to ATSC 480p, 720p and 1080i
                                     DTV/HDTV video formats, includes full aspect ratio control, standard and high definition
                                     frame synchronization, digital color correction, digital noise reduction, advanced video
                                     enhancement, HD-SDI and analog outputs, and System Control Software
</TABLE>

TV PRODUCTS

LINE QUADRUPLERS (VP401).  The Company's line quadrupler video processors 
produce cinema-like images. The processors accept input from sources 
formatted for conventional 525-line or 625-line TV standards, and convert 
them into line-quadrupled, noticeably artifact-free, high resolution signals 
for projection TV systems and electronic cinema. The processors are precision 
instruments employing three complex digital signal processes utilizing 
patented technology in the fields of decoding, scan conversion and detail 
enhancement. These products substantially reduce color blurring, rainbow 
patterns, dot crawl and visible scan lines, and deliver sharp image details.

LINE TRIPLING VIDEO PROCESSORS (VP301).  The Company's line tripling video 
processors utilize certain of the same technologies as the Company's line 
quadruplers, and deliver similar results for smaller projection TV systems. 

LINE DOUBLING VIDEO PROCESSORS (VP251).  The Company's line doubling video 
processors utilize certain of the same technologies as the Company's line 
quadruplers, and deliver similar results for direct-view or projection TV 
systems.

VS50 CHROMA DECODER.  The VS50 decodes NTSC and PAL signals into high 
quality, artifact-free components to greatly improve image quality for high 
quality standard scan rate displays and video production.

REAR PROJECTION MULTIMEDIA DISPLAY SYSTEM (RP5800).  The Company's 58 inch 
wide, HDTV rear screen multimedia projection system incorporates a VP250 line 
doubling video processor.  This display system is designed for customers with 
space, remodeling or lighting constraints and provides HDTV quality images.  
During 1998 the Company offered the RP4800, a 48 inch wide, rear screen 
projection system. The RP4800, which is based on a different projector 
chassis than the RP5800, was discontinued in December 1998 with the 
introduction of the RP5800.

                                       -5-

<PAGE>

LS-TM-700 LCD PROJECTOR.  The LS700 is an LCD-based front projection system 
produced by In Focus Systems, Inc. ("In Focus-Registered Trademark-"), 
incorporating line doubling and video processing ASICs of the Company.  This 
product combines the image quality for which the Company is recognized with 
the compact form factor, ease-of-use, reliability and low cost of ownership 
of an LCD projector. 

     Home theater and industrial product sales as a percentage of total 
revenues for fiscal 1998, 1997 and 1996 were 84%, 88% and 80%, respectively. 

BROADCAST PRODUCTS 

DFD-U DIGITAL DECODER.  The DFD-U uses 10-bit processing with patented 
decoding and bandwidth expansion circuitry to convert PAL or NTSC analog 
signals into the digital component data required for video compression. 
Additional circuits include time base correction and full frame 
synchronization. The combination results in a significantly artifact-free 
digital signal that enables additional channel capacity with reduced noise 
levels and higher quality video signals from MPEG video compression engines. 

A2D1F.  The A2D1F decodes NTSC signals into high quality, artifact-free 
components prior to the time the signal is transmitted. The output signal is 
used in applications such as studio manipulation and digital video 
compression. 

     The Company's Digital Format Translator-TM- ("DFT") products, used in 
conjunction with existing NTSC production equipment at post-production, 
network or network affiliate studios, provide broadcasters with the ability 
to produce programming in various DTV and HDTV video formats.  In addition to 
translating standard resolution video into higher resolution formats, certain 
of the DFT products enable broadcasters to transform standard source material 
(4:3 aspect ratio) into a wide screen (16:9 aspect ratio) format.  The 
products provide user-friendly means for studio engineers to control a broad 
range of factors that ultimately contribute to superior image quality.  The 
translators have a modular design and can be configured to suit particular 
customer's needs. Examples of configurations are the DFT3, DFT3S and DFT3A 
described below.

DFT3 - DIGITAL FORMAT TRANSLATOR.  The DFT3 base model translator uses 
patented Faroudja technologies to translate 525 line interlace serial digital 
component video into the customers choice of either the ATSC 720 line 
progressive or 1080 line interlace HDTV video formats.  The product includes 
the ability to choose from among multiple preset aspect ratios, standard and 
high definition frame synchronization, digital color correction and HD-SDI 
outputs.

DFT3S - DIGITAL FORMAT TRANSLATOR.  The DFT3S contains all the features of 
the DFT3, plus advanced video enhancement and Window's NT-based system 
control software that allows the highest level of user control over system 
features. 

DFT3A - DIGITAL FORMAT TRANSLATOR.  The DFT3A is a fully featured DFT3.  It 
contains all features of the DFT3S and Faroudja patented adaptive comb filter 
decoding for upconverting the full range of NTSC signals (analog, composite 
and digital) into the full range of ATSC DTV and HDTV video formats:  480 
line progressive, 720 line progressive and 1080 line interlace.  Digital 
noise reduction and a variety of analog monitoring options are also added to 
round out the DFT3A and make it the most advanced and feature rich product in 
its class. 

     Broadcast product sales as a percentage of total revenues for fiscal 
1998, 1997 and 1996 were 10%, 2% and 16 %, respectively. 

OEM PRODUCTS

     The Company co-brands certain of its stand alone video processing 
products with Vidikron of America, Inc. ("Vidikron").  In 1998, sales to 
Vidikron accounted for 10% of total Company revenues.  

The Company has also designed and developed board level and ASIC products 
incorporating the Company's technologies for the OEM market.  ASIC product 
offerings include the FLI2000 broadcast quality NTSC/PAL decoder integrated 
circuit, with time base correction and detail enhancement, and the FLI9000 
set of eight proprietary ASICs.  The FLI9000 chip set includes the FLI2000 
and additional deinterlacing and enhancement chips.  In Focus incorporates 
the FLI9000 chip set into the LS700 projector.  To date, sales from board and 
ASIC products have not been material.

RESEARCH AND DEVELOPMENT; NEW PRODUCTS

     The Company has devoted, and expects to continue to devote, significant 
resources to its research and development efforts. In 1996, the Company 
established a VLSI design group to develop high performance video application 
specific integrated circuits ("ASICs").  As of December 31, 1998, the Company 
had a staff of 20 full-time research and development personnel.  During 1998, 
1997 and 1996 the Company's research and development expenses were 
approximately $4.8 million, $4.2 million and  $2.5 million, respectively. The 
Company anticipates that its research and development expenses will increase 
in absolute dollars for the foreseeable future. 

                                       -6-

<PAGE>

     The Company has a number of products in development with introduction 
planned during the next several years. For the home theater and industrial 
markets, the Company is developing new line multipliers with video scaling 
capabilities for very large screen high resolution systems, liquid crystal 
display ("LCD") and Digital Light Processing-Registered Trademark- based 
projector systems ("DLP"), and a video processor for less sophisticated 
industrial applications.  For the broadcast market the Company is continuing 
to develop and cost-reduce its DFT products to respond to the needs of the 
emerging DTV/HDTV market.

     The Company's other planned research products include expanded 
development of line multipliers, compression pre-processors for broadcast 
products which include noise reduction to increase compressor efficiency and 
next-generation ASICs that include enhanced capabilities, greater integration 
and denser chip geometries. 

     The markets for the Company's products are characterized by evolving 
industry standards, rapid technological change, frequent new product 
introductions and short product life cycles. The Company's future success 
will depend, in large part, on its ability to continue to enhance its 
existing products, develop new products and features to meet changing 
customer requirements and evolving industry standards, and enter into 
royalty-bearing licenses.  Sales from Company's line multiplier product lines 
decreased in 1998 and the Company anticipates that sales of such products 
will experience limited growth, or decline, in future periods.  Home theater 
and industrial market sales decreased in 1998, which the Company attributes 
to increased competition, pricing pressure and consumer confusion over HDTV. 
The Company believes that the confusion resulting from HDTV and related 
market weakness could continue until HDTV broadcast begins on a wide-scale 
basis. The Company expects that approximately one-half of its total revenues 
in 1999 will be derived from sales of recently introduced products and 
products which the Company is developing for introduction in 1999.  The 
success of new products depends on a number of factors, including proper 
selection and timely introduction, successful and timely completion of 
product development, accurate estimation of demand, market acceptance of new 
products of the Company and its OEM customers, the Company's ability to offer 
new products at competitive prices, the availability of adequate staffing to 
produce and sell such new products, and competition from products introduced 
by competitors. Certain of these factors are outside the control of the 
Company.  Sales of the Company's board and ASIC products, and future license 
and royalty revenues, depend in part upon the ability of the Company's OEM 
customers and licensees to successfully develop and market products 
incorporating the Company's products or technology.  There can be no 
assurance that the Company's broadcast products will be widely accepted by 
the broadcast market.  There can be no assurance as to the amount of 
royalties, if any, that the Company will receive in the future.  The Company 
does not currently have any license agreements in effect pursuant to which it 
expects to receive substantial royalties. 

     The incorporation of the Company's products into its OEM customers' 
product designs often requires significant expenditures by the Company, which 
expenditures may precede volume sales of the Company's products, if any, by 
one year or more. 

     The introduction of new or enhanced products also requires the Company 
to manage the transition from older products in order to minimize disruption 
in customer ordering patterns, to avoid excessive levels of older product 
inventories and to ensure that adequate supplies of new products can be 
delivered to meet customer demand. 

     There can be no assurance that the Company will identify new product 
opportunities, will successfully develop and bring to market new products, 
will be chosen to supply board level or ASIC products for incorporation into 
OEMs' products or will respond effectively to technological changes or 
product announcements by others, or that the Company's new products will 
achieve market acceptance. A failure in any of these areas would have a 
material adverse effect on the Company's business, financial condition and 
operating results.  See "Factors Affecting Future Operating Results - 
DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND RISK OF TECHNOLOGICAL CHANGE."

TECHNOLOGY

     The Company has significant expertise in a number of technologies 
relating to video image enhancement. 

ENCODING TECHNOLOGY.  A NTSC or PAL signal consists of a luminance signal and 
two color-difference signals. In a conventional NTSC or PAL encoder, the 
color-difference signals are modulated on a subcarrier and added to the 
luminance signal. In this case, the spectrum of both the luminance signal and 
the modulated chrominance signal are mixed together, which generates "rainbow 
patterns," "dot crawl" and other artifacts in TV receivers. Faroudja's 
patented pre-filtering technology is applied to luminance and chrominance 
signals separately so that they will not interfere with each other. The two 
signals are added together without an overlaid spectrum, which significantly 
reduces rainbow patterns and other artifacts. 

DECODING TECHNOLOGY.  The color section of the NTSC standard was originally
designed with severe bandwidth restrictions. This causes colors in various video
images to "blur" and "smear." These effects are aggravated by storage media,
such as VHS tapes, that further degrade the chroma or color signal. The Faroudja
decoder technology utilizes proprietary circuitry to recreate and correct color
details. This is accomplished by making use of the sharper black and white
transitions to develop a correction signal that is then used to sharpen the
color transitions. As a result, colors are restored with sharp details and video
images retain their original crisp image. Digital adaptive comb filter circuitry
eliminates decoding errors from imperfect separation of the luminance and
chrominance signals and enables the 

                                       -7-

<PAGE>

reproduction of sharper, cleaner color images. The Company's decoder 
technology has two separate correction circuits that create color transitions 
that are clear, sharp and natural by eliminating the artifact known as "dot 
crawl", a rapid upward movement of colored dots on sharp vertical 
transitions, and hanging dots which lie underneath all the colored horizontal 
transitions. Dot crawl and hanging dots are readily apparent with large, 
highly saturated, stationary graphics such as titles and credits. 

MOTION COMPENSATION TECHNOLOGY.  The inherent scan and frame rate changes 
that are required to display the enhanced video image make motion 
compensation necessary in the reconstruction of the enhanced picture. TV 
images are transmitted in an interlaced fashion in which the picture is 
transmitted in two parts, the first being the odd lines of the picture, the 
second the even lines. This creates a time delay of 16 milliseconds between 
the odd and even lines of the image. If motion is present, artifacts can be 
generated in the conversion to a line doubled or quadrupled image. Also, 
while TV images are displayed at approximately 60 frames per second, cinema 
film sources are displayed at 24 frames per second. To ensure an image 
noticeably free from artifacts, the motion of the video has to be taken into 
account and identification of the source material as video or film is 
necessary. The Company's motion and film detection technology is used in most 
of its video enhancement products. 

LINE MULTIPLIER TECHNOLOGY.  The line multiplier technology reduces scan line 
visibility resulting from utilizing a 525 line interlaced broadcast standard 
on today's large screen TVs by changing the interlaced video signal to a 
progressively scanned signal. The Company's line multiplier technology 
detects motion and interpolates correctly to "fill in the blanks." This 
technology can detect the difference between a film image that has been 
transferred to video or a video image that emanates from a video camera. 
After detecting the image type, the line multiplier technology selects its 
algorithm to compensate accordingly. This is critical because today's home 
theaters are primarily used to show films that were transferred to video, 
whether on tape, laser disc, DVD or off the air. 

DETAIL ENHANCEMENT TECHNOLOGY.  The best video sources such as DVD (if 
properly recorded) provide good resolution while others such as digital 
satellite reception and laser discs often provide acceptable resolution. 
However, common sources such as broadcast or VHS tapes are noticeably 
deficient. The problem is compounded when scan lines are doubled or 
quadrupled and when other signal processing is applied. The resulting picture 
is free of artifacts (including visible scan lines) but dull, with loss of 
definition and a general blurriness. The Company's proprietary technology 
increases the visibility of small image details, whether horizontal or 
vertical, without introducing ringing or noise artifacts and without 
modifying large edge response through the use of non-linear processing. This 
technique expands the apparent bandwidth of large edge signals without 
introducing artifacts, such as ringing, in both the horizontal and vertical 
domains. The combination of these two techniques results in an image that 
gives a greater feeling of depth. 

NOISE REDUCTION.  All analog video sources contain some degree of picture 
noise. This is manifested as low level moving or shimmering artifacts, or an 
excessive graininess in the picture. High quality digital sources such as 
DVDs have much reduced noise content. Noise reduction processing is required 
to bring analog sources, either existing archive material or new material 
from traditional cameras, up to digital standards. Small static details in 
the picture have to be distinguished from the moving noise artifacts so that 
correct discrimination can be accomplished. The Company makes use of its 
motion detection and adaptive video filtering technologies to optimize noise 
reduction in the video images.

TIME BASE CORRECTION.  Video sources which are being transmitted from a 
broadcast studio or by a satellite or cable TV head end derive line and frame 
scan rates from stable crystal controlled sources which are timing accurate. 
Video produced by consumer video cassette recorders, camcorders and, to a 
lesser extent, video discs are subject to timing errors, because the playback 
relies on the mechanical rotation of the storage medium for timing accuracy. 
In the case of VCRs, line lengths may vary causing color decoding and video 
picture alignment problems. If a VCR source is to be transmitted in the 
industry standard digital D1 format, this line timing variability is not 
permissible. The Company's time base correction technology permits its 
decoders not only to separate the luminance and chrominance components of the 
video source but to re-lock the video to a crystal reference. This stabilizes 
the picture, particularly when video is overlaid on other video sources, and 
makes it compliant with digital studio transmission standards. 

SCALING.  As new video standards and display technologies emerge, the need to 
reformat the video picture by scaling in both the horizontal and vertical 
domains becomes more important. The Company currently produces line doublers 
and quadruplers which scale the picture by factors of two.  DFT products 
scale the picture by non-integer ratios to convert traditional video sources 
to the new DTV and HDTV formats and the Company has under development line 
multiplication products that scale by non-integer ratios. This capability is 
required for PC interface products, and LCD and DLP-TM- based products, all 
of which have finite numbers of pixels in their display format.  When pixel 
based displays are used to display video, the video source should be scaled 
to convert the original number of lines to the number of lines in the display 
device to avoid the creation of video artifacts. 

STRATEGIC RELATIONSHIPS AND LICENSING

     The Company believes that strategic relationships with other 
manufacturers will provide opportunities to facilitate the entry of video 
image enhancement products into new markets.

                                       -8-

<PAGE>

     In March 1997, the Company entered into a license agreement with S3 
Incorporated ("S3"), which allows S3 to incorporate certain of the Company's 
technologies, including line doubling, detail enhancement, cross-color 
suppression, motion tracking and compensation and digital compression 
filtering, in S3's advanced graphics accelerator products for mainstream 
multimedia PC systems.  To the extent that S3 incorporates the Company's 
technologies in S3 products the Company will receive royalties.  The license 
agreement was exclusive for certain markets provided that certain conditions, 
including the payment of minimum quarterly license fees, were satisfied.  S3 
has advised the Company that it will not make payments necessary to maintain 
its exclusive rights with respect to any periods after March 31, 1998.  S3 
has not shipped any products that incorporate the Company's technology and 
there can be no assurance that S3 will develop products or pay any future 
royalties under the license agreement.

     Yves Faroudja, the Company and General Instrument Corporation ("GI") are 
parties to a world-wide license agreement dated May 1, 1996 pursuant to which 
GI licensed certain patents to the Company and the Company licensed certain 
patents to GI relating to video compression and decompression.  The licenses 
are royalty-free so neither party is obligated to pay, nor entitled to 
receive, license fees from the other party.  The agreement grants exclusive 
rights to each company in defined fields of use, includes the right to grant 
sublicenses and extends until the last to expire of the licensed patents.  As 
a result of that agreement, GI could produce products in the field of scan 
conversion of source material presented to a compression system competitive 
with the Company's upconverter products. 

     In December 1998, the Company entered into a manufacturing, sales and 
distribution agreement with In Focus, pursuant to which In Focus agreed to 
incorporate the Company's line doubling and video processing circuitry into 
an In Focus LCD projector to be known as the "LS-TM-700." The agreement 
granted to the Company the exclusive right to sell the LS700 in the home 
theater market.  The Company also agreed that until May 30, 1999 it would not 
allow any company other than In Focus to offer or sell any front-screen 
LCD-based home theater projection devices incorporating the Company's 
proprietary ASICs.  Shipments of LS700s to the Company's home theater 
customers began in January 1999.
      
     The patented technologies which the Company uses to produce standalone 
products for home theater, industrial and broadcast applications may also be 
used in other applications, such as digital television sets and digital 
set-top boxes, for improving the image quality displayed from standard 
definition video sources.  The Company may offer to license these 
technologies, such as decoding, line multiplication, detail enhancement, 
motion tracking, motion compensation, time base correction and scaling, to 
strategic partners such as semiconductor chip manufacturers, for wide scale 
deployment. The Company is not currently a party to any such license 
agreements.  There can be no assurance that the Company will identify 
additional strategic partners or enter into additional license agreements for 
the uses described or any other uses, or that any such relationships or 
agreements will result in substantial revenues to the Company. See "Factors 
Affecting Future Operating Results - DEPENDENCE ON STRATEGIC RELATIONSHIPS."

SALES AND MARKETING

     Faroudja markets its products for the TV market through a network of 
home theater, industrial and commercial dealers as well as OEM customers. As 
of December 31, 1998, the Company maintained a sales force of eight persons 
at its headquarters in Sunnyvale, California, and three employees in regional 
offices. The Company's marketing programs include trade shows, training 
seminars, public relations and advertising.  The Company also uses its web 
site (www.faroudja.com) for marketing, and intends to place greater emphasis 
on Internet marketing in the future.  Revenues from S3 and Vidikron accounted 
for 10.6% and 11.1%, respectively, of total revenues in 1997.  Revenues from 
Vidikron accounted for 10% of total revenues in 1998.                         
  

     The Company currently distributes its home theater products through 
approximately 300 home theater dealers throughout the United States.  This 
distribution channel is managed by a Company national sales manager, two 
regional managers, one field training manager, independent sales 
representatives and a customer service department. 

     The Company also sells its products to the industrial market for uses 
such as corporate boardrooms, executive conference centers and auditoriums, 
through a network of more than 100 industrial dealers.  These dealers 
typically provide installation, product integration, on site training and 
customer support.  This network is managed directly by the national sales 
manager and two regional managers that manage home theater distribution and 
by independent industrial sales representatives. 

     For the broadcast market, the Company has relied, and expects to 
continue to rely on, direct sales and marketing. The Company has two 
employees who sell directly to the broadcast market.  The Company may also 
enter into reseller arrangements with companies, such as systems integrators, 
that sell to the broadcast market.

     The Company has OEM and/or co-branding relationships with Vidikron and 
In Focus.  OEM and/or co-branding relationships with Ampro Corporation 
("Ampro"), CinemaPro Corporation dba Runco International ("Runco") and NEC 
Technologies, Inc. USA ("NEC") ended in 1998.  There can be no assurance that 
the Company will continue to receive any revenues from continuing 
relationships or that it be successful in developing additional OEM 
relationships. 

                                       -9-

<PAGE>

     Export sales represented approximately 18.6%, 13.1% and 15.3% of the 
Company's total revenues in 1998, 1997 and 1996, respectively.  While export 
sales remained flat in 1998, they increased as a percentage of total revenues 
from the prior year because of the decrease in the Company's total revenues. 
The Company has a non-exclusive worldwide distribution arrangement with 
Vidikron pursuant to which Vidikron distributes the Company's line doublers 
and line quadruplers.    In addition, the Company has distributors or dealers 
in over 35 countries worldwide.  Export sales to international customers 
entail a number of risks, including unexpected changes in, or impositions of, 
legislative or regulatory requirements, delays resulting from difficulty in 
obtaining export licenses for certain technology, tariffs, quotas and other 
trade barriers and restrictions, longer payment cycles, greater difficulty in 
accounts receivable collection, potential adverse taxes, currency exchange 
fluctuations, the burdens of complying with a variety of foreign laws and 
other factors beyond the Company's control. See "Factors Affecting Future 
Operating Results - RISKS ASSOCIATED WITH EXPORT SALES AND OPERATIONS."

     The Company's future success will depend, in large part, on the 
continued efforts of its network of direct and indirect distributors and 
dealers. The loss of, or reduction in sales to, any of the Company's key 
customers could have a material adverse effect on the Company's operating 
results. See "Factors Affecting Future Operating Results - DISTRIBUTION 
RISKS; DIVERSIFICATION OF SALES CHANNELS."

     The Company's business is characterized by short lead times and quick 
delivery schedules. As a result, the Company does not believe that backlog at 
any given time is a meaningful indication of future sales. 

MANUFACTURING

     TV AND BROADCAST PRODUCTS.  The Company's manufacturing operations are 
located in Sunnyvale, California and consist mainly of materials procurement, 
final assembly, testing, quality assurance and shipping of products. The only 
product assembly performed by the Company is final assembly, which consists 
of building chassis and installing circuit boards and wires and cables. The 
Company performs testing and quality assurance of all products, except for 
projection systems, at its Sunnyvale facilities and plans to expand its 
in-house automated testing efforts as its product volume increases. 

     The Company subcontracts other manufacturing functions, including the 
production of its printed circuit boards. Bestronics, Inc. ("Bestronics") 
assembles more than 80% of the Company's circuit boards. The Company's 
reliance on independent printed circuit board assemblers limits its control 
over delivery schedules, quality assurance and product cost. The Company also 
relies on suppliers for components, such as DC Electronics, Inc. ("DC 
Electronics") which builds all of the Company's wire and cable harnesses. 

     The RP4800 Rear Projection System, a 48 inch wide rear screen projection 
system that was sold by the Company until December 1998, utilized a projector 
chassis provided by Audio Video Source, Inc. ("AVS") and modified to the 
Company's specifications.  AVS also manufactured the RP4800 for the Company 
on a contract basis including integrating, assembling and testing the various 
components of the system. 

     The Company's RP5800 Rear Projection System utilizes a projector chassis 
purchased from Barco, Inc.  The RP5800 is manufactured for the Company on a 
contract basis by Visual Structures, Inc.  Visual Structures integrates, 
assembles and tests the various components of the system, including the 
Company's line doubler.

     The LS700 projector is manufactured by In Focus incorporating ASICs 
provided by the Company.  The projector is co-branded with the names of both 
In Focus and the Company.

     Disruption in service by any of the Company's subcontractors or the 
Company's suppliers could lead to supply constraints or delays in the 
delivery of the Company's products. Such supply constraints or delays could 
have a material adverse effect on the Company's business, operating results 
and financial condition. 

 WAFER FABRICATION.  The Company contracts all of its wafer fabrication, 
assembly and testing to independent foundries and contractors, which enables 
the Company to focus on its design strengths, minimize fixed costs and 
capital expenditures and gain access to advanced manufacturing facilities. As 
the Company continues to develop ASIC products, it will continue to outsource 
its wafer production. The Company's engineers work closely with the Company's 
foundries and subcontractors to increase yields, lower manufacturing costs 
and assure quality. The Company's primary foundry is ST Microelectronics, 
Inc. ("ST"). In addition, Micro Devices Technology, Inc. ("MDT") and TEMIC 
Semiconductors ("TEMIC") have manufactured the Company's integrated circuits 
since 1993 and 1996, respectively. Most of the Company's devices are 
currently fabricated using complementary metal oxide semiconductor ("CMOS") 
process technology with 0.5 and 0.8 micron feature sizes. New devices that 
are being designed are in 0.25 micron and 0.35 micron sizes. The Company 
currently purchases products from all of its foundries under individually 
negotiated purchase orders. The Company does not currently have a long-term 
supply contract with any of its wafer fabrication foundries and, therefore, 
none are obligated to supply products to the Company for any specific period, 
in any specific quantity or at any specified price, except as may be provided 
in a particular purchase order. The Company's reliance on independent 
foundries and assembly and testing houses involves a number of risks.

                                       -10-

<PAGE>

See "Factors Affecting Future Operating Results - RELIANCE ON INDEPENDENT 
FOUNDRIES AND MANUFACTURING."

COMPETITION

     The markets in which the Company competes are intensely competitive and 
are characterized by rapid technological change, rapid product obsolescence 
and price competition. The Company expects competition to increase in the 
future from existing competitors and from other companies that may enter the 
Company's existing or future markets with products or technologies which may 
be less costly or provide higher performance or more desirable features than 
the Company's products. For example, during the year ended December 31, 1998, 
the low end of the Company's line multiplier family, line doublers, faced 
heavy competition from other line processor manufacturers and from certain 
projector manufacturers that included built-in line doublers in their 
projectors.  These trends are expected to continue.  The Company's existing 
and potential competitors include several large domestic and international 
companies that have substantially greater financial, manufacturing, 
technical, marketing, distribution and other resources than the Company. In 
the market for TV video processors, the Company's principal competitors are 
DWIN Electronics, Inc. ("DWIN"), Extron Electronics ("Extron"), Miranda 
Techologies Inc. ("Miranda"), NEC, Runco, Snell & Wilcox, Inc. ("Snell & 
Wilcox"), Sony Corporation ("Sony") and Yamashita Engineering Manufacturing, 
Inc. ("YEM").  DVDO, Inc. ("DVDO") and Genesis Microchip Inc. ("Genesis"), 
have recently emerged as competitors with chip solutions.  In the market for 
broadcast products, the Company's principal competitors are Extron, Leitch 
Incorporated ("Leitch"), Miranda, Panasonic Broadcast & Television Systems 
Company ("Panasonic"), Snell & Wilcox, and Vistek Electronics, Ltd. 
("Vistek"). As the Company's products penetrate broader markets and as these 
markets become commercial markets, the Company expects to face competition 
from diversified electronic and semiconductor companies. 

     Yves Faroudja, the Company and GI are parties to a royalty free, 
world-wide license agreement dated May 1, 1996 pursuant to which GI licensed 
certain patents to the Company and the Company licensed certain patents to GI 
relating to video compression and decompression. As a result of that 
agreement, GI could produce products in the field of scan conversion of 
source material presented to a compression system competitive with the 
Company's upconverter. 

     The Company has licensed and intends to continue to license its 
technologies and intellectual property.  The Company also offers for sale 
board level or ASIC products, developed by or for the Company, which 
implement certain of the Company's technologies.  The Company's licensees and 
OEM customers may be larger and have greater market recognition and 
financial, technological, engineering, manufacturing and distribution 
capabilities than the Company.  In addition, such licensees and OEM customers 
may use such technologies and subsystems either alone or in combination with 
other technologies to develop products which could compete with the Company's 
technologies and products.  At present, the Company believes that S3 and GI 
are licensees which could compete with certain of the Company's technologies 
and products.  While the Company may sell board level or ASIC products and 
receive royalties from such licensees, there can be no assurance that the 
technologies and products offered by such licensees and OEM customers will 
not compete directly with those of the Company, have performance, cost or 
other advantages over those of the Company or have an adverse impact on the 
sales or other licensing activities of the Company. 

     Certain of the Company's principal competitors maintain their own 
manufacturing facilities, including semiconductor foundries, and may 
therefore benefit from certain capacity, cost and technical advantages. Since 
the Company does not operate its own semiconductor manufacturing, assembly or 
testing facilities, it may not be able to reduce its costs as rapidly as 
companies that operate their own facilities. The failure of the Company to 
introduce lower cost versions of its products in a timely manner or to 
successfully manage its manufacturing, assembly and testing relationships 
would have a material adverse effect on its business, operating results and 
financial condition. 

     The Company believes that its ability to compete successfully in the 
rapidly evolving markets for high performance video image enhancement 
technology depends on a number of factors, including protection of its 
proprietary technology and information, the price, quality, form factor and 
performance of the Company's and its competitors' products, the timing and 
success of new product introductions by the Company, its customers and its 
competitors, the emergence of new industry standards, the Company's ability 
to obtain adequate foundry capacity, the number and nature of the Company's 
competitors in a given market and general market and economic conditions. 
There can be no assurance that the Company will compete successfully in the 
future with respect to these or any other competitive factors.  See "Factors 
Affecting Future Operation Results - COMPETITION."

PROPRIETARY RIGHTS AND LICENSES

     The Company's future success depends, in part, on its ability to protect 
its proprietary technology and information.  Although the Company relies on a 
combination of patents, copyrights, trademarks, trade secrets and licensing 
arrangements with third parties to protect certain of its intellectual 
property, the Company believes that factors such as the technological and 
creative skills of its personnel and the success of its ongoing product 
development efforts are more important in maintaining its competitive 
position.  The Company generally enters into confidentiality or license 
agreements with its employees, distributors, customers and potential 
customers and limits access to its proprietary information.  The Company 
holds or is the exclusive licensee of 54 U.S. and 11 foreign patents, and 11 
U.S. and 25 foreign 

                                       -11-

<PAGE>

patent applications. The Company depends on these patents for the enhancement 
of its current products and the development of future products.  Most of 
these patents and patent applications are owned by Yves Faroudja, the 
Company's founder and Chief Technical Officer.  Mr. Faroudja has granted the 
Company an exclusive perpetual, royalty-free, license to use patented and 
unpatented technologies developed by him prior to January 20, 1997.  As the 
Company is a licensee of such patents and applications, it is subject to 
risks not generally faced by other companies that own the intellectual 
property upon which their businesses rely.  There can be no assurance that 
patents will issue from any pending applications or that any claims allowed 
from pending applications will be of sufficient scope or strength, or be 
issued in all countries necessary to provide meaningful protection or any 
commercial advantage to the Company.  Also, competitors of the Company may be 
able to design around the licensed patents.  The laws of certain foreign 
countries in which the Company's products are or may be developed, 
manufactured or sold, including various countries in Asia, may not protect 
the Company's products or intellectual property rights to the same extent as 
the laws of the United States, and thus, may increase the likelihood of 
piracy of the Company's technology and products.  There can be no assurance 
that the steps taken by the Company to protect its intellectual property 
rights will be adequate to prevent misappropriation of its technology or that 
the Company's competitors will not independently develop technologies that 
are equivalent or superior to the Company's technology. 

     The video image enhancement and related industries are characterized by 
vigorous protection and pursuit of intellectual property rights or positions, 
which have resulted in significant and often protracted and expensive 
litigation.  The Company may from time to time be subject to proceedings 
alleging infringement by the Company of intellectual property rights owned by 
third parties.  If necessary or desirable, the Company may seek licenses 
under such intellectual property rights.  However, there can be no assurance 
that such licenses will be offered or that the terms of any offered license 
will be acceptable to the Company.  The failure to obtain such a license from 
a third party for technology used by the Company could cause the Company to 
incur substantial liabilities and to suspend or cease the manufacture of 
products requiring such technology. See "Factors Affecting Future Operation 
Results -LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF THIRD 
PARTY INFRINGEMENT." 

     The Company may initiate claims or litigation against third parties for 
infringement of the Company's proprietary rights or to establish the validity 
of the Company's proprietary rights.  For example, in January 1997 and May 
1997, the Company filed actions against DWIN and Snell & Wilcox, 
respectively, seeking relief and damages for the infringement of certain 
patents.

EMPLOYEES

     As of December 31, 1998, the Company had 60 full-time employees, 
including 20 full-time employees primarily involved in research and 
development activities, 12 in marketing and sales, 12 in finance and 
administration and 16 in manufacturing and quality assurance.  Most employees 
are based at the Company's headquarters in Sunnyvale, California.  The 
Company's employees are not represented by any collective bargaining unit and 
the Company has never experienced a work stoppage.  The Company believes that 
its employee relations are good.  The Company intends to expand its employee 
base in 1999, primarily in research and development, and believes that its 
future success will depend largely on its ability to attract and retain 
highly-skilled engineering personnel.  Competition for such personnel is 
intense.  The Company's future success will depend to a significant extent 
upon the continued services of members of senior management and other key 
employees of the Company.  The loss of the service of any of these 
individuals could have a material adverse effect on the Company. 

FACTORS AFFECTING FUTURE OPERATING RESULTS

POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS; SEASONALITY.  The 
Company's period to period operating results have varied in the past and are 
likely to vary significantly in the future as a result of a number of 
factors, including the volume and timing of orders received during the 
period, the amount and timing of royalty revenues, the timing of new product 
introductions by the Company and its competitors, demand for and market 
acceptance of the Company's products, product line maturation, the impact of 
price competition on the Company's average selling prices, delays encountered 
by the Company's strategic partners, the availability and pricing of 
components for the Company's products and other manufacturing problems, 
changes in product or distribution channel mix, product returns, price 
protection charges from customers and the unexpected loss of key customers.  
Many of these factors are beyond the Company's control. In addition, due to 
the short life cycles of the Company's products, the Company's failure to 
consistently introduce new, competitive products in a timely manner could 
have a material adverse affect on operating results for one or more product 
cycles. 

     Gross margins may vary from period to period as a result of various 
factors, including the volume of sales, the mix of products sold, new product 
introductions, fluctuations in the receipt of royalty revenues, the mix of 
distribution channels and adjusting prices to meet competition. The Company's 
gross margins may also be adversely affected by shortages in the availability 
of key components for the Company's products. To maintain favorable margin 
levels on product sales, the Company must introduce new products, introduce 
enhanced versions of existing products and continuously reduce the cost of 
its products. The Company anticipates that it will incur lower overall gross 
margins in future periods as it introduces lower margin products for consumer 
markets and as price competition increases for all products. 

                                       -12-

<PAGE>

     Customers generally do not order the Company's products in advance of 
their needs.  As a result, the Company's backlog is relatively small.  Even 
though backlogs are small and future sales are difficult to forecast, the 
Company must undertake development projects, initiate sales and marketing 
activities, stock inventory, plan production, order components and make other 
commitments months in advance of receiving orders for its products. A 
shortfall in revenues in a given quarter may adversely impact the Company's 
operating results due to its inability to make a corresponding adjustment to 
expenses during that quarter. 

     The Company currently derives a substantial portion of its total 
revenues from the sale of a relatively low unit volume of high priced 
products.  The Company's backlog at the beginning of a quarter typically does 
not include all sales required to achieve the Company's sales objectives for 
that quarter. Consequently, the Company's total revenues and operating 
results for a quarter depend upon the Company obtaining new orders for 
products to be shipped in the same quarter.  On occasion, a significant 
amount of the Company's quarterly sales are attributable to a limited number 
of customers.  These factors combine to make the volume and timing of orders 
received by the Company during a quarter difficult to forecast. 

     A disproportionate percentage of the Company's total revenues result 
from sales made in the last month of a quarter.  As a result, a shortfall in 
sales in any quarter as compared to expectations may not be identifiable 
until the end of the quarter.  This sales cycle may also increase the impact 
of a delay in shipment near the end of a particular quarter, due for example, 
to shipment rescheduling or cancellation, or manufacturing difficulties 
experienced by the Company or its suppliers.  Either an unexpected shortfall 
in sales late in a quarter or a delay in shipment may cause total revenues in 
a particular quarter to fall significantly below the Company's expectations 
and may thus materially adversely affect the Company's operating results for 
that quarter. 

     The Company's industry is subject to a high degree of seasonality.  
Demand for the Company's products has historically been highest in the third 
and fourth quarters of each calendar year. As a result, sales are typically 
highest in these quarters and may be lower in following quarters. 

RISKS ASSOCIATED WITH NEW MARKETS AND APPLICATIONS; MARKET ACCEPTANCE.  A 
substantial portion of the Company's revenues in 1998 were derived from sales 
of products that address the home theater and industrial TV markets.  Certain 
of the Company's current products and future product plans address markets 
that are not now and may never become substantial commercial markets. The 
Company's future growth will depend, in large part, on the Company's ability 
to identify new markets for its products and to apply its video enhancement 
technology to evolving markets and applications.  There can be no assurance 
that these markets will become substantial commercial markets or that the 
Company's products will achieve market acceptance in those markets.  The 
Company also intends to exploit new display technologies and what it believes 
will be the convergence of the TV and PC markets.  There can be no assurance 
that these new display technologies will be successful or that the TV and PC 
markets will converge, that these new market will present substantial 
commercial opportunities, or that the Company's products will adequately 
address these markets in a timely manner.  The Company has experienced, and 
expects to continue to experience, technological and pricing constraints that 
may interfere with its development of products that address emerging markets. 
For example, price has been an issue for certain OEMs that considered 
incorporating the Company's current ASICs into their products. In addition, 
certain prospective development partners have deferred or abandoned joint 
development plans for reasons including market uncertainties regarding which 
technologies should be bundled on highly integrated chips.  There can be no 
assurance that the Company or its OEM customers will continue their existing 
product development efforts, or, if continued, that such efforts will be 
successful, that markets will develop in a timely manner, if at all, for any 
of the Company's or such customers' products, or that the Company's and its 
customers' products will not be superseded by other technologies or products. 

RISKS ASSOCIATED WITH CHANGING TV STANDARDS.  The Company is developing 
products that are designed to conform with certain current industry broadcast 
standards. However, there can be no assurance that manufacturers will 
continue to follow these standards or that more desirable standards will not 
emerge.  The acceptance of the Company's products also depends in part upon 
content providers developing and marketing content for end user systems, such 
as video and audio playback systems, in a format compatible with the 
Company's products. There can be no assurance that these or other factors 
beyond the Company's control will not adversely affect the development of 
markets for the Company's products. 

     The FCC has required broadcasters to begin broadcasting DTV signals in 
May 1999, targeting the eventual phase out of the current analog signals by 
the year 2006. There is considerable uncertainty among broadcasters and 
providers of broadcast, reception and display equipment as to how DTV will be 
implemented, as to how broadly and rapidly DTV will be deployed, and as to 
when, if ever, analog TV will be discontinued. There can be no assurance that 
the market for the Company's home theater and industrial or broadcast 
products will continue following the introduction of DTV or if competing 
standards or technologies emerge that are preferred by manufacturers and 
consumers. In addition, there can be no assurance that DTV and related 
products will gain market acceptance or that content providers will develop 
and market content for end-user systems using a digital format or a format 
compatible with the Company's products. There can be no assurance that such 
factors, all of which are beyond the Company's control, will not adversely 
affect the development of markets for the Company's products. 

DEPENDENCE ON NEW PRODUCT DEVELOPMENT AND RISK OF TECHNOLOGICAL CHANGE.  The
markets for the Company's products are 

                                       -13-

<PAGE>

characterized by evolving industry standards, rapid technological change, 
frequent new product introductions and short product life cycles. The 
Company's future success will depend, in large part, on its ability to 
continue to enhance its existing products, to develop new products and 
features to meet changing customer requirements and evolving industry 
standards, and on its ability to identify and enter into royalty-generating 
license agreements with prospective licensees. The Company anticipates that 
sales from its line multiplier product lines will experience limited growth, 
or may decline, in future periods.  The Company's home theater and industrial 
sales decreased in 1998, which the Company attributes to increased 
competition, pricing pressure and consumer confusion over HDTV.  The Company 
believes that the introduction of new products throughout 1999 and increased 
emphasis on board and ASIC products will improve its competitive position.  
The Company believes that the confusion associated with HDTV broadcast will 
continue until HDTV broadcast begins on a wide-scale basis.  The Company 
expects that approximately one-half of its total revenues in 1999 will be 
derived from sales of recently introduced products and products which the 
Company is developing for introduction in 1999.  The success of new products 
depends on a number of factors, including proper selection and timely 
introduction, successful and timely completion of product development, 
accurate estimation of demand, market acceptance of new products of the 
Company and its OEM customers, the Company's ability to offer new products at 
competitive prices, the availability of adequate staffing to produce and sell 
such new products, and competition from products introduced by competitors.  
Certain of these factors are outside the control of the Company.  Sales of 
the Company's board and ASIC products, and future license and royalty 
revenues, depend in part upon the ability of the Company's OEM customers and 
licensees to successfully develop and market products incorporating the 
Company's products or technology. There can be no assurance that the 
Company's broadcast products will be widely accepted by the broadcast market. 
There can be no assurance as to the amount of royalties, if any, that the 
Company will receive in the future.  The Company does not currently have any 
license agreements in effect pursuant to which it expects to receive 
substantial future royalties.  

     The incorporation of the Company's products into its OEM customers' 
product designs often requires significant expenditures by the Company, which 
expenditures may precede volume sales of the Company's products, if any, by 
one year or more. The introduction of new or enhanced products also requires 
the Company to manage the transition from older products in order to minimize 
disruption in customer ordering patterns, to avoid excessive levels of older 
product inventories and to ensure that adequate supplies of new products can 
be delivered to meet customer demand. 

     There can be no assurance that the Company will identify new product 
opportunities, will successfully develop and bring to market new products, 
will be chosen to supply board level or ASIC products for incorporation into 
OEMs' products or will respond effectively to technological changes or 
product announcements by others, or that the Company's new products will 
achieve market acceptance. A failure in any of these areas would have a 
material adverse effect on the Company's business, financial condition and 
operating results. 

COMPETITION.  The markets in which the Company competes are intensely 
competitive and are characterized by rapid technological change, rapid 
product obsolescence and price competition.  The Company expects competition 
to increase in the future from existing competitors and from other companies 
that may enter the Company's existing or future markets with products or 
technologies which may be less costly or provide higher performance or more 
desirable features than the Company's products.  During 1998 competition in 
the home theater and industrial markets increased at the low end from 
manufacturers of less expensive line multipliers, from projector 
manufacturers building line multipliers into their projectors and from 
companies offering relatively inexpensive chips performing functions 
analogous to functions performed by the Company's products.  The Company's 
existing and potential competitors include several large domestic and 
international companies that have substantially greater financial, 
manufacturing, technical, marketing, distribution and other resources than 
the Company.  In the market for TV video processors, the Company's principal 
competitors are DWIN, Extron, Miranda, NEC, Snell & Wilcox, Sony and YEM.  
DVDO and Genesis have recently emerged as competitors with chip solutions.  
In the market for broadcast products, the Company's principal competitors are 
Extron, Leitch, Miranda, Panasonic, Snell & Wilcox, and Vistek. As the 
Company's products penetrate broader markets and as these markets become 
commercial markets, the Company expects to face competition from diversified 
electronic and semiconductor companies. 

     Yves Faroudja, the Company and GI are parties to a royalty free, 
world-wide license agreement dated May 1, 1996 pursuant to which GI licensed 
certain patents to the Company and the Company licensed certain patents to GI 
relating to video compression and decompression. As a result of that 
agreement, GI could produce products in the field of scan conversion of 
source material presented to a compression system competitive with the 
Company's Digital Format Translator-TM- products. 

     The Company's licensees and OEM customers may be larger and have greater 
market recognition and financial, technological, engineering, manufacturing 
and distribution capabilities than the Company.  In addition, such licensees 
and OEM customers may use such technologies and subsystems either alone or in 
combination with other technologies to develop products which could compete 
with the Company's technologies and products. At present, the Company 
believes that S3 and GI are licensees which could compete with certain of the 
Company's technologies and products. 

     Certain of the Company's principal competitors maintain their own
manufacturing facilities, including semiconductor foundries, and may therefore
benefit from certain capacity, cost and technical advantages. Since the Company
does not operate its own 

                                       -14-

<PAGE>

semiconductor manufacturing, assembly or testing facilities, it may not be 
able to reduce its costs as rapidly as companies that operate their own 
facilities. The Company's failure to introduce lower cost versions of its 
products in a timely manner or to successfully manage its manufacturing, 
assembly and testing relationships would have a material adverse effect on 
its business, operating results and financial condition. 

     The Company believes that its ability to compete successfully in the 
rapidly evolving markets for high performance video technology depends on a 
number of factors, including protection of its intellectual property and, the 
price, quality and performance of the Company's and its competitors products, 
the timing and success of new product introductions by the Company, its 
customers and its competitors, the emergence of new industry standards, the 
Company's ability to obtain and locate adequate foundry capacity, the number 
and nature of the Company's competitors in a given market and general market 
and economic conditions. There can be no assurance that the Company will 
compete successfully in the future with respect to these or any other 
competitive factors.

DEPENDENCE ON STRATEGIC RELATIONSHIPS.  The Company expects that a 
significant portion of its annual revenues and profits in the future will 
depend on strategic relationships. The Company depends on companies like 
Vidikron to sell, and In Focus to manufacture, products which incorporate the 
Company's technology and a failure by these companies to do so will adversely 
affect the Company's total revenues in the future. There can be no assurance 
that the Company will identify new strategic partners or enter into 
additional strategic relationships or that any of the Company's strategic 
relationships will result in the introduction of new products incorporating 
the Company's technology or will result in substantial revenues for the 
Company. In the event that the Company's strategic relationships fail to 
result in substantial revenues to the Company, the Company's business, 
financial condition and operating results will be materially adversely 
affected. 

     The Company has licensed and intends to continue to license its 
technologies and intellectual property.  The Company also offers for sale 
board level or ASIC products, developed by the Company, which implement 
certain of the Company's technologies. The Company's licensees and OEM 
customers may be larger and have greater market recognition and financial, 
technological, engineering, manufacturing and distribution capabilities than 
the Company.  In addition, such licensees and OEM customers may use such 
technologies and subsystems either alone or in combination with other 
technologies to develop products that compete with the Company's technologies 
and products.  While the Company may sell board level or ASIC products and 
receive royalties from such licensees, there can be no assurance that the 
technologies and products offered by such licensees and OEM customers will 
not compete directly with those of the Company, have performance, cost or 
other advantages over those of the Company or have an adverse impact on the 
sales or other licensing activities of the Company. 

RISKS ASSOCIATED WITH EXPORT SALES AND OPERATIONS.  The Company intends to 
expand its international presence in order to increase its export sales.  
Export sales to international customers entail a number of risks, including 
unexpected changes in, or impositions of, legislative or regulatory 
requirements, delays resulting from difficulty in obtaining export licenses 
for certain technology, tariffs, quotas and other trade barriers and 
restrictions, longer payment cycles, greater difficulty in accounts 
receivable collection, potentially adverse taxes, currency exchange 
fluctuations, the burdens of complying with a variety of foreign laws and 
other factors beyond the Company's control. The Company would also be subject 
to general geopolitical risks in connection with international operations, 
such as political, social and economic instability, potential hostilities and 
changes in diplomatic and trade relationships. Although the Company has not 
to date experienced any material adverse effect on its operations as a result 
of such regulatory, geopolitical and other factors, there can be no assurance 
that such factors will not adversely affect the Company's operations in the 
future or require the Company to modify its current business practices. There 
can be no assurance that one or more of the foregoing factors will not have a 
material adverse effect on the Company's business, financial condition and 
operating results or require the Company to modify its current business 
practices. 

DISTRIBUTION RISKS; DIVERSIFICATION OF SALES CHANNELS.  The Company sells its 
products domestically and internationally through distributors and dealers, 
as well as to OEM customers, and the Company's success depends on the 
continued efforts of this network of direct and indirect distributors and 
dealers.  In 1998, sales to Vidikron, an OEM customer accounted for 10% of 
total Company revenues.  The loss of, or reduction in sales to, any of the 
Company's key customers, could have a material adverse affect on the 
Company's operating results.  The short life cycles of the Company's products 
and the difficulty in predicting future sales increase the risk that new 
product introductions, price reductions by the Company or its competitors or 
other factors affecting the video imaging industry could result in 
significant product returns.  In addition, there can be no assurance that new 
product introductions by competitors or other market factors will not require 
the Company to reduce prices in a manner or at a time which has a material 
adverse impact upon the Company's business, financial condition and operating 
results. 

     An integral element of the Company's strategy is to enhance and diversify
its distribution channels. The Company's ability to achieve revenue growth in
the future will depend in large part on its success in recruiting and training
sufficient sales personnel, distributors and resellers.  Certain of the
Company's existing distributors currently distribute, or may in the future
distribute, the product lines of the Company's competitors.  There can be no
assurance that the Company will be able to attract, train and retain a
sufficient number of its existing or future third-party distributors or direct
sales personnel or that such third-party distributors will recommend, or
continue to recommend, the Company's products, or devote sufficient resources to
market and provide customer support for such 

                                       -15-

<PAGE>

products.  All of these factors could have a material adverse effect on the 
Company's business, financial condition and operating results. 

RELIANCE ON INDEPENDENT FOUNDRIES AND MANUFACTURING.  The Company currently 
relies on independent foundries to manufacture, assemble and test all of its 
semiconductor components and products.  These independent foundries fabricate 
products for other companies and may also manufacture products of their own 
design.  The Company currently purchases products from all of its foundries 
pursuant to individually negotiated purchase orders.  The Company does not 
have a long-term supply contract with any of these foundries, and, therefore, 
none of them is obligated to supply products to the Company for any specific 
period, in any specific quantity or at any specified price, except as may be 
provided in a particular purchase order.  The Company's reliance on 
independent foundries involves a number of risks, including the inability to 
obtain adequate capacity, unavailability of or interruption of access to 
certain process technologies, reduced control over delivery schedules, 
quality assurance, manufacturing yields and cost, and potential 
misappropriation of the Company's intellectual property. From time to time, 
the semiconductor industry has experienced severe capacity constraints, and 
this pattern is expected to continue.  The Company obtains foundry capacity 
through forecasts that are generated in advance of expected delivery dates, 
and the Company places purchase orders up to six months prior to scheduled 
delivery.  The Company's ability to obtain the foundry capacity necessary to 
meet the demand for its products is based in part on its ability to 
accurately forecast demand.  If the Company fails to accurately forecast its 
future demand, the Company may be unable to obtain adequate supplies of 
integrated circuits on a timely basis.  There can be no assurance that the 
Company will be able to accurately forecast the demand for its products or 
obtain sufficient foundry capacity in the future.  In addition, the Company's 
obligation to place purchase orders in advance of delivery subjects the 
Company to inventory risks, including the risk of obsolescence. 

     While the Company has not experienced any material disruptions in supply 
to date, there can be no assurance that manufacturing problems will not occur 
in the future.  In the event that any of the Company's foundries are unable 
or unwilling to produce sufficient supplies of the Company's products in 
required volumes at acceptable costs, the Company will be required to 
reallocate production among its other existing foundries or to identify and 
qualify acceptable alternative foundries.  This qualification process could 
take six months or longer, and no assurance can be given that any additional 
source would become available to the Company or would be in a position to 
satisfy the Company's production requirements on a timely basis.  The loss of 
any of the Company's foundries as a supplier, the inability of the Company in 
a period of increased demand for its products to expand supply or the 
Company's inability to obtain timely and adequate deliveries from its current 
or future suppliers could reduce or delay shipments of the Company's 
products.  Any of these developments could damage relationships with the 
Company's current and prospective customers and could have a material adverse 
effect on the Company's business, financial condition and operating results. 

     The Company subcontracts the manufacturing of its broadcast and TV 
products pursuant to individually negotiated purchase orders.  The Company 
does not have any long-term agreements with its subcontractors and contract 
manufacturers. The Company's reliance on third-party manufacturers limits its 
control over delivery schedules, quality assurance and product cost.  
Disruptions in the provision of services by the Company's assemblers or other 
circumstances that would require the Company to seek alternative sources of 
assembly could lead to supply constraints or delays in the delivery of the 
Company's products. In addition, the need for high quality assurance by the 
Company may increase costs paid by the Company to third parties for 
manufacturing and assembly of the Company's products. These constraints or 
delays could damage relationships with current and prospective customers and 
could have a material adverse effect on the Company's business, financial 
condition and operating results. 

LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF THIRD PARTY 
INFRINGEMENT.  The Company's future success depends in part upon its ability 
to protect its technology and information. The Company seeks to protect its 
intellectual property rights and to limit access to its proprietary 
information through a combination of patents, trademarks, copyrights, trade 
secrets, and nondisclosure and licensing arrangements, all of which afford 
only limited protection. There can be no assurance that patents will issue 
from any pending applications, or that any claims allowed from pending 
applications will be of sufficient scope or strength, or be issued in all 
countries necessary to provide meaningful protection or commercial advantage 
to the Company.  Also, competitors of the Company may be able to design 
around the licensed patents.  The laws of certain foreign countries in which 
the Company's products are or may be developed, manufactured or sold, 
including various countries in Asia, may not protect the Company's products 
or intellectual property rights to the same extent as the laws of the United 
States.  There can be no assurance that the steps taken by the Company to 
protect its intellectual property rights will be adequate to prevent 
misappropriation of its technology or that the Company's competitors will not 
independently develop technologies that are substantially equivalent or 
superior to the Company's technology. 

     There can be no assurance that the Company's intellectual property 
rights, if challenged, will be upheld as valid, will be adequate to prevent 
misappropriation of its technology or will prevent the development of 
competitive products. Additionally, there can be no assurance that the 
Company will be able to license or obtain patents or other intellectual 
property protection in the future. 

     Substantially all of the intellectual property used by the Company is 
licensed to the Company by Yves Faroudja. The Company faces certain risks 
because the Company is a licensee and not the owner of such intellectual 
property rights. Under his agreement with the Company, Mr. Faroudja retains 
the non-exclusive right to license his patents and technologies to third 
parties for use outside the Company's field of use.  Notwithstanding the 
particular terms of the license agreement with Mr. Faroudja, the Company 
faces the risk that 

                                       -16-

<PAGE>

he may attempt to terminate the granted licenses and that such an attempt may 
be successful or that the response to such attempt may consume substantial 
financial and personnel resources. In the event the Company's resources are 
so consumed, such consumption could have a material adverse affect on the 
Company's business, financial condition and operating results. 

     The video image enhancement and related industries are characterized by 
vigorous protection and pursuit of intellectual property rights or positions, 
which have resulted in significant and often protracted and expensive 
litigation.  The Company may from time to time be subject to proceedings 
alleging infringement by the Company of intellectual property rights owned by 
third parties.  If necessary or desirable, the Company may seek licenses 
under such intellectual property rights.  However, there can be no assurance 
that such licenses will be offered or that the terms of any offered license 
will be acceptable to the Company.  The failure to obtain such a license from 
a third party for technology used by the Company could cause the Company to 
incur substantial liabilities and to suspend or cease the manufacture of 
products requiring such technology. 

     The Company may initiate claims or litigation against third parties for 
infringement of the Company's proprietary rights, like the suits it filed 
against DWIN and Snell & Wilcox, or to establish the validity of the 
Company's proprietary rights.  Litigation by or against the Company could 
result in significant expense to the Company and could divert the efforts of 
the Company's technical and management personnel, whether or not such 
litigation results in a determination favorable to the Company.  Such 
diversion could have a material adverse effect on the Company's business, 
financial condition and operating results.  In addition, litigation initiated 
by the Company could result in the assertion of counter claims against the 
Company.  In the event of an adverse result in any such litigation, the 
Company could be required to pay substantial damages, attorney fees, costs 
and expenses.  The Company could also be ordered to cease infringing a third 
party's intellectual property rights (including, marketing, using, selling 
and importing infringing products, and employing infringing methods or 
processes).  An adverse determination could also result in the Company 
expending significant resources to develop non-infringing technology or to 
obtain licenses to the technology allegedly infringed. There can be no 
assurance that the Company would be successful in such development or that 
any such license would be available on reasonable terms, if at all.  In the 
event that any third party makes a successful intellectual property claim 
against the Company or its customers, the Company's business, financial 
condition and operating results could be materially adversely affected. 

DEPENDENCE ON SENIOR MANAGEMENT AND OTHER KEY EMPLOYEES.  The Company's 
future success will depend to a significant extent upon the continued service 
of members of senior management and other key employees of the Company, 
particularly Yves Faroudja, the Company's founder, Chief Technical Officer 
("CTO") and Co-Chairman.  The loss of the service of any of these individuals 
could have a material adverse effect on the Company.  

     Mr. Faroudja entered into an agreement with the Company pursuant to 
which he serves as an advisor, and continues to serve as the Company's CTO 
until a new CTO is identified and appointed.  The agreement further provides 
that when a new CTO is appointed, Mr. Faroudja will become a Senior Fellow of 
the Company.  Mr. Faroudja has elected to terminate the agreement on June 30, 
1999.  The Company does not know how much time Mr. Faroudja will devote to 
the Company's affairs in the future.

     The Company does not maintain key man life insurance on any of its 
employees.  The Company believes that its future success will depend to a 
significant extent upon its ability to attract, train and retain highly 
skilled technical, management, sales, marketing and consulting personnel.  
During 1998, a number of VLSI engineers left the Company.  While the Company 
has not yet replaced the VLSI engineers, it has retained certain of the 
engineers as consultants on an interim basis to complete projects in 
progress.  The Company has initiated recruiting efforts, but there can be no 
assurance that the Company will be successful in attracting or retaining 
qualified replacements for these VLSI engineers.  The failure to attract or 
retain such replacements could have a material adverse effect on the 
Company's business, financial condition and operating results.

     Competition for skilled executive, technical, management, sales, 
marketing, consulting and other personnel is intense, and the Company expects 
that such competition will continue for the foreseeable future.  The Company 
has from time to time experienced difficulty in locating candidates with 
appropriate qualifications.  There can be no assurance that the Company will 
be successful in attracting or retaining such personnel, and the failure to 
attract or retain such personnel could have a material adverse effect on the 
Company's business, financial condition and operating results. 

DEPENDENCE ON ROYALTY REVENUES.  There can be no assurance as to the amount 
of royalties, if any, that the Company will receive in the future under its 
license agreement with S3.  S3 has not made any payments necessary to 
maintain its exclusive license rights with respect to any periods after March 
31, 1998 and the Company does not currently have any other license 
agreements in effect pursuant to which it expects to receive substantial 
future royalties.  Revenues from S3 accounted for 10.6% of the Company's 
total revenues for the year ended December 31, 1997 and 6.1% of total 
revenues for the year ended December 31, 1998.

POSSIBLE VOLATILITY OF STOCK PRICE.  Factors such as announcements of 
developments related to the Company's business, announcements of 
technological innovations or new products or enhancements by the Company or 
its competitors, sales of the Company's Common Stock 

                                       -17-

<PAGE>

into the public market, developments in the Company's relationships with its 
customers, distributors and suppliers, shortfalls or changes in total 
revenues, gross margin, earnings or other financial results from analysts' 
expectations, regulatory developments, fluctuations in results of operations 
and general conditions in the Company's market, the market served by the 
Company's customers or the economy as a whole, could cause the price of the 
Company's Common Stock to fluctuate, perhaps substantially. In addition, in 
recent years the stock market in general, and the market for shares of small 
capitalization and technology stocks in particular, have experienced extreme 
price and volume fluctuations, which have often been unrelated or 
disproportionate to the operating performance of affected companies. There 
can be no assurance that the market price of the Company's Common Stock will 
not decline substantially, or otherwise experience significant fluctuations 
in the future, including fluctuations that are unrelated to the Company's 
performance. 

YEAR 2000 PROBLEM.  Certain computers, software and equipment with embedded 
computing capability recognize only the last two, rather than all four digits 
of the year in any date.  As a result they may fail to recognize and properly 
process date information or otherwise malfunction unless they are 
reprogrammed or replaced at the turn of the century (the "Year 2000 
Problem").  While the Company does not believe the Year 2000 Problem will 
impact the performance and functionality of its products and is actively 
working to identify and address internal and external issues associated with 
the Year 2000 Problem, there can be no assurance that the Company will 
identify all of its Year 2000 Problems, resolve internal and external Year 
2000 Problems on a timely or cost-effective basis, or be successful in 
avoiding the impact of business disruptions which may be experienced by the 
Company's suppliers, service providers and other third parties as a result of 
Year 2000 Problems.  Failure by the Company or third parties doing business 
with the Company to identify and resolve Year 2000 problems on a timely basis 
could have a material adverse effect on the Company's financial position, 
liquidity or results of operations.

EXECUTIVE OFFICERS OF THE COMPANY

     Set forth below is the name, age and office held with the Company of 
each of the executive officers of the Company as of March 30, 1999 and such 
executive officers' other business experience during the past five years. 
Except as otherwise indicated, each such executive officer was elected at the 
meeting of the Board of Directors held after the annual meeting of 
stockholders held on June 10, 1998. The term of office for each executive 
officer extends until the next meeting of the Board of Directors for the 
election of officers and until their respective successors are duly elected. 

     GLENN W. MARSCHEL, JR. (age 52) has served as President, Chief Executive 
Officer and Co-Chairman of the Board of Directors since joining the Company 
in October 1998.  He has served as Executive Chairman of the Board of 
Directors of Additech, Inc., a petrochemicals company, since October 1997.  
From December 1995 to August 1997 Mr. Marschel was President and Chief 
Executive Officer of Paging Network, Inc., a telecommunications company, and 
from April 1995 to November 1995 he served as Vice Chairman of First 
Financial Management Company, a company in the credit report and collections 
business.  Prior thereto, from January 1972 to January 1995, Mr. Marschel 
held positions of increasing responsibility at Automatic Data Processing, 
Inc., an information systems company, last serving as President of ADP's 
Employer Services Group.  Mr. Marschel is also a director of Sabre Group 
Holdings, Inc.

     YVES C. FAROUDJA (age 65) is co-founder of the Company and has served as 
a director of the Company since its inception in 1971. Mr. Faroudja served as 
the Company's President from 1971 to July 1996, has been the Company's Chief 
Technical Officer since July 1996.  Mr. Faroudja has served as Co-Chairman of 
the Board of Directors since October 1998 and is Chairman of the Board's 
Executive Committee. 

     ROBERT A. SHEFFIELD (age 50) joined the Company in July 1998 as Vice 
President - Finance and Chief Financial Officer.  From 1996 to June 1998, Mr. 
Sheffield was the Vice President - Finance and Chief Financial Officer of 
Asante Technologies, a designer, manufacturer and supplier of local area 
networking products.  From 1994 to 1995, Mr. Sheffield was the Vice President 
of New Business Development for Time Warner/Atari Games ("Time Warner 
Interactive"), a video arcade and consumer video entertainment software 
company, and from 1988 to 1994, Mr. Sheffield was Time Warner Interactive's 
Vice President - Finance and Chief Financial Officer.  From 1985 to 1988 Mr. 
Sheffield served as the Vice President - Finance and Chief Financial Officer 
of Televideo Systems, Inc., a manufacturer of video display terminals, 
personal computers and networks and, from 1984 to 1985 was Vice President - 
Finance and Chief Financial Officer of Gill Management Services, Inc., a 
computer services and software development firm. 

     DONALD S. BUTLER (age 53) joined the Company in May 1996 as Vice 
President and General Manager of the VLSI Division.  In October 1996, as Vice 
President-Engineering, he assumed responsibility for all engineering 
functions, and in July 1998 he was promoted  to the position of Senior Vice 
President-Engineering. Prior to joining the Company, from 1989 to May 1996, 
Mr. Butler was Vice President of Engineering at the Integrated Systems Center 
of General Instrument Corporation, a manufacturer of cable and satellite TV 
equipment. From 1974 to 1989, he held several engineering and engineering 
management positions within GI's Microelectronics Division. 

     NIKHIL BALRAM, PH.D. (age 36 ) joined the Company in January 1999 as 
Vice President-Advanced Technology.  From July 1997 to January 1999, Dr. 
Balram was Director of Systems Architecture and Manager of the Video Group at 
S3 Incorporated, a manufacturer of multimedia integrated circuits.  From 
January 1995 to July 1997, Dr. Balram held various research and development 
positions at Kaiser 

                                       -18-

<PAGE>

Electronics, a manufacturer of military avionics display systems, last 
serving as Staff Scientist.  From June 1994 to January 1995, Dr. Balram did 
marketing and engineering at the multimedia business unit of Rexon/Tecmar, 
Inc., a data storage company.  From March 1992 to June 1994, Dr. Balram was a 
staff engineer with the Video/Graphics VLSI Development group of IBM 
Corporation, a computer company.

     THOMAS A. HARVEY (age 50) joined the Company in June 1997 as Vice 
President-Sales and Marketing. From September 1990 to May 1997, Mr. Harvey 
was Senior Vice President of the Western Zone Sales Consumer Products Group 
of Sony Electronics, Inc. ("Sony Electronics"), a leading electronics 
supplier. From June 1989 to August 1990, Mr. Harvey was the President of the 
Consumer Sales Company division of Sony Electronics. From August 1987 to May 
1989, he was the President of the Consumer Audio Products group of Sony 
Electronics. 

     KENNETH S. BOSCHWITZ (age 45) joined the Company in June 1997 as Vice 
President-Business Development and General Counsel.  In June 1998, he became 
Secretary of the Company.  From May 1984 to September 1996, Mr. Boschwitz 
held various legal and management positions with General Instrument 
Corporation, a manufacturer of cable and satellite TV equipment, including 
Vice President and General Counsel of GI's Communications Division. 

ITEM 2.  PROPERTIES

     The Company occupies approximately 20,000 square feet of space in 
Sunnyvale, California pursuant to a lease that extends until September 30, 
2003. In 1997, the Company leased an additional 10,000 square feet of space 
in Sunnyvale, California for a term which extends until September 2003 and 
leased 2,000 square feet in Phoenix, Arizona for a research and development 
facility.  The Company determined that leased space exceeded its needs and 
terminated the Phoenix lease on October 31, 1998 and is actively seeking to 
sublease the additional 10,000 square feet in Sunnyvale.  There can be no 
assurance that the Company will be able to sublease the additional Sunnyvale 
space or that the rent obtained from a sublease will be equal to the rent 
payable on the Company's lease.  The aggregate annual gross rent for the 
Company's facilities was approximately $289,000 in 1997, approximately 
$465,000 in 1998 and will be approximately $424,000 in 1999.

ITEM 3.  LEGAL PROCEEDINGS

     In January 1997 the Company filed an action against DWIN and in May 1997 
filed an action against Snell & Wilcox, seeking injunctive relief and 
unspecified monetary damages for the infringement of US Patent Number 
4,876,596 (the "596 Patent").   Both actions were filed in the United States 
District Court, Northern District of California, San Jose Division.  The case 
against DWIN is Civil Action No. C-97 20010 SW (PVT) and the case against 
Snell & Wilcox is Civil Action No. C-97 20422 SW (PVT).  The 596 Patent was 
issued on October 24, 1989, is owned by Yves Faroudja and is licensed to the 
Company.  DWIN and Snell & Wilcox raised defenses and counterclaims that the 
596 Patent is invalid and not infringed.  They also sought to recover 
attorneys' fees and costs. 

     On February 18, 1998, the court in the Snell & Wilcox action granted the 
Company's motion for leave to amend its complaint to add claims of 
infringement of U.S. Patent Number 4,998,287 (the "287 Patent") and U.S. 
Patent Number 4,881,125 (the "125 Patent"), and to name additional Snell & 
Wilcox products as being within the category of infringing products.  The 287 
patent was issued on March 5, 1991 and the 125 Patent was issued on November 
14, 1989.  The 287 and 125 patents are owned by General Instrument and 
licensed to the Company.  By order dated May 1, 1998, the court granted Snell 
& Wilcox's motion for summary judgment as to the 596 Patent on the basis of 
non-infringement.  The Company, Snell & Wilcox and General Instrument settled 
the case effective as of December 8, 1998.  The settlement provides that 
Snell & Wilcox home theater products are subject to a royalty-bearing license 
from the Company.  On January 21, 1999, the court's summary judgment ruling 
as to the 596 Patent was vacated and had no further force or effect.  The 
case was dismissed on January 21, 1999, with prejudice as to licensed home 
theater products and without prejudice as to other products.

     In the DWIN action the Company amended its complaint to add claims of 
infringement of the 287 Patent on August 17, 1998. On February 24, 1999, the 
court in the DWIN action granted DWIN's motion for summary judgment as to the 
596 Patent on the basis of non-infringement.    The case continues with 
respect to the 287 Patent and is in the early stages of discovery.

     The Company's management believes that a finding that all of the claims 
of the patents are invalid or that the patents have not been infringed in the 
DWIN action will not have a material adverse effect on the Company because 
the Company's products and business are protected by a variety of patents and 
the Company will remain competitive even in the absence of the protection 
afforded by the patents which are involved in that litigation. 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.


                                       -19-

<PAGE>

                                       PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER 
MATTERS.

Price Range of Common Stock

The Company's Common Stock (Nasdaq symbol "FDJA") began trading publicly on 
the Nasdaq Stock Market on October 30, 1997.  Prior to that date there was no 
public market for the Company's Common Stock.  The follow table presents, for 
the periods indicated, the intraday high and low sale prices for the Common 
Stock as reported by the Nasdaq Stock Market.


<TABLE>
<CAPTION>
Fiscal 1997                                            High              Low
-----------                                          --------         --------
<S>                                                  <C>              <C>
Fourth Quarter (from October 30, 1997)                $10.50           $5.50

Fiscal 1998                                            High              Low
-----------                                          --------         --------
<S>                                                  <C>              <C>
First Quarter                                         $11.13           $6.44
Second Quarter                                        $12.38           $8.50
Third Quarter                                         $8.63            $3.69
Fourth Quarter                                        $4.31            $2.31
</TABLE>

As of March 1, 1999, there were approximately 350 holders of record of the 
Company's Common Stock which the Company believes represents more than 3,000 
beneficial holders.  The Company has not paid cash dividends on its Common 
Stock and presently intends to retain any earnings for investment in its 
business.

ITEM 6.  SELECTED FINANCIAL DATA.

     SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                             Year Ended December 31
-----------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)                        1998        1997       1996        1995       1994
                                                             ----------------------------------------------------------
<S>                                                          <C>          <C>        <C>        <C>          <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenues                                                $12,270     $17,006    $13,126    $11,954      $8,065
Net (loss) income                                              (3,469)      1,251        N/A        N/A         N/A
Pro forma net (loss) income (1)                                  N/A        N/A        1,319 (1)  3,070 (1)   1,228 (1)
Net (loss) income per share (diluted)                          ($0.29)      $0.13        N/A        N/A         N/A
Pro forma net (loss) income per share (diluted) (1)              N/A        N/A        $0.16 (1)  $0.43 (1)   $0.15 (1)
Shares used in diluted per share
  computation                                                  12,146       9,925      8,191      7,176       7,979
-----------------------------------------------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term
  investments                                                 $20,419     $23,549     $3,083     $2,759      $1,064
Working capital                                                24,487      26,987      5,861      4,744       2,223
Total assets                                                   28,721      33,489      9,604      6,734       3,434
Total long-term debt                                              -          -           -          -           -
Total stockholders' equity                                     26,498      29,348      7,245      5,515       2,826

-----------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
QUARTERLY DATA:
                                           1998                                          1997
                            ---------------------------------------------  ----------------------------------------------
                                4th        3rd         2nd          1st        4th         3rd         2nd        1st
                            ---------------------------------------------  ----------------------------------------------
<S>                         <C>           <C>         <C>         <C>         <C>         <C>         <C>        <C>
Total revenues                $2,554      $3,005      $3,353      $3,358      $4,130      $5,012      $4,279     $3,585
Gross profit                   1,215       1,362       1,940       2,254       2,820       3,346       2,992      2,586
Net (loss) income               (903)     (1,821)       (754)          8         326         391         285        249
Net (loss) income per share
(diluted)                     $(0.08)     $(0.15)     $(0.06)     $ 0.00      $ 0.03      $ 0.04      $ 0.03     $ 0.03
</TABLE>

(1) Reflects the pro forma effect of the Company being treated as a C 
Corporation rather than an S Corporation for federal and state income tax 
purposes from January 1, 1994.
(2) See Note 1 of Notes to Consolidated Financial Statements for an explanation 
of the basis used to calculate net (loss) income per share.

                                       -20-

<PAGE>

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
RESULTS OF OPERATION.

THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE 
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CONCERNING THE COMPANY'S 
FUTURE PRODUCTS, EXPENSES, REVENUE, LIQUIDITY AND CASH NEEDS AS WELL AS THE 
COMPANY'S PLANS AND STRATEGIES.  SUCH FORWARD-LOOKING STATEMENTS INVOLVE 
KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES.  THESE FORWARD-LOOKING STATEMENTS 
ARE BASED UPON CURRENT EXPECTATIONS.  THE COMPANY'S ACTUAL RESULTS AND TIMING 
OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THE DESCRIPTIONS IN THESE 
FORWARD-LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS, INCLUDING THOSE 
SET FORTH BELOW. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY UPDATE OR 
REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW 
INFORMATION, FUTURE EVENTS, OR OTHERWISE.

Overview

     Faroudja, Inc. (the "Company") began operations in 1971 through two 
related companies, Faroudja Laboratories, Inc. ("FLI") and later Faroudja 
Research Enterprises, Inc. ("FRE"). The Company was incorporated in December 
1996 under the laws of the state of Delaware to succeed to the business of 
FLI and FRE. From inception to 1988 the Company specialized in the 
development, manufacturing and sale of products to the broadcast industry.  
In 1988 the Company introduced its initial product for the home theater and 
industrial markets - a video processor referred to as a line multiplier.  In 
1998, 1997, and 1996, sales of products for the home theater and industrial 
markets comprised approximately 84%, 88% and 80%, respectively, of the 
Company's total revenues. In 1998 the Company focused significant attention 
on re-entering the Broadcast market by introducing an upconverter to support 
television broadcasters' transition from analog to digital television - the 
Digital Format Translator-TM- ("DFT").  Due in part to this shift in focus, 
sales of broadcast products increased as a percentage of total Company sales 
in 1998 from 1997.

     The Company's revenues declined in 1998 for the first time in more than 
five years.  Sales of home theater and industrial line multipliers 
experienced the most significant year to year decline. From 1995 through 
1997, the Company's total revenues increased sequentially on an annual basis, 
primarily as a result of the introduction of a number of new products for the 
home theater and industrial markets. 

     In 1998 the Company reported a significant net loss due to the 
substantial drop in line multiplier sales in the home theater and industrial 
markets.  Net income declined in 1997 from 1996 primarily as a result of 
increased research and development expenses, as well as expenses relating to 
the expansion of the sales and marketing staff.  In 1996, the Company 
established an in-house very large scale integration ("VLSI") design 
department to develop high performance application specific integrated 
circuits ("ASIC") to enhance video image quality in the Company's traditional 
home theater and industrial markets as well as for use in the TV and PC 
industries.

     To maintain favorable margin levels on product sales, the Company must 
introduce new products, introduce enhanced versions of its products, and 
continue its cost reduction efforts.  In 1998 the Company increased research 
and development efforts relating to the design and development of DFTs and 
development of ASIC products.  Sales and marketing expenses increased 
slightly due to the Company's efforts to reenter the broadcast market.  
General and administrative expenses rose significantly due to costs of being 
a public company.  In 1999, on an absolute dollar basis, research and 
development expenses are expected to increase, marketing and sales expenses 
are expected to remain level, and general and administrative expenses are 
expected to decline from 1998. Consequently, to be profitable in 1999, 
revenues will have to significantly increase.

     The Company's quarterly operating results have varied in the past and 
are likely to vary significantly in the future from period to period as a 
result of a number of factors, including the volume and timing of orders 
received during the period, fluctuations in the amount, and timing of, 
license and royalty revenues, the timing of new product introductions by the 
Company and its competitors, demand for, and market acceptance of, the 
Company's products, product line maturation, the impact of price competition 
on the Company's average selling prices, delays encountered by the Company's 
strategic partners, the availability and pricing of components for the 
Company's products, changes in product or distribution channel mix and 
product returns or price protection charges from customers. Many of these 
factors are beyond the Company's control. In addition, due to the short 
product life cycles that characterize the markets for the Company's products, 
the Company's failure to introduce new, competitive products consistently and 
in a timely manner could materially adversely affect operating results for 
one or more product cycles. 

In March 1997, the Company entered into a license agreement with S3, 
Incorporated ("S3") pursuant to which significant royalty payments were 
received for use of certain Company technology.  No royalty payments have 
been made by S3 with respect to any periods after March 31, 1998.

Results of Operations


                                       -21-

<PAGE>

     The following table sets forth certain items from the Company's 
consolidated statements of income expressed as a percentage of total revenues 
for the periods indicated.

<TABLE>
<CAPTION>
                                                                  Year Ended December 31,
                                                       -------------------------------------------
                                                              1998           1997            1996
                                                       -------------------------------------------
<S>                                                    <C>               <C>              <C>
Revenues:
  Product sales                                               93.9%          91.2%           96.2%
  License and royalty revenues                                 6.1            8.8             3.8
                                                       -------------------------------------------
      Total revenues                                         100.0          100.0           100.0
Cost of sales                                                 44.8           30.9            36.5
                                                       -------------------------------------------
Gross margin                                                  55.2           69.1            63.5
Operating expenses:
  Research and development                                    39.3           24.8            18.8
  Sales and marketing                                         28.9           20.4            16.2
  General and administrative                                  28.2           12.8            12.4
  Financing expense                                              -            1.8               -
                                                       -------------------------------------------
      Total operating expenses                                96.4           59.8            47.4
                                                       -------------------------------------------
Operating (loss) income                                      (41.2)           9.3            16.1
Other income:
  Interest income                                              9.2            2.1             0.6
  Other, net                                                   0.0            0.5             0.0
                                                       -------------------------------------------
(Loss) income before provision for income taxes              (32.0)          11.9            16.7
Benefit (provision) for income taxes                           3.7           (4.5)           (5.2)
                                                       -------------------------------------------
Net (loss) income                                            (28.3)%         7.4%           11.5%
                                                       -------------------------------------------
                                                       -------------------------------------------
</TABLE>

Total Revenues.  

     Total revenues in 1998 decreased by $4.7 million or 27.8% from revenues 
recorded in 1997.  Revenues increased $3.9 million or 29.5% for 1997 from 
1996.
 
     The decrease in revenues in 1998 was due in significant part to the 
reduction in sales of line multiplier products for the home theater and 
industrial markets.  Sales of line multipliers decreased by $4.0 million in 
1998 from 1997.  The shortfall was largely attributable to a significant 
reduction in sales of line multipliers to OEM customers.  OEMs either sell 
the Company's video processors with their projection systems or integrate the 
Company's video processing components into their projection systems, with the 
resulting combination representing the most significant part of a home 
theater installation.  Sales of line multipliers were also negatively 
impacted by the increased market acceptance of video processors produced by 
other manufacturers, pricing pressure from those competing products and 
consumer confusion over high definition television ("HDTV").  Licensing 
revenue decreased by $.8 million in 1998 from 1997, primarily as a result of 
the discontinuance of royalty payments from S3 after March 31, 1998.  It is 
likely that license revenues will continue to decline in 1999, unless the 
Company is successful in entering into royalty bearing license agreements 
with third parties.  In 1998, the Company re-entered the Broadcast market 
with the introduction of the DFT.  This resulted in a $.9 million increase in 
sales of Broadcast products in 1998 from 1997.  In 1998, sales to Vidikron 
accounted for 10% of total Company revenues.

     The increase in sales in 1997 was due primarily to increased shipments 
of line multiplier products for the home theater and industrial markets, 
shipments of new products (including the VP100 decoder, DV1000 Digital Video 
Disc player, VP300 line tripler, and VP280 frame doubler), and $1.5 million 
of license and royalty revenues from S3. These factors offset a reduction in 
sales to the broadcast market.  Revenues from S3 accounted for 10.6% of total 
revenues in 1997. Sales to Vidikron accounted for 11.1% of total revenues in 
1997.  By the end of 1998, sales of VP100s and DV1000s were negligible and 
those products will be completely phased out in the first half of 1999.

     Export sales, consisting primarily of line multiplier products shipped 
to dealers and distributors in Asia, Europe and Canada, represented 18.6%, 
13.1%, and 15.3% of total revenues in 1998, 1997, and 1996, respectively. In 
absolute dollars, total export sales for 1998 were only slightly higher than 
in 1997. All export sales are denominated in U.S. dollars. The Company has 
not experienced nor does it anticipate any foreign currency exchange 
exposures.  The Company intends to pursue efforts to increase its export 
sales in the future, however, there can be no assurance that any growth in 
export sales will be achieved. The Company believes that current economic 
conditions in Asia might adversely impact any increase in sales to that 
region in 1999.   

                                       -22-

<PAGE>
     
     The Company's future success will depend, in large part, on its ability 
to continue to enhance its existing products and to develop new products and 
features to meet changing customer requirements and evolving industry 
standards. Sales from the Company's line multiplier product lines decreased 
in 1998 and the Company anticipates that sales of such products will 
experience limited growth, or decline, in future periods.  Home theater and 
industrial market sales decreased in 1998, which the Company attributes to 
increased competition, pricing pressure, and consumer confusion over HDTV. 
The Company believes that the confusion resulting from HDTV and related 
market weakness could continue until HDTV broadcasting begins on a wide-scale 
basis.  With the continuing rollout of HDTV in 1999, the Company anticipates 
that sales of its Broadcast products, and specifically the DFT will increase 
in 1999 and over the next several years.

Gross Profit. 

     Gross profit as a percentage of total revenues was 55.2% in 1998, 69.1% 
in 1997, and 63.5% in 1996.  The 14% absolute percentage decrease in gross 
margin in 1998 from 1997 was due to several factors.  First, gross margins of 
line multipliers decreased as prices of certain major product families were 
significantly reduced in August 1998.  Second, high gross margin licensing 
revenues were reduced in 1998 with the end of payments from S3.  Third, in 
the third quarter of 1998 certain excess and obsolete inventory items were 
written down to their net realizable value.  Fourth, the new Broadcast market 
product, the DFT, produced only $1.0 million revenue in its first year of 
sales.  

     The increase in gross margin in 1997 compared to 1996 was primarily due 
to increased license and royalty revenues. Product gross margin as a 
percentage of product sales increased to 66.1% in 1997 from 62.01% in 1996, 
due primarily to product cost reduction efforts. 

Research and Development Expenses. 

     Research and development expenses increased to $4.8 million in 1998 from 
$4.2 million in 1997 and from $2.5 million in 1996. The increase in 1998 was 
primarily due to the development of the DFT and for the costs associated with 
development of ASICs. Research and development expenses as a percentage of 
total revenues rose in 1998 to 39.3% due to the increased spending of $.6 
million in 1998 from 1997 coupled with the significant decline in total 
revenues in 1998 from 1997. 

     In 1997 the increases were primarily due to costs incurred by the 
Company for the development of ASICs used in the full range of the Company's 
products. Research and development expenses as a percentage of total revenues 
increased to 24.8% in 1997 from 1996 due to expansion of the Company's VLSI 
department which was established in 1996.  The Company intends to increase 
its research and development efforts in 1999, primarily in the design and 
development of board and ASIC products, and therefore expects that research 
and development expenses will continue to increase in absolute dollars. 

Sales and Marketing Expenses. 

     Sales and marketing expenses increased to $3.6 million in 1998 from $3.5 
million in 1997 and from $2.1 million in 1996.  In 1998, due to the decline 
in revenues from 1997, sales and marketing expenses were higher as a 
percentage of total revenue at 28.9%.  Categories of expenses that rose in 
1998 were expenses for trade shows such as the Consumer Electronics Show and 
the National Association of Broadcasters Show, and for advertising and 
brochures.  Categories of expenses that declined in 1998 were commissions to 
outside sales representatives as the Company shifted sales responsibilities 
more to direct employee sales staff. 

     Sales and marketing expenses increased as a percentage of total revenues 
to 20.4% in 1997 from the prior year primarily due to increases in the 
Company's sales and marketing staff, including the addition of sales 
executives and the development of a network of regional managers and sales 
representatives. The Company expects its sales and marketing expenses in 1999 
to remain similar to 1998 spending levels.

General and Administrative Expenses. 

     General and administrative expenses increased to $3.5 million in 1998 
from $2.2 million in 1997 and from $1.6 million in 1996.  Due to the 
significant increase in general and administrative expenses coupled with the 
year over year decline in total revenues, the percentage of expenses to 
revenue increased to 28.2% in 1998.  The increases in absolute expenses were 
due primarily to expenses of being a public company such as outside 
professional legal and accounting fees associated with annual reports, 
registration statements and other SEC filings, for legal expenses involving 
patent litigation, and for one time charges for management changes. 

     General and administrative expenses increased as a percentage of total
revenues to 12.8% in 1997 and 12.4% in 1996, primarily due to additions to the
Company's general and administrative staff, including the hiring of a new chief
executive officer, 

                                       -23-

<PAGE>

chief financial officer and general counsel, and an increase in professional 
fees. 

     The Company expects that general and administrative expenses both in 
absolute dollars and as a percentage of total revenues will decrease in 1999.

Financing Expense. 

     In 1997 the Company spent $.3 million in the first quarter related to 
financing activity. There were no such expenses in 1998.

Other Income. 

     Interest and other income increased to $1.1 million in 1998 from 
$447,000 in 1997, and from $83,000 in 1996. The increase in interest income 
in 1998 over 1997 is derived from investments in short-term, interest bearing 
investment grade securities as a result of two investments made in the 
Company in 1997. They include the investment of the $15.6 million net 
proceeds from the Company's initial public offering completed in October 
1997, and the $5 million investment by S3 in the Company in June 1997.  The 
Company anticipates that interest income will decrease slightly in 1999.

Provision for Income Taxes. 

     The Company's benefit for income taxes was 11.6% for 1998 compared to 
provisions for income taxes of 38% and 40% for 1997 and 1996, respectively. 
The 1998 tax rate reflects the benefit of refundable taxes offset by state 
taxes and the valuation allowance for certain deferred tax assets.  The 1997 
tax rate is lower than the pro forma 1996 tax rate primarily due to tax 
credits.

     Under the Statement of Financial Accounting Standards No. 109 ("SFAS 
109"), deferred tax assets and liabilities are determined based on differences 
between financial reporting and tax bases of assets and liabilities and are 
measured using the enacted tax rates and laws that will be in effect when the 
differences are expected to reverse.  SFAS 109 provides for the recognition 
of deferred tax assets if realization of such assets is more likely than not. 
 Based on the weight of available evidence, the Company has provided a 
valuation allowance against deferred tax assets for 1998.  The Company will 
continue to evaluate the realization of the deferred tax assets on a 
quarterly basis.

     The Company's FLI subsidiary was an S Corporation from inception until 
March 1996.  As an S Corporation, FLI earnings were taxed directly to its 
stockholders.  FRE was a C Corporation since its inception.  The pro forma 
provision for income taxes, calculated assuming FLI's S Corporation status 
terminated January 1, 1994, reflects an effective tax rate for the year ended 
December 31, 1996 of 40%.

Liquidity and Capital Resources.

     The Company has historically funded its capital requirements from its 
cash flow from operations.  Funding requirements in the past have been 
primarily related to the growth in accounts receivable, inventories and 
capital equipment. 

Operating Activities. 

     In 1998, net cash used by operating activities was $3.2 million, 
primarily composed of (i) $3.5 million of net loss, (ii) a $.9 million 
decrease in accrued income taxes payable,  (iii) a $.7 million increase in 
income taxes receivable; (iv) a $.6 million decrease in accrued compensation 
and benefits, (v) a $.4 million increase in inventories, (vi) and a $.3 
million decrease in accounts payable. These were primarily offset by (i) a 
$1.3 million decrease in accounts receivable, (ii) a $.9 million decrease in 
deferred tax assets and  (iii) $.9 million of depreciation and amortization. 

     In 1997, net cash provided by operating activities was $1.1 million, 
primarily composed of (i) $1.3 million of net income, (ii) $.6 million of 
depreciation and amortization, (iii) a $.7 million increase in accounts 
payable, (iv) a $.5 million increase in accrued compensation, (v) a $.8 
million increase in income taxes payable and (vi) a $.3 million increase in 
other accrued liabilities. These were primarily offset by (i) a $.3 million 
increase in accounts receivable, (ii) a $1.3 million increase in inventory, 
(iii) a $.5 million increase in deferred tax assets, (iv) a $.4 million 
increase in other current assets and (v) a $.5 million decrease in deferred 
revenues.

     In 1996, net cash provided by operating activities was $1.3 million, 
primarily composed of (i) $1.5 million of net income, (ii) $.4 million of 
depreciation and amortization, (iii) a $.2 million increase in accrued 
compensation and benefits, (v) a $.3 million increase in other liabilities 
and (vi) $.5 million of deferred revenues. These were partially offset by a 
(i) a $1.2 million increase in accounts receivable primarily attributable to 
$1.0 million due from a licensing customer from an agreement completed in 
December, 1996, and  (ii) an increase in deferred tax assets of $.5 million. 


                                       -24-

<PAGE>

Investing Activities. 

     Capital equipment purchases in 1998, 1997 and 1996 were $.5 million, 
$1.2 million, and $1.0 million, respectively, primarily for computer hardware 
and software used in research and development, research and development test 
equipment and furniture and fixtures. 

Financing Activities. 

     In October 1997, the Company effected its initial public offering. Net 
proceeds, after underwriting discounts and commissions and expenses 
associated with the offering, were $15.6 million. In June 1997, the Company 
also received $5.0 million from a private placement of Common Stock with S3.  
In 1996, the Company raised $4.0 million through a private placement of its 
Common Stock to a group of investors.  In connection with its status as a 
Subchapter S Corporation, the Company distributed $4.0 million in 1996 to the 
Company's stockholders. 

Liquidity. 

     At December 31, 1998, the Company had approximately $20.4 million of 
cash and cash equivalents, a bank credit facility for $2.0 million, and 
working capital of approximately $24.5 million. 

     The cash and cash equivalents are predominantly held in three types of 
cash investments.  These investments are obligations issued by U.S. federal 
agencies, money market funds that subject the Company to limited interest 
rate or credit risk, and commercial paper of U.S. corporations with A1/P1 
credit ratings. 

     Cash, cash equivalents and short-term investments at December 31, 1998 
declined by $3.1 million or 13.3% from the balances at December 31, 1997.  
The most significant reason for the cash decrease was that total gross 
profits from total revenues were significantly less than operating expenses. 
Cash was also used to purchase both engineering test equipment and product 
inventory, and to reduce the accounts payable balances. The decline in cash, 
cash equivalents and short-term investments was partially offset by strong 
customer collections that reduced accounts receivable balances. 

     In April 1998, the Company renewed its bank revolving line of credit 
that expires in April, 1999. The line of credit is secured by substantially 
all of the Company's tangible assets. Borrowings are limited to defined 
percentages of eligible accounts receivable. In addition, the Company must 
satisfy certain financial covenants.  No borrowings were made under the 
line of credit agreement in either 1998 or 1997.

     The Company's future capital requirements are expected to include (i) 
supporting the expansion of research and development, (ii) funding the 
acquisition of capital equipment, primarily for research and development and 
consisting of such items as research and development equipment, computers and 
furniture, and (iii) funding the growth of working capital items such as 
receivables and inventory.  
     
     The Company believes that its current cash, cash equivalents and 
short-term investments will be sufficient to support the Company's planned 
activities through at least the next twelve months. 

     The Company may investigate means to acquire greater control over 
semiconductor production, whether by joint venture, prepayments, equity 
investments in or loans to wafer suppliers. In addition, as part of its 
business strategy, the Company occasionally evaluates potential acquisitions 
of businesses, products and technologies. Accordingly, a portion of its 
available cash may be used for the acquisition of complementary products, 
technologies or businesses or to assure foundry capacity. Such potential 
transactions may require substantial capital resources, which may require the 
Company to seek additional debt or equity financing. There can be no 
assurance that the Company will consummate any such transactions. 

Year 2000. 

     Certain computers, software and equipment with embedded computing 
capability recognize only the last two, rather than all four digits of the 
year in any date.  As a result they may fail to recognize and properly 
process date information or otherwise malfunction unless they are 
reprogrammed or replaced at the turn of the century (the "Year 2000 
Problem").  The Company is dependent upon computers, software and equipment 
with embedded computing capability for all phases of its operations including 
production, distribution and accounting. The Company has developed a plan to 
determine the impact of the Year 2000 Problem on its operations.  This plan 
covers an assessment of internal and external Year 2000 Problems, formal 
contacts with the Company's significant suppliers, customers, financial 
organizations, service providers and others to determine their Year 2000 
readiness, 

                                       -25-

<PAGE>

remediation of problems where found, and a contingency plan for problems 
which cannot be solved on a timely or cost-effective basis.  

     The Company has completed an assessment of the products it designs, 
manufactures and distributes and believes that the performance and 
functionality of such products will not be affected by Year 2000 Problems.  

     With regard to internal risks associated with Year 2000 Problems, the 
Company recently completed a major upgrade of its main business computer 
systems, which replaced a majority of its existing systems, and plans to 
complete this system upgrade during the first half of 1999.  The system 
selected is Year 2000 compliant and is expected to eliminate most of the 
Company's internal Year 2000 Problems.  The Company will test its main 
operations computer systems and continue testing other internal systems, 
including engineering workstations and desktop computers, for Year 2000 
compliance.  The Company intends to address any problems identified 
immediately and to replace any deficient element of its systems that cannot 
be made Year 2000 compliant by other means.  The Company believes that any 
significant Year 2000 Problems will be solved by the fourth quarter of 1999.  
The Company has developed a contingency plan for its operations activities 
that involves a full detail paper backup for its production, purchase order 
and inventory requirements for the first six months of the year 2000.  While 
it is not presently possible to precisely quantify the overall cost of this 
work, the Company does not believe that the cost of addressing the Year 2000 
Problem, as it relates to the Company's internal systems, will have a 
material adverse effect on the Company's financial position, liquidity or 
results of operations.  The Company has incurred total costs to date of 
approximately $65,000 to address Year 2000 Problems and expects that such 
costs will not exceed an additional $35,000 for the remainder of 1999. 

     In addition to the Company's own systems and equipment, the Company 
relies, directly and indirectly, on the systems and equipment of its 
suppliers, distributors, customers, creditors, financial organizations, 
utility companies, telecommunication service companies and other service 
providers.  Some of these third parties may have Year 2000 Problems outside 
of the Company's control that could adversely affect the Company.

     There can be no assurance that the Company will identify all of its Year 
2000 Problems, resolve its internal Year 2000 Problems on a timely or 
cost-effective basis, or be successful in avoiding the impact of business 
disruptions which may be experienced by the Company's suppliers, service 
providers and other third parties as a result of Year 2000 Problems.  Failure 
by the Company or third parties doing business with the Company to identify 
and resolve Year 2000 problems on a timely basis could have a material 
adverse effect on the Company's financial position, liquidity or results of 
operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.

INTEREST RATE RISK.  The Company's exposure to interest rate risk relates 
primarily to its investment portfolio.  Fixed rate securities may have their 
fair market value adversely impacted by a rise in interest rates, while 
floating rate securities may produce less income than expected if interest 
rates fall. Due in part to these factors, the Company's future investment 
income may fall short of expectations due to changes in interest rates or the 
Company may suffer losses in principal if forced to sell securities which 
have declined in market value due to changes in interest rates.

The Company invests its excess cash in debt instruments of the U.S. 
Government and its agencies, and in high-quality corporate issuers.  Due to 
the short-term nature of all of the Company's investments in 1998 (average 
portfolio duration and contractual maturity of investments were approximately 
three months) the Company has assessed that there is no material exposure 
risk arising from its investments. 

                                       -26-

<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

<TABLE>
<CAPTION>
     INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
     --------------------------------------------------------------
     Financial Statements:                                                                    Page
<S>                                                                                           <C>
     Consolidated Balance Sheets as of December 31, 1998 and 1997...........................  28

     Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996.  29

     Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998,
        1997 and 1996 ......................................................................  30

     Consolidated Statements of Cash Flows for the years ended
          December 31, 1998, 1997 and 1996..................................................  31

     Notes to Consolidated Financial Statements.............................................  32

     Report of Ernst & Young LLP, Independent Auditors......................................  41

                   Financial Statement Schedule:

     Schedule II: Valuation and Qualifying Accounts.........................................  44
</TABLE>

     All other schedules are omitted because they are not applicable or not 
required or because the required information is included in the Consolidated 
Financial Statements or the Notes thereto.


                                       -27-

<PAGE>

CONSOLIDATED BALANCE SHEETS
 (In thousands, except share data)

<TABLE>
<CAPTION>
                                                                             December 31,
                                                                       1998               1997
                                                                     ---------------------------
<S>                                                                  <C>                <C>
ASSETS
Current assets:
     Cash and cash equivalents                                       $ 20,419           $ 23,272
     Short-term investments                                                 -                277
     Trade accounts receivable, less allowance for doubtful
        Accounts of $136 in 1998 and $167 in 1997                       1,764              3,098
     Inventories                                                        3,348              2,943
     Deferred tax assets                                                    -                942
     Income taxes receivable                                              738                  -
     Prepaid expenses and other current assets                            441                596
                                                                     ---------------------------
Total current assets                                                   26,710             31,128

Property and equipment, net                                             1,778              2,026
Other assets                                                              233                335
                                                                     ---------------------------
TOTAL ASSETS                                                         $ 28,721           $ 33,489
                                                                     ---------------------------
                                                                     ---------------------------


LIABILITIES AND STOCKHOLDERS' EQUITY 
Current liabilities:
     Accounts payable                                                $  1,125           $  1,445
     Accrued compensation and benefits                                    587              1,217
     Income taxes payable                                                   -                872
     Other accrued liabilities                                            511                607
                                                                     ---------------------------
Total current liabilities                                               2,223              4,141

Commitments

Stockholders' equity:
     Preferred Stock $0.001 par value; 5,000,000 shares
       authorized, none issued and outstanding                              -                  -
     Common Stock $0.001 par value; 50,000,000 shares
       authorized; 12,205,147, and 12,058,913 shares
       issued and outstanding in 1998 and 1997,                            
       respectively                                                        12                 12
     Additional paid-in capital                                        30,027             28,978
     Deferred compensation                                               (173)              (238)
     Retained earnings (accumulated deficit)                           (3,368)               596
                                                                     ---------------------------
Total stockholders' equity                                             26,498             29,348
                                                                     ---------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                           $ 28,721           $ 33,489
                                                                     ---------------------------
                                                                     ---------------------------
</TABLE>

See accompanying notes.

                                       -28-

<PAGE>





CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share data)

<TABLE>
<CAPTION>
                                                                                         YEAR ENDED DECEMBER 31,
                                                                             1998                  1997                  1996 
                                                                      ----------------------------------------------------------
<S>                                                                   <C>                    <C>                    <C>         
     Revenues: 
               Product sales                                          $     11,520           $     15,506           $     12,626
               License and royalty revenues                                    750                  1,500                    500
                                                                      ----------------------------------------------------------
     Total revenues                                                         12,270                 17,006                 13,126

     Cost of product sales                                                   5,499                  5,262                  4,797
                                                                      ----------------------------------------------------------
     Gross profit                                                            6,771                 11,744                  8,329

     Operating expenses:
               Research and development                                      4,822                  4,215                  2,464
               Sales and marketing                                           3,551                  3,465                  2,127
               General and administrative                                    3,458                  2,182                  1,623
               Financing expenses                                                -                    312                      -
                                                                      ----------------------------------------------------------
     Total operating expenses                                               11,831                 10,174                  6,214
                                                                      ----------------------------------------------------------

     Operating (loss) income                                                (5,060)                 1,570                  2,115
     Other income:
               Interest income                                               1,134                    364                     83
               Other, net                                                        -                     83                      -
                                                                      ----------------------------------------------------------
     (Loss) income before income taxes                                      (3,926)                 2,017                  2,198
     
     Benefit (provision) for income taxes                                      457                   (766)                  (687)
                                                                      ----------------------------------------------------------
     Net (loss) income                                                $     (3,469)          $      1,251           $      1,511
                                                                      ----------------------------------------------------------
                                                                      ----------------------------------------------------------
     Pro forma data (unaudited):
               Historical income before provision for income taxes                                                  $      2,198
               Pro forma provision for income taxes                                                                         (879)
                                                                                                                    ------------
     Pro forma net income                                                                                           $      1,319
                                                                                                                    ------------
                                                                                                                    ------------

     Per share data:
               Net (loss) income per share     Basic                       ($0.29)                 $ 0.14
                                               Diluted                     ($0.29)                 $ 0.13
                                                                      ------------------------------------
                                                                      ------------------------------------
               Pro forma net income
                   per share (unaudited)       Basic                                                                $       0.17
                                               Diluted                                                              $       0.16
                                                                                                                    ------------
                                                                                                                    ------------
               Shares used in per share
                   computations                Basic                    12,145,781              9,040,616              7,976,892
                                               Diluted                  12,145,781              9,924,558              8,191,303
                                                                      ----------------------------------------------------------
                                                                      ----------------------------------------------------------
</TABLE>
See accompanying notes.


                                       -29-

<PAGE>

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
 (In thousands, except share data)


<TABLE>
<CAPTION>




                                                                                            Retained     Accumulated          
                                                                Additional                  Earnings        Other             
                                         Common Stock             Paid-In     Deferred     Accumulated  Comprehensive         
                                     Shares        Amount         Capital   Compensation    (Deficit)      Income        Total  
                                   -------------------------------------------------------------------------------------------- 
<S>                                <C>             <C>          <C>         <C>             <C>         <C>            <C>      
Balance at December 31, 1995        7,156,895      $ 3,611      $     -        $  -         $  1,869         $ 35      $ 5,515  
Net Income                                  -            -            -           -            1,511            -        1,511  
Unrealized gain on                                                                                                              
  available-for-sale                                                                                                            
  securities of $32                         -            -            -           -                -           32           32  
                                                                                                                       -------  
Comprehensive income                                                                                                     1,543  
                                                                                                                                
                                                                                                                       -------  
Sale of Common Stock                1,043,105        4,000            -           -                -            -        4,000  
Issuance of warrants to                                                                                                         
  purchase Common Stock                                                                                                         
  for future services                       -            -          222           -                -            -          222  
Reincorporating in                                                                                                              
  Delaware                                  -       (7,603)       7,603           -                -            -            -  
Distribution to                                                                                                                 
  stockholders                              -            -            -           -           (4,035)           -       (4,035) 
                                   -------------------------------------------------------------------------------------------- 
Balance at                                                                                                                      
  December 31, 1996                 8,200,000            8        7,825           -             (655)          67        7,245  
Net Income                                  -            -            -           -            1,251            -        1,251  
Reclassification adjustment for                                                                                                 
  gains included in net income                                                                                                  
  of $67                                    -            -            -           -                -          (67)         (67) 
                                                                                                                       -------  
Comprehensive income                                                                                                     1,184  
                                                                                                                       -------  
Sale of Common Stock                                                                                                            
  net of issue costs                3,833,334            4       20,532           -                -            -       20,536  
Issuance of Common                                                                                                              
  Stock for services and                                                                                                        
  upon exercise of                                                                                                              
  option and warrants                  25,579            -           99           -                -            -           99  
Issuance of warrants to                                                                                                         
  purchase Common Stock                                                                                                         
  for technology acquired                   -            -          250           -                -            -          250  
Deferred compensation                                                                                                           
  on employee stock                                                                                                             
  option grants                             -            -          272        (272)               -            -            -  
Amortization of deferred                                                                                                        
  compensation                              -            -            -          34                -            -           34  
                                   -------------------------------------------------------------------------------------------- 
Balance at                                                                                                                      
  December 31, 1997                12,058,913           12       28,978        (238)             596            -       29,348  
Net loss                                    -            -            -           -           (3,469)           -       (3,469) 
                                                                                                                       -------  
Comprehensive loss                                                                                                      (3,469) 
                                                                                                                       -------  
Issuance of Common Stock                                                                                                        
  for cash upon exercise                                                                                                        
  of options and employee                                                                                                       
  stock purchase plan                 146,234            -          554           -                -            -          554  
Reclassification of undistributed                                                                                               
  retained earnings                         -            -          495           -             (495)           -            -  
Amortization of                                                                                                                 
  deferred compensation                     -            -            -          65                -            -           65  
                                   -------------------------------------------------------------------------------------------- 
Balance at December 31, 1998       12,205,147      $    12      $30,027       $(173)         $(3,368)        $  -      $26,498  
                                   -------------------------------------------------------------------------------------------- 
                                   -------------------------------------------------------------------------------------------- 
</TABLE>
See accompanying notes.

                                       -30-

<PAGE>

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
<TABLE>
<CAPTION>

                                                                    YEAR ENDED DECEMBER 31,
                                                               1998          1997           1996
                                                             ------------------------------------
<S>                                                          <C>           <C>           <C>
OPERATING ACTIVITIES
Net (loss) income                                            $ (3,469)     $  1,251      $  1,511
Adjustments to reconcile net (loss) income to net cash
         provided by (used in) operating activities:
         Depreciation and amortization                            921           561           422
         Amortization of deferred compensation                     65            34             -
         Loss on disposal of equipment                              -             5             -
         Gain on sales of short-term investments                    -           (83)            -
Changes in operating assets and liabilities:
         Trade accounts receivable                              1,334          (330)       (1,193)
         Inventories                                             (405)       (1,260)          (96)
         Deferred tax assets                                      942          (482)         (462)
         Income taxes receivable                                 (738)            -             -
         Prepaid expenses and other current assets                 81          (372)          (27)
         Accounts payable                                        (320)          716           128
         Accrued compensation and benefits                       (630)          545           186
         Income taxes payable                                    (872)          756            68
         Other accrued liabilities                                (96)          265           258
         Deferred revenue                                           -          (500)          500
                                                             ------------------------------------
Net cash provided by (used in) operating activities            (3,187)        1,106         1,295
                                                             ------------------------------------
INVESTING ACTIVITIES
Purchases of equipment                                           (497)       (1,200)         (967)
Proceeds from sale of equipment                                     -            13             -
Other assets                                                        -          (110)            -
Purchases of short-term investments                                 -             -        (1,061)
Sales of short-term investments                                     -         1,612             -
Maturities of short-term investments                              277             -           461
                                                             ------------------------------------
Net cash provided by (used in) investing activities              (220)          315        (1,567)
                                                             ------------------------------------
FINANCING ACTIVITIES
Issuance of Common Stock                                          554        20,635         4,000
Distribution to stockholders                                        -             -        (4,035)
                                                             ------------------------------------
Net cash provided by (used in) financing activities               554        20,635           (35)
                                                             ------------------------------------
(Decrease) increase in cash and cash equivalents               (2,853)       22,056          (307)
Cash and cash equivalents at beginning of year                 23,272         1,216         1,523
                                                             ------------------------------------
Cash and cash equivalents at end of year                     $ 20,419      $ 23,272      $  1,216
                                                             ------------------------------------
                                                             ------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the period for income taxes                 $    225      $    465      $  1,117
                                                             ------------------------------------
                                                             ------------------------------------
SUPPLEMENTAL DISCLOSURES OF NONCASH FINANCING ACTIVITIES
Issuance of warrants to acquire Common Stock
         for future services                                 $      -      $      -      $    222
                                                             ------------------------------------
                                                             ------------------------------------
Issuance of warrants to acquire Common Stock
         for technology acquired                             $      -      $    250      $      -
                                                             ------------------------------------
                                                             ------------------------------------
</TABLE>
See accompanying notes.

                                       -31-

<PAGE>

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

Business and Basis of Presentation

Faroudja, Inc. (the "Company") designs, develops and sells a range of video 
image enhancement products and technology for the home television, 
professional broadcast and personal computer markets. Although traditional 
business has been directed to sales of complete subsystem units, the Company 
has recently expanded its activities to include the design and development of 
board and chip level products for applications in the television as well as 
the personal computer markets.

The accompanying financial statements reflect the operations of Faroudja 
Laboratories, Inc. ("FLI") and Faroudja Research Enterprises, Inc. ("FRE"), 
both of which were California corporations. FLI and FRE, which were owned by 
common stockholders, were merged in December 1996, with FLI surviving the 
merger. Subsequently, in order to effect a reverse stock split and a 
reincorporation in Delaware, FLI merged with a wholly owned subsidiary of a 
newly formed Delaware corporation, Faroudja, Inc. In this transaction, the 
FLI stockholders received 0.69185 shares of the Company's Common Stock for 
each share of FLI Common Stock held by them. 

All outstanding stock options and warrants to purchase FLI Common Stock were 
assumed by the Company at the same exchange ratio. The effect of this 
exchange on Common Stock, stock options and warrants has been reflected in 
the accompanying financial statements on a retroactive basis. All 
intercompany balances and transactions between the Company and FLI have been 
eliminated.

On December 30, 1996, FLI and FRE were merged through the exchange of 0.21258 
shares of FLI Common Stock for each outstanding share of FRE Common Stock. As 
the outstanding shares of both entities were held in the same percentage by 
identical stockholders prior to the merger, this transaction was accounted 
for as if it were a pooling-of-interests.

Prior to March 1996, FRE and FLI were each owned 100% by two individuals (the 
"Founders"). In March 1996, new investors acquired a 56.25% ownership 
interest in both entities through the purchase of shares held by the Founders 
for ($14,000,000) and newly issued FLI shares for ($4,000,000). Simultaneous 
with this transaction, the Founders received a distribution from FLI in the 
amount of $4,000,000. The new investors also acquired an option from the 
Founders to acquire an additional 1,537,500 shares held by the Founders for a 
total of $6,000,000. Such option was exercised on September 5, 1997. Prior to 
the March 1996 transaction, FLI had elected to be treated as an S Corporation 
for income tax purposes. FRE was a C Corporation for income tax purposes.

Use of Estimates

The preparation of financial statements in conformity with generally accepted 
accounting principles requires management to make estimates and assumptions 
that affect the amounts reported in the financial statements and accompanying 
notes. Actual results could differ from these estimates.

Sources of Supply

The Company currently relies on a limited number of independent foundries to 
manufacture, assemble and test all of its semiconductor components and 
products. In addition, the Company subcontracts the manufacturing of its 
broadcast and television products with two principal suppliers. While 
alternate sources of supply exist, in the event of the discontinuance of any 
of the above supplier relationships, the Company would be required to locate 
and qualify new suppliers, which could take several months.

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three 
months or less when purchased, to be cash equivalents. Cash equivalents 
consist primarily of deposits in banks, money market accounts, commercial 
paper and discount notes.

Short-Term Investments

The Company accounts for its short-term investments in accordance with 
Statement of Financial Accounting Standards No. 115, "Accounting for Certain 
Investments in Debt and Equity Securities" ("SFAS 115").

Under SFAS 115, all affected debt and equity securities must be stated at 
fair value and classified as held-to-maturity, trading or available-for-sale. 
Management determines the appropriate classification of securities at the 
time of purchase and reevaluates such designation as of each balance sheet 
date.

At December 31, 1998 and 1997, all debt and equity securities were designated 
as available-for-sale. Available-for-sale securities are carried at fair 
value, with unrealized gains and losses reported net of tax as part of 
accumulated other comprehensive income in stockholders' equity. Realized 
gains and losses and declines in value judged to be other-than-temporary, if 
any, on available-for-sale securities are

                                       -32-

<PAGE>

included in other income. The cost of securities sold is based on the 
specific identification method. Interest on securities classified as 
available-for-sale is included in interest income.

Concentration of Credit Risk

The Company sells its products primarily through a network of distributors, 
dealers and through original equipment manufacturing ("OEM") arrangements. 
The Company performs ongoing credit evaluations of its customers and 
generally does not require collateral. Uncollectible accounts receivable have 
not been significant in any period presented.

At December 31, 1998, seven customers accounted for 45% of the accounts 
receivable balance, including one customer that accounted for 22% of the 
accounts receivable balance.

At December 31, 1997 four customers accounted for 45% of the accounts 
receivable balance and no other single customer accounted for more than 10% 
of the Company's ending accounts receivable balance.

Inventories

Raw materials, work-in-process and finished goods inventories are stated at 
the lower of standard cost (which approximates actual cost) or market value.

Property and Equipment

Property and equipment are recorded at cost. Depreciation and amortization 
are provided using the straight-line method over the estimated useful lives 
of the assets (ranging from three to seven years). Leasehold improvements are 
amortized over the shorter of the lease term or the estimated useful life. 
Depreciation expense was $745,000, $540,000 and $249,000 for 1998, 1997 and 
1996, respectively.

Revenue Recognition

Sales revenue is recognized upon shipment of products to customers net of 
discounts, rebates and allowances. The Company does not grant rights of 
return. Non-refundable minimum royalties are recognized as revenue in the 
period to which they relate.

Advertising Costs

The Company expenses advertising costs as incurred. Advertising expense 
amounted to $374,000, $430,000 and $395,000 in 1998, 1997 and 1996, 
respectively.

Financing Expense

In 1997, the Company incurred and expensed approximately $312,000 of expenses 
related to financing activities.

Stock-Based Compensation

As permitted by Statement of Financial Accounting Standards No. 123, 
"Accounting for Stock-Based Compensation" ("SFAS 123"), the Company has 
elected to follow Accounting Principles Board Opinion No. 25, "Accounting for 
Stock Issued to Employees" ("APB 25") and related interpretations in 
accounting for its employee and director stock option and purchase plans. 
Under APB 25, if the exercise price of the Company's employee stock options 
is not less than the market price of the underlying stock on the date of 
grant, no compensation expense is recognized.

Net Income (Loss) Per Share

Basic earnings per share is calculated based on the weighted average number 
of common shares outstanding during the period. Diluted earnings per share 
also gives effect to the dilutive effect of stock options and warrants 
(calculated based on the treasury stock method). A reconciliation of shares 
used in the calculation follows:

<PAGE>

<TABLE>
<CAPTION>
                                                                   1998            1997           1996
                                                              --------------------------------------------
<S>                                                           <C>               <C>            <C>
Weighted average shares outstanding                             12,145,781      9,040,616      7,976,892
Dilutive effect of stock options and warrants                            -        833,942        214,411
                                                              --------------------------------------------
Shares used in computation of diluted net (loss) income per
share                                                           12,145,781      9,874,558      8,191,303
                                                              --------------------------------------------
                                                              --------------------------------------------
</TABLE>

Options and warrants to purchase 1,991,905 and 445,200 shares of the 
Company's common stock would have been anti-dilutive in 1998 and 1997, 
respectively and were, therefore, excluded from the respective diluted 
calculation.


                                       -33-

<PAGE>

Comprehensive Income (Loss)

As of January 1, 1998, the Company adopted Statement of Financial Accounting 
Standard No. 130, Reporting Comprehensive Income ("SFAS 130"). SFAS 130 
establishes new rules for the reporting and display of comprehensive income 
and its components; however, the adoption of this Statement had no impact on 
the Company's net income or stockholders' equity. SFAS 130 requires 
unrealized gains or losses on the Company's available-for-sale securities, 
which prior to adoption, were reported separately in stockholders' equity, to 
be included in comprehensive income. Prior year financial statements have 
been reclassified to conform to the requirement of SFAS 130.

Recent Accounting Pronouncements

Effective January 1998, the Company adopted Statement of Financial Accounting 
Standards No. 131, "Disclosures about Segments of an Enterprise and Related 
Information" ("SFAS 131"), which established revised standards for the 
reporting of financial and descriptive information about operating segments 
in financial statements. The Company has determined that it operates in only 
one segment, which is the development, manufacture and supply of video image 
enhancement technology.

In June 1998, the Financial Accounting Standards Board issued Statement of 
Financial Accounting Standards No. 133, "Accounting for Derivative Financial 
Instruments and for Hedging Activities" ("SFAS 133") which provides a 
comprehensive and consistent standard for the recognition and measurement of 
derivatives and hedging activities. SFAS 133 is effective for years beginning 
after June 15, 1999 and is not anticipated to have an impact on the Company's 
results of operations or financial condition when adopted.

2. SHORT-TERM INVESTMENTS

The following is a summary of available-for-sale securities at December 31, 
1998 and 1997 (in thousands):

<TABLE>
<CAPTION>
                                          Cost and
                                        Fair Market 
                                           Value 
                                        -----------
<S>                                     <C>
At December 31, 1998:
  Commercial paper                          $ 6,977
  Government agency discount notes           10,844
                                        -----------
                                            $17,821
                                        -----------
                                        -----------

Reported as:
  Cash equivalents                          $17,821
                                        -----------
                                            $17,821
                                        -----------
                                        -----------




At December 31, 1997:
  Certificates of deposit                   $   277
  Commercial paper                            5,106
  Government agency discount notes           11,780
                                        -----------
                                            $17,163
                                        -----------
                                        -----------

Reported as:
  Cash equivalents                          $16,886
  Short-term investments                        277
                                        -----------
                                            $17,163
                                        -----------
                                        -----------
</TABLE>


The estimated fair value amounts discussed above have been determined by the 
Company using available market information. The investments are held in 
commercial paper of U.S. corporations with A1/P1 credit ratings and U.S. 
federal agency discount obligations.

As of December 31, 1998, the average portfolio duration and contractual 
maturity of the investments were approximately three months.

There were no realized gains or losses for the year ended December 31, 1998. 
Realized gains and losses for the year ended December 31, 1997 were $185,000 
and $102,000, respectively.

                                       -34-

<PAGE>

3. INVENTORIES

Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
                               December 31,
                          1998             1997
                       ---------       ---------
<S>                    <C>             <C>
Raw materials            $1,072          $  770
Work-in-process           1,048           1,508
Finished goods            1,228             665
                       ---------       ---------
                         $3,348          $2,943
                       ---------       ---------
                       ---------       ---------
</TABLE>

4. PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                  December 31,
                                             1998             1997
                                          --------         ---------
<S>                                       <C>              <C>
Machinery and equipment                    $ 2,782           $ 2,373
Purchased computer software                    952               915
Furniture, fixtures and equipment              314               290
Vehicles                                        84                84
Leasehold improvements                         227               200
                                          --------         ---------
                                             4,359             3,862
Accumulated depreciation                    (2,581)           (1,836)
                                          --------         ---------
                                           $ 1,778           $ 2,026
                                          --------         ---------
                                          --------         ---------
</TABLE>

5. OPERATING LEASES

The Company leases its main facilities in Sunnyvale, California under two 
lease agreements from the same landlord expiring September 30, 2003. The 
lease agreement for the primary facility is cancelable at the Company's 
option upon four months' notice. Payments are adjusted annually based on 
changes in the Consumer Price Index on one lease and increase $.60 per square 
foot per year under the other lease. At December 31, 1998, future estimated 
minimum payments under these leases are approximately as follows (in 
thousands):

<TABLE>
<S>                                              <C>
1999                                             $  424
2000                                                439
2001                                                456
2002                                                472
2003                                                364
                                               --------
Total minimum lease payments                     $2,155
                                               --------
                                               --------
</TABLE>

Rent expense under operating leases amounted to $465,000, $289,000 and 
$186,000 in 1998, 1997 and 1996, respectively.

6. STOCKHOLDERS' EQUITY

Initial Public Offering

In October 1997 the Company sold a total of 3,000,000 shares of Common Stock 
at $6.00 per share through its initial public offering. Net proceeds, after 
underwriters' discounts, commissions and fees, and other costs associated 
with the offering, totaled $15,588,006. In connection with the offering, S3 
Incorporated ("S3") received an additional 307,018 shares of Common Stock 
pursuant to certain anti-dilution provisions which the Company had granted 
under a Stock Purchase Agreement (see Note 7).

Warrants

In 1996, the Company issued a warrant to purchase 65,152 shares of Common 
Stock at an exercise price of $0.15 to a limited liability company in which a 
member of the Company's Board of Directors has a substantial interest. The 
warrant was issued in exchange for services to be performed by the director. 
As of December 31, 1998, 21,718 shares under the warrant were exercisable. 
The remaining 43,434 shares will become exercisable if certain defined events 
occur prior to February 1999. The warrant expires on December 31, 1999. The 
Company is expensing $222,000, the value of the warrant, over the related 
service period.

                                       -35-

<PAGE>

In 1997, one of the Founders granted to the Company an exclusive (excluding 
certain rights retained by the Founder), worldwide, perpetual, irrevocable 
and royalty-free right and license to patents owned by him. The Founder has a 
nonexclusive, nontransferable right to the patents for applications and uses 
outside of the Company's business as defined in the license agreement. In 
exchange for rights granted, the Founder received a warrant to purchase 
100,000 shares of Common Stock at $7.50 per share. The warrant vests over a 
three-year period and expires in January 2002. The Company is amortizing 
$250,000, the value of the warrant, over the estimated useful economic life 
of the patents.

Stock Plans

In 1995, the Company adopted the 1995 Stock Option Plan (the "1995 Plan"). A 
total of 1,700,000 shares of Common Stock were reserved for issuance under 
the 1995 Plan. In January 1997, the Board of Directors adopted, and the 
stockholders approved, the 1997 Performance Stock Option Plan (the "1997 
Plan"). The 1997 Plan succeeds the 1995 Plan and has terms similar to that 
Plan. No additional options will be granted under the 1995 Plan and shares 
reserved for future option grants thereunder are available for grant under 
the terms of the 1997 Plan. In June 1997, the Board of Directors adopted and 
the stockholders' approved an amendment to the 1997 Plan increasing the 
number of shares reserved for issuance by 250,000 shares. Under the terms of 
the 1997 Plan, the Board of Directors may grant options to directors, 
employees and consultants. Options may be either incentive stock options or 
nonstatutory stock options, at the discretion of the Board of Directors. 
Incentive stock options may be granted to employees with exercise prices of 
no less than the fair value and nonstatutory options may be granted to 
employees, directors, and consultants with exercise prices of no less than 
85% of the fair value, of the Common Stock on the date of grant, as 
determined by the Board of Directors. If, at the time of grant, the optionee 
owns stock possessing 10% or more of the voting power of all classes of 
stock, the option price shall be at least 110% of the fair value, and the 
option shall not be exercised more than five years after the date of grant. 
Except as noted above, options expire ten years after the date of grant, or 
earlier if employment or service is terminated. Options become exercisable as 
determined by the Board of Directors. Options generally vest over three or 
four years.

In December 1996, the Board of Directors adopted, and in 1997 the 
stockholders approved, the 1997 Non-Employee Directors Stock Option Plan (the 
"Directors Plan"). A total of 100,000 shares of Common Stock were reserved 
for issuance pursuant to the terms of the Directors Plan, which provides for 
the grant of nonqualified stock options to nonemployee directors of the 
Company.

In January 1997, the Board of Directors adopted, and the stockholders 
approved, the 1997 Employee Stock Purchase Plan (the "Purchase Plan"). A 
total of 400,000 shares were reserved for future issuance under the Purchase 
Plan. The Purchase Plan permits eligible employees to purchase Common Stock 
through payroll deductions at a price equal to the lower of 85% of the fair 
value of the Company's Common Stock at the beginning or end of the applicable 
offering period. Payroll deductions are at the election of the employee 
subject to a maximum of 10% of the employee's salary. In 1998, 41,223 shares 
were issued under the Purchase Plan. There were no shares issued in 1997.

During 1996, the Company adopted SFAS 123. In accordance with the Statement, 
the Company applies APB 25 in accounting for option grants to employees under 
the Plan and, accordingly, does not recognize compensation expense for 
options granted to employees with exercise prices of not less than fair value 
on the date of grant.

A summary of the Company's stock option activity, and related information 
follows:

<TABLE>
<CAPTION>
                                                                  Years Ended December 31
                                       ----------------------------------------------------------------------------------
                                                       Weighted -                    Weighted-                  Weighted-
                                                        Average                       Average                    Average
                                          1998          Exercise         1997         Exercise        1996       Exercise
                                         Options         Price          Options        Price        Options       Price
                                       ----------------------------------------------------------------------------------
<S>                                    <C>            <C>              <C>           <C>          <C>
Outstanding at January 1                 1,659,190        $4.48        1,441,988        $3.46       180,576        $1.16
Granted                                    670,950         4.72          432,570         7.55     1,261,412         3.79
Exercised                                 (105,013)        3.27           (7,380)        1.68             -            -
Canceled                                  (398,374)        5.33         (207,988)        3.90             -            -
                                       -----------                    ----------                 ----------
Outstanding at end of period            (1,826,753)       $4.49        1,659,190        $4.48     1,441,988        $3.46
                                       -----------                    ----------                 ----------
                                       -----------                    ----------                 ----------
Weighted-average fair value of
    options granted during the period        $2.50                         $2.19                     $1.23
</TABLE>

                                       -36-

<PAGE>

<TABLE>
<CAPTION>
                                                     DECEMBER 31, 1998
                                                     -----------------
                                  Options Outstanding                              Options Exercisable
             ----------------------------------------------------------------    -------------------------
                                                     Weighted-
                                                      Average       Weighted-                    Weighted-
                                                     Remaining       Average                      Average
                Range of          Number of         Contractual      Exercise     Number of      Exercise
             Exercise Prices       Options              Life          Price        Options         Price
             ----------------------------------------------------------------    -------------------------
<S>                             <C>                 <C>             <C>          <C>             <C>
             $1.16-$2.63           204,030              7.24          $1.51        164,948         $1.28
             $3.69-$3.75           481,850              9.76          $3.74        116,666         $3.75
             $3.83-$3.91           718,404              7.62          $3.85        512,632         $3.85
             $7.00-$8.12           279,446              8.11          $7.49        101,980         $7.47
             $8.50-$10.38          143,023              8.89          $8.63         14,393         $9.50
                                -----------                                     ----------
                                 1,826,753              8.32          $4.49        910,619         $3.86
                                -----------                                     ----------
                                -----------                                     ----------
</TABLE>

Pursuant to APB 25, for certain options granted in June 1997, the Company 
recognized as deferred compensation expense the excess of the deemed value 
for financial reporting purposes of the Common Stock issuable upon the 
exercise of such options over the aggregate exercise price of such options. 
The total deferred compensation expense of $272,000 is being amortized over 
the vesting period of such options.

Reserved Shares

The Company has reserved shares of Common Stock for future issuance as 
follows:

<TABLE>
<CAPTION>
                                                       December 31,
                                                           1998
                                                       ------------
<S>                                                    <C>
Warrants                                                   165,152
Stock purchase plan                                        358,777
Stock option plans:
    Outstanding options                                  1,826,753
    Reserved for future grants                             629,604
                                                       -----------
                                                         2,980,286
                                                       -----------
                                                       -----------
</TABLE>


Had the Company valued its stock options granted to employees according to 
the provisions of SFAS 123, pro forma net income and basic net income per 
share would have been as follows (in thousands except per share data):


<TABLE>
<CAPTION>
                                                               December 31,
                                                          1998               1997
                                                      ------------------------------
<S>                                                   <C>                  <C>
Net income (loss)--as reported                           ($3,469)            $1,251

Net income (loss)--pro forma                              (4,210)               868


Basic net income per share--as reported                   ($0.29)             $0.14
Basic net income per share--pro forma                     ($0.35)             $0.10
</TABLE>


The pro forma net loss is not necessarily indicative of potential pro forma 
effects on results for future years.

The value of options granted prior to the Company's initial public offering 
were determined using the minimum value method using the following weighted 
average assumptions in 1997: a risk free interest rate of 5.63%, an expected 
option life of 72 months and no dividends. The value of options granted 
following the initial public offering in 1997 were determined using the 
Black-Scholes method and the weighted average assumptions were as follows: an 
expected volatility factor of 0.7764, a risk free interest rate of 5.63%, an 
expected option life of 72 months and no dividends. 

                                       -37-

<PAGE>

The value of options granted in 1998 were determined using the Black-Scholes 
method and the weighted average assumptions were as follows: an expected 
volatility factor of 0.66, a risk free interest rate of 5.46%, an expected 
option life of 48 months and no dividends.

Reclassification

In accordance with Securities and Exchange Commission Staff Accounting 
Bulletin Topic 4.B., the Company reclassified $495,000 from retained earnings 
to paid-in capital to reflect the undistributed accumulated earnings of 
Faroudja Laboratories, Inc. There was no impact on total stockholders' equity 
as a result of this reclassification.

7. LICENSE AGREEMENT

In March 1997, the Company entered into a license agreement with S3 
Incorporated covering the incorporation of the Company's video processing 
technologies into integrated circuits for use in PCs. Portions of the license 
were exclusive for certain markets for a period of five years provided that 
performance criteria, including minimum license fees, were satisfied. S3 made 
no minimum license payments necessary to maintain its exclusive rights with 
respect to any periods after March 31, 1998. There can be no assurance as to 
the amount of royalties, if any, the Company will receive in the future as 
the Company does not currently have any license agreements in effect pursuant 
to which it expects to receive substantial royalties.

In December 1996, S3 paid the Company $1 million, $500,000 of which was 
refundable if a definitive license agreement between the parties was not 
consummated. Accordingly, the Company recognized $500,000 of license and 
royalty revenue in 1996 and the remaining $500,000 in March 1997.

On June 30, 1997, the Company sold a total of 526,316 shares of its Common 
Stock to S3 pursuant to a Stock Purchase Agreement for $4,948,200, net of 
expenses associated with the transaction. S3 was entitled to certain 
anti-dilution, registration and other rights as set forth in the Stock 
Purchase Agreement. As a result of the anti-dilution rights, S3 received an 
additional 307,018 shares of Common Stock upon completion of the Company's 
initial public offering in October 1997.

8. INCOME TAXES

The provision (benefit) for income taxes computed under Statement of 
Financial Accounting Standards, No. 109, "Accounting for Income Taxes," 
consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                                                              Pro Forma
                                       December 31,     December 31,      December 31,        December 31,
                                          1998             1997               1996               1996
                                          ----             ----               ----               ----
                                                                                              (Unaudited)
<S>                                    <C>              <C>               <C>                 <C>
Federal:
    Current                             $(1,386)          $ 1,059           $   992           $ 1,157
    Deferred                                808              (369)             (440)             (455)
                                        -------           -------           -------           -------
                                           (578)              690               552               702

State:
    Current                                 (13)              143               201               247
    Deferred                                134               (67)              (66)              (70)
                                        -------           -------           -------           -------
                                            121                76               135               177
                                        -------           -------           -------           -------
Provision (benefit) for income taxes    $  (457)          $   766           $   687           $   879
                                        -------           -------           -------           -------
                                        -------           -------           -------           -------
</TABLE>

                                       -38-

<PAGE>


The provision for income taxes differs from the amount computed by applying 
the statutory federal income tax rate to income before taxes. The sources and 
tax effects of the differences are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                               Pro Forma
                                      December 31,      December 31,      December 31,        December 31,
                                          1998             1997               1996                1996
                                          ----             ----               ----                ----
                                                                                              (Unaudited)
<S>                                   <C>               <C>               <C>                 <C>
Tax at U.S. Statutory
  Rate                                    $(1,335)          $   686           $   747          $   747
State income taxes,
  net of federal benefit                      120                30                79              107
S Corporation
  earnings prior to change
  in tax status                                --                --              (252)              --
Deferred taxes
  recorded due to change
  in tax status                                --                --              (149)              --
Research and development
  tax credits                                  --              (137)               (9)              --
Valuation allowance                           632                --                --               --
Other                                         126               187               271               25
                                          -------           -------           -------          -------
                                          $  (457)          $   766           $   687          $   879
                                          -------           -------           -------          -------
                                          -------           -------           -------          -------
</TABLE>

The pro forma provision for income taxes in 1996 reflects the additional tax 
expense which would have been incurred had FLI's status as an S Corporation 
terminated on January 1, 1996, exclusive of the effects of the establishment 
of deferred tax assets and liabilities at that date.

Deferred income taxes reflect the net tax effects of temporary differences 
between the carrying amounts of assets and liabilities for financial 
reporting purposes and the amounts used for income tax purposes. Significant 
components of the Company's deferred tax liabilities and assets are as 
follows (in thousands):

<TABLE>
<CAPTION>
                                                                    December 31,
                                                               1998             1997
                                                               ----             ----
<S>                                                          <C>               <C>
     Reserves and accruals not currently deductible          $   591           $   686
     Tax credit                                                  151                 -
     State net operating losses                                  107                 -
     Other, net                                                  172               324
                                                             -------           -------
Total gross deferred tax assets                                1,021             1,010
Less valuation allowance                                        (822)                -
                                                             -------           -------
Net deferred tax assets                                          199             1,010
Deferred tax liabilities:
     Depreciation of property and equipment                     (199)              (68)
                                                             -------           -------
     Total deferred taxes                                    $     -           $   942
                                                             -------           -------
                                                             -------           -------
</TABLE>

As of December 31, 1998, the Company had state tax loss carryforwards of 
approximately $1,800,000 and federal tax credit carryforwards of 
approximately $151,000. The state tax loss carryforwards will expire in 2003, 
and the federal tax credit carryforwards will expire in 2018, if not 
utilized. Because of the change in ownership provisions of the Internal 
Revenue Code, a portion of the Company's net operating loss and tax credit 
carryforwards may be subject to annual limitations. The annual limitation 
may result in the expiration of net operating loss and tax credit 
carryforwards before utilization.

Realization of deferred tax assets is dependent on future earnings, if any, 
the timing and the amount of which are uncertain. Accordingly, a valuation 
allowance, in an amount equal to the net deferred tax asset as of December 
31, 1998 has been established to reflect these uncertainties. The valuation 
allowance increased by approximately $822,000 during the fiscal year ended 
December 31, 1998. The Company will continue to evaluate the realization of 
the deferred tax assets on a quarterly basis.

                                       -39-

<PAGE>

9. EXPORT SALES AND SIGNIFICANT CUSTOMERS

The Company has developed and is marketing a range of video image enhancement 
products directed at the consumer/industrial markets and the television 
broadcast market.

Product sales to these markets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                    December 31,
                                                    1998                 1997               1996
                                                  --------             --------            -------
<S>                                               <C>                  <C>                 <C>
Consumer/industrial                               $ 10,311             $ 15,199            $10,601
Broadcast                                            1,209                  307              2,025
                                                  --------             --------            -------
                                                  $ 11,520             $ 15,506            $12,626
                                                  --------             --------            -------
                                                  --------             --------            -------
</TABLE>

The Company had product sales by region as follows (in thousands):

<TABLE>
<CAPTION>
                                                                       December 31,
                                                    1998                 1997                1996
                                                  --------             --------            -------
<S>                                                <C>                 <C>                 <C>
Revenues to customers:
    U.S.A                                          $ 9,241             $ 13,285            $10,612
    Asia                                             1,080                1,182              1,115
    Europe                                             521                  345                479
    Canada                                             478                  269                200
    Latin America and other                            200                  425                220
                                                  --------             --------            -------
                                                  $ 11,520             $ 15,506            $12,626
                                                  --------             --------            -------
                                                  --------             --------            -------
</TABLE>

In 1998, sales to one customer accounted for 10% of total revenues. In 1997, 
sales to two customers accounted for 11% of total revenues. In 1996, sales to 
one customer accounted for 11% of total revenues.

10. 401K PLAN

During 1994, the Company adopted a defined contribution retirement plan under 
Internal Revenue Service Code Section 401(k). Employees are eligible, 
following one month of employment, to contribute a specified percentage of 
their salary, not to exceed the statutory limit, to the plan. The Company 
matches a percentage of employee contributions. The Company's contributions 
were $166,000 in 1998, $147,000 in 1997 and were insignificant during 1996.

11. CREDIT FACILITIES

In March 1997, the Company established a revolving line of credit with a bank 
for borrowings of up to $1,000,000. In May 1997, the line was increased to 
$2,000,000, including secured letters of credit. The line of credit 
agreement, which includes certain financial covenants, expires in April 1999. 
Borrowings under the line of credit are collaterized by substantially all of 
the Company's tangible assets and contract rights and are limited to a 
defined percentage of eligible accounts receivable. In addition, the Company 
must satisfy certain financial covenants.  Borrowings against the line of 
credit bear interest at prime plus 1.5% (equivalent to 9.25% at December 31, 
1998). At December 31, 1998, there were no borrowings against the line of 
credit.

                                       -40-

<PAGE>

                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Faroudja, Inc.

     We have audited the accompanying consolidated balance sheets of 
Faroudja, Inc. as of December 31, 1998 and 1997, and the related consolidated 
statements of income, stockholders' equity and cash flows for each of the 
three years in the period ended December 31, 1998. Our audits also included 
the financial statement schedule listed in the Index as Item 14(a). These 
financial statements and schedule are the responsibility of the Company's 
management. Our responsibility is to express an opinion on these financial 
statements and schedule based on our audits.

     We conducted our audits in accordance with generally accepted auditing 
standards. 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, the financial statements referred to above present 
fairly, in all material respects, the consolidated financial position of 
Faroudja, Inc. at December 31, 1998 and 1997 and the consolidated results of 
its operations and its cash flows for each of the three years in the period 
ended December 31, 1998, in conformity with generally accepted accounting 
principles. Also, in our opinion, the related financial statement schedule, 
when considered in relation to the basic financial statements taken as a 
whole, present fairly in all material respects the information set forth 
therein.

                                       /S/ ERNST & YOUNG LLP

Palo Alto, California
January 25, 1999

                                       -41-

<PAGE>


ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE.

          Not applicable.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

     Information concerning directors of the Company is incorporated herein 
by reference from the Registrant's definitive proxy statement to be filed for 
the annual meeting of stockholders to be held on June 10, 1999 ("1999 Proxy 
Statement"). Information concerning the executive officers of the Registrant 
is included in Part I, page 18, of this annual report on Form 10-K.

ITEM 11.  EXECUTIVE COMPENSATION.

     The section labeled "Executive Compensation" of the 1999 Proxy Statement 
is incorporated herein by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

     The section labeled "Security Ownership of Certain Beneficial Owners" of 
the 1999 Proxy Statement is incorporated herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The section labeled "Certain Relationships and Related Transactions" of the
1999 Proxy Statement is incorporated herein by reference.

                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.



     (a)  (1) Financial Statements-see Index to Financial Statements and
          Financial Statement Schedules at page 27 of this Form 10-K.
          (2) Financial Statement Schedules-see Index to Financial Statements
          and Financial Statement Schedules at page 27 of this Form 10-K. 
          (3) Exhibits-see Exhibit Index at page 45 of this Form 10-K.

     (b)  Reports on Form 8-K.

          No reports on Form 8-K were filed during the last quarter of 1998.

                                       -42-

<PAGE>

                                   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.

                              FAROUDJA, INC.


                              By:       /S/ GLENN W. MARSCHEL, JR.
                                        --------------------------------------
                                        Glenn W. Marschel, Jr.
                                        PRESIDENT AND CHIEF EXECUTIVE OFFICER
                              Date:     March 29, 1999

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature 
appears below hereby constitutes and appoints Glenn W. Marschel, Jr. and 
Robert A. Sheffield his true and lawful attorneys-in-fact and agents, each 
with full power of substitution, for him in his true name, place and stead, 
in any and all capacities, to sign this Form 10-K and all amendments hereto, 
and to file the same, with exhibits thereto and other documents in connection 
therewith, with the Securities and Exchange Commission, granting unto said 
attorneys-in-fact and agents full power and authority to do and perform each 
and every act and thing requisite and necessary to be done in and about the 
premises, as fully to all intents and purposes as he might or could do in 
person, hereby ratifying and confirming all that said attorneys-in-fact and 
agents, or their substitute or substitutes, may lawfully do or cause to be 
done by virtue hereof.

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

<TABLE>
<CAPTION>
SIGNATURE                                            TITLE                                                     DATE
---------                                            -----                                                     ----
<S>                                                  <C>                                                       <C>
                                                     Chief Executive Officer, President and Director
   /S/ GLENN W. MARSCHEL, JR.                        (Principal Executive Officer)                             March 29, 1999
---------------------------------
Glenn W. Marschel, Jr.

                                                     Vice President of Finance and Chief Financial Officer
   /S/ ROBERT A. SHEFFIELD                           (Principal Financial and Accounting Officer)              March 29, 1999
---------------------------------
Robert A. Sheffield
                                                     Chief Technical Officer, Director and Chairman of the
   /S/ YVES C. FAROUDJA                              Executive Committee                                       March 29, 1999
---------------------------------
Yves  C. Faroudja

   /S/ MERV L. ADELSON                               Director                                                  March 29, 1999
---------------------------------
Merv  L. Adelson

   /S/ STUART D. BUCHALTER                           Director                                                  March 29, 1999
---------------------------------
Stuart  D. Buchalter

   /S/ KEVIN B. KIMBERLIN                            Director                                                  March 29, 1999
---------------------------------
Kevin  B. Kimberlin

   /S/ MATTHEW D. MILLER                             Director                                                  March 29, 1999
---------------------------------
Matthew  D. Miller

   /S/ WILLIAM N. SICK                               Director                                                  March 29, 1999
---------------------------------
William  N. Sick

   /S/ WILLIAM J. TURNER                             Director                                                  March 29, 1999
---------------------------------
William  J. Turner
</TABLE>
                                       -43-

<PAGE>

                                 FAROUDJA, INC.

                  SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                BALANCE AT      CHARGED TO   CHARGED TO                   BALANCE
                                                                 BEGINNING       COSTS AND     OTHER                      END OF
                                                                 OF PERIOD       EXPENSES     ACCOUNTS    DEDUCTIONS(1)   PERIOD
                                                                ----------      ----------   ----------   ------------    -------
<S>                                                              <C>            <C>           <C>         <C>             <C>
Year ended December 31, 1998 deducted from asset accounts:
   Allowance for doubtful accounts ...........................      $167          $ 17          $ -          $ 48          $136
                                                                ----------      ----------   ----------   ------------    -------

Year ended December 31, 1997 deducted from asset accounts:
   Allowance for doubtful accounts ...........................      $110          $101          $ -          $ 44          $167
                                                                ----------      ----------   ----------   ------------    -------

Year ended December 31, 1996 deducted from asset account:
   Allowance for doubtful accounts ...........................      $ 10          $143          $ -          $ 43          $110
                                                                ----------      ----------   ----------   ------------    -------
</TABLE>

-----------
(1)  Uncollectible accounts written off, net of recoveries.

                                       -44-

<PAGE>

                                 FAROUDJA, INC.

                                INDEX TO EXHIBITS

                                  (ITEM 14(c))


<TABLE>
<CAPTION>
EXHIBIT  DESCRIPTION
NUMBER   -----------
------
<S>      <C>
3.1      The Company's Restated Certificate of Incorporation, as amended on
         August 12, 1997. (1)
3.2      The Company's By-Laws. (1)
4.1      Warrant, dated January 20, 1997, for the purchase of Common Stock
         issued to Yves Faroudja. (1)
4.2      Warrant, dated December 17, 1997, for the purchase of Common Stock
         issued to Adelson Investors, LLC. (1)
4.3      Specimen of Common Stock Certificate. (1)
10.1     Letter Agreement, dated December 31, 1996, between the Company and Merv
         L. Adelson for certain consulting services. (1)
10.2     Amendment to Letter Agreement, dated December 17, 1997, between the
         Company and Merv L. Adelson. (2)
10.3     Letter Agreement, dated November 13, 1995, by and among certain
         stockholders of the Company listed therein and Spencer Trask Holdings,
         Inc. (1)
10.4     Amendment to Letter Agreement, dated February 9, 1996, among certain
         stockholders of the Company listed therein and Spencer Trask Holdings,
         Inc. (1)
10.5     Lease Agreement, dated August 27, 1997, by and among the Company and
         the Landlords listed therein. (1)
10.6     The Company's 1995 Stock Option Plan, dated August 1, 1995 and amended
         on August 19, 1996, February 11, 1997, April 30, 1997 and June 13,
         1997. (1)
10.7     The Company's 1997 Non-Employee Directors Stock Option Plan, dated
         January 2, 1997. (1)
10.8     The Company's 1997 Performance Stock Option Plan, dated January 2, 1997
         and amended on June 13, 1997. (1)
10.9     The Company's Amended 1997 Employee Stock Purchase Plan, dated January
         2, 1997 and amended on August 12, 1997 and September 30, 1997. (1)
10.10    Employment Agreement, dated as of July 8, 1996, between the Company and
         Michael J. Moone. (1)
10.11    Employment Agreement, dated March 8, 1996, between the Company and Yves
         C. Faroudja. (1)
10.12    Registration and Shareholders' Rights Agreement, dated March 7, 1997,
         among the Company and Yves & Isabell Faroudja and certain Stockholders
         of the Company. (1)
10.13    Three (3) Registration Rights Agreements, dated December 31, 1996 among
         the Company and each of Adelson Investors, LLC, Images Partners, LP and
         Roger K. Baumberger as Liquidating Trustee for Faroudja Images, Inc.
         (1)
10.14    Registration Rights Agreement, dated March 7, 1997 among the Company
         and Faroudja Images Investors, LLC. (1)
10.15    Agreement, dated January 20, 1997 among Yves Faroudja and the Company
         for the transfer of intellectual property to the Company. (1)
10.16    License Agreement, dated March 31, 1997, between the Company and S3
         Incorporated. (1) (3)
10.17    Stock Purchase Agreement, dated June 30, 1997, between the Company and
         S3 Incorporated. (1)
10.18    Investor's Rights Agreement, dated June 30, 1997, between the Company
         and S3 Incorporated. (1)
10.19    Business Loan Agreement, dated April 5, 1997, between the Company and
         Silicon Valley Bank. (1)
10.20    Commercial Guaranty, dated April 5, 1997, by the Company for the
         benefit of Silicon Valley Bank. (1)
10.21    Commercial Security Agreement, dated April 5, 1997, by the Company for
         the benefit of Silicon Valley Bank. (1)
10.22    Promissory Note, dated April 5, 1997, by the Company for the benefit of
         Silicon Valley Bank. (1)
10.23    Promissory Note, dated June 6, 1997, by the Company for the benefit of
         Silicon Valley Bank. (1)
10.24    Loan Modification Agreement, dated June 6, 1997, by and between the
         Company and Silicon Valley Bank. (1)
10.25    Three (3) Amended and Restated Options to Purchase Shares of Common
         Stock of the Company, dated March 7, 1997 among the Company, Yves
         Faroudja and Isabell Faroudja, Faroudja Images, Inc. and each of
         Adelson Investors, LLC, Faroudja Images Investors, LLC and Images
         Partners, LP. (1)
10.26    Amended and Restated Option to Purchase Shares of Common Stock of the
         Company, dated December 31, 1996 among the Company, Yves Faroudja and
         Isabell Faroudja, Faroudja Images, Inc. and Roger K. Baumberger as
         Liquidating Trustee of Faroudja Images, Inc. (1)
10.27    Consulting Services Agreement, dated July 22, 1997, between the Company
         and Matthew D. Miller. (1)
10.29    Purchase Agreement dated December 18, 1997, between the Company and
         Audio Video Source, Inc. (3)
10.30    Agreement, dated March 8, 1998, between the Company and Yves Faroudja
         for advisory services. (2)
10.31    Loan Modification Agreement, dated April 1, 1998 between the Company
         and Silicon Valley Bank (4)
10.32    Amendment to the Company's 1997 Performance Stock Option Plan dated
         June 10, 1998.
</TABLE>

                                       -45-

<PAGE>

<TABLE>
<S>      <C>
10.33    Letter Agreement, dated June 30, 1998, between the Company and Michael
         C. Hoberg.
10.34    Letter Agreement, dated November 30, 1998, between the Company and
         Michael J. Moone.
10.35    Letter Agreement, dated January 28, 1999, among the Company and Yves
         Faroudja and Isabell Faroudja amending the Registration and
         Shareholders' Rights Agreement, dated March 7, 1997, among the Company
         and Yves & Isabell Faroudja.
10.36    Letter Agreement, dated January 13, 1999, between the Company and
         Nikhil Balram.
21.1     List of the Subsidiaries of the Company. (1)
23       Consent of Ernst & Young LLP, Independent Auditors.
24       Power of Attorney (included on page 43 of this Form 10-K).
27       Financial Data Schedules.
</TABLE>

-----------
(1)  Filed as an exhibit to the Company's Registration Statement on Form S-1,
     File No. 333-32375, and incorporated herein by reference.

(2)  Filed as an exhibit to the Company's Annual Report on Form 10-K for the
     year ended December 31, 1997, and incorporated herein by reference.

(3)  Confidential treatment has been granted. Non-public information has been
     omitted and filed separately with Commission.

(4)  Filed as an exhibit to the Company's Registration Statement on Form S-1,
     File No. 333-59901, and incorporated herein by reference.

                                       -46-