<PAGE>

================================================================================

                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                _______________

                                   Form 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934

                  For the fiscal year ended: December 31, 2000

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

                       Commission File Number: 000-30865

                               AVICI SYSTEMS INC.
             (Exact Name of registrant as specified in its charter)

          DELAWARE                                              02-0493372
    (State or other jurisdiction of                        (I.R.S. Employer
     incorporation or organization)                      Identification Number)

                              101 BILLERICA AVENUE
                     North Billerica, Massachusetts  01862
                    (Address of principal executive offices)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (978) 964-2000

        Securities registered pursuant to Section 12(b) of the Act: None

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

                         Common Stock, $.0001 Par Value

  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 report(s), 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. [_]

  The aggregate market value of the voting stock held by non-affiliates of the
Registrant, as of March 7, 2001, was approximately $649,917,943 (based on the
closing price of the Registrant's Common Stock on March 7, 2001, of $14.375 per
share).

  The number of shares outstanding of the Registrant's $.0001 par value Common
Stock as of March 7, 2001 was 48,891,805.

                       DOCUMENT INCORPORATED BY REFERENCE

  The registrant intends to file a definitive proxy statement pursuant to
Regulation 14A within 120 days of the end of the fiscal year ended December 31,
2000. Portions of such proxy statement are incorporated by reference into Part
III of this Form 10-K.

================================================================================

                                      -1-
<PAGE>

                               AVICI SYSTEMS INC.

                           ANNUAL REPORT ON FORM 10-K

                          YEAR ENDED DECEMBER 31, 2000

                               TABLE OF CONTENTS
<TABLE>
<CAPTION>

<S>                                                                                                  <C>
PART I.............................................................................................   3
 ITEM 1.      BUSINESS.............................................................................   3
 ITEM 2.      PROPERTIES...........................................................................  10
 ITEM 3.      LEGAL PROCEEDINGS....................................................................  11
 ITEM 4.      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..................................  11
PART II............................................................................................  11
 ITEM 5.      MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS................  11
 ITEM 6.      SELECTED CONSOLIDATED FINANCIAL DATA.................................................  11
 ITEM 7.      MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  13
 ITEM 7A.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...........................  25
 ITEM 8.      CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............................  27
 ITEM 9.      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.  47
PART III...........................................................................................  47
 ITEM 10.     DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...................................  47
 ITEM 11.     EXECUTIVE COMPENSATION...............................................................  47
 ITEM 12.     SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.......................  47
 ITEM 13.     CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.......................................  47
PART IV............................................................................................  48
 ITEM 14      EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.....................  48
SIGNATURES.........................................................................................  50

</TABLE>

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<PAGE>

                     FACTORS THAT MAY AFFECT FUTURE RESULTS

          Our prospects are subject to certain uncertainties and risks. This
Annual Report on Form 10-K contains certain forward-looking statements within
the meaning of the federal securities laws that also involve substantial
uncertainties and risks. Our future results may differ materially from our
historical results and actual results could differ materially from those
projected in the forward-looking statements as a result of certain risk factors.
Readers should pay particular attention to the considerations described in the
section of this report entitled "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Factors That May Affect Future
Results." Readers should also carefully review the risk factors described in the
other documents that we file from time to time with the Securities and Exchange
Commission.

                                     PART I

ITEM 1.   BUSINESS

OVERVIEW

          Avici Systems Inc., a Delaware corporation, was incorporated in 1996.
We provide high-speed data networking equipment that enables telecommunications
companies and Internet service providers to transmit high volumes of information
across their fiber optic networks. Our high-performance solution is being
marketed to telecommunications companies and Internet service providers,
referred to as carriers, that are creating next-generation optical networks to
address the increasing data traffic across the Internet. The Avici Terabit
Switch Router product (TSR(R)) is designed to cost-effectively provide:

 . high-speed/high-volume capacity;

 . high levels of operational availability and redundancy, which we refer to as
   carrier-class reliability; and

 . the ability to incrementally add capacity to the network without disrupting
   network performance, which we refer to as in-service scalability.

     Our TSR also optimizes bandwidth by dynamically managing and prioritizing
network traffic, thereby enabling carriers to provision new revenue-generating
services, such as video streaming and Voice-over-Internet Protocol, or VoIP. Our
TSR provides these benefits through our proprietary technologies, including our
application specific integrated circuits, or ASICs, and distributed system
design, as well as our Composite Link technology, which enables the TSR to
combine multiple lower speed connections to create a single high-speed
connection. AT&T has deployed the TSR in its North American IP backbone network.
The TSR has also been deployed by France Telecom R & D in the VTHD research
network, by several agencies of the United States government and by the DARPA-
funded National Transparent Optical Network. In addition, Enron Broadband
Services, Qwest Communications and Williams Communications have agreed to future
minimum purchases of the TSR. Deployment of the TSR is dependent upon successful
completion of field trials with these customers. The TSR is currently in trials
and tests with additional prospective customers.

INDUSTRY BACKGROUND

  DEMAND FOR DATA SERVICES IS FUELING NETWORK GROWTH

  Data traffic over today's communications networks continues to grow at an
exponential rate.  This proliferation of data traffic is being driven by a
number of factors, including increases in the number of Internet users worldwide
and business use of the Internet for applications such as e-commerce, video
streaming and virtual private networks. To keep pace with the growing demand,
transmission speeds have increased from kilobits per second to megabits per
second to gigabits per second. The next step in transmission speed is referred
to as terabits per second. One terabit per second is equal to one trillion bits
per second.

  LIMITATIONS OF THE EXISTING PUBLIC NETWORK INFRASTRUCTURE

  The existing public networks are largely built on technologies that were
originally designed to provide only voice services. These networks are based on
circuit switch technology, which dedicates an individual connection, or part

                                      -3-
<PAGE>

of the network, for the duration of a call even while there are pauses in the
conversation. Although adequate for voice traffic, circuit switch technology is
inefficient for the transmission of large volumes of data traffic, which tends
to occur in large, intermittent bursts. As data traffic carried over the
existing network infrastructure began to increase, carriers increased the
capacity of their networks by overlaying devices designed to increase data
transmission rates and that are based on network standards such as Synchronous
Optical Network, or SONET.

  At the same time, carriers also sought to increase the efficiency of data
transmission through their networks by adopting packet switching technologies,
such as Asynchronous Transfer Mode, or ATM, and Internet Protocol, or IP, which
divide data traffic into individual packets and transmit them independently over
the network. These packet-switching technologies enable carriers to send data
from multiple sources on the same connection, thereby substantially reducing the
bandwidth wasted using circuit switch technology. With much of the growth in
data traffic attributable to the increasing use of the Internet, IP has become
the predominant standard for transmitting data across networks. Nevertheless,
carriers have been forced to adopt and deploy multiple protocols, such as SONET,
ATM, IP and Ethernet at gigabit speeds, or Gigabit Ethernet, and a variety of
devices within their networks in an effort to manage the proliferation of IP-
based data services.

  The advent of Dense Wave Division Multiplexing, or DWDM, an optical technology
that multiplies the amount of data that can be carried over existing fiber optic
lines, has provided carriers with substantial raw capacity in the core of their
optical networks.  Following their widespread deployment of DWDM technology,
carriers are focusing on the deployment of routers, devices designed to forward
IP-based data packets, to take advantage of the expanded bandwidth enabled by
DWDM.

  LIMITATIONS OF EXISTING ROUTERS

  The transmission capacity of fiber optic lines has increased at a greater rate
than the transmission capacities of routers. This has created a chasm between
the capabilities of existing routers and the optical transmission network and
has produced bottlenecks in the public network. This chasm results in large part
because of the limited ability of existing router designs to adapt to the
evolving and increasing bandwidth demands of carriers. For example, current
router offerings employ a centralized design, which inherently limits the number
of interfaces available and, accordingly, the ability to incrementally increase
the bandwidth capacity of a router. This limitation requires that carriers
either inefficiently cluster multiple routers to emulate the functionality of a
single large router with greater capacity or repeatedly undertake disruptive and
expensive large-scale upgrades, known as forklift upgrades, to address the
increases in optical transmission speeds and capacities.

  At the same time, traditional routers are unable to communicate with the newer
generation of optical transmission equipment to dynamically change bandwidth or
enable the provisioning of new services without disrupting the entire network.
This limitation increases the time and effort required for carriers to deliver
new services or reconfigure the network in the event of sudden changes in
bandwidth demand.

  CARRIER REQUIREMENTS FOR A NEW ARCHITECTURE

     To respond to the challenges created by the increasing volume of data
traffic on the existing public networks, carriers are not only focused on
optimizing their next-generation optical networks for more efficient data
transmission, but are also searching for a means to rapidly provision new
revenue-generating data communications services. As a result, carriers are
demanding solutions with the following attributes:

     Reduced Network Cost and Complexity. A major portion of expenditures
relating to the deployment of routers is dedicated to the interconnection of
multiple, fixed configuration routers in order to provision the required amounts
of bandwidth. This is costly in terms of capital and, more importantly,
increases the ongoing costs of running a network.  Each router must be managed
as an independent element of the network, and with each addition of capacity
increasing the complexity of network design and management, the number of
personnel needed to manage the network increases.  The personnel involved with
these configuration changes are often among the carrier's best IP resources and
could be better utilized to design and deliver new services.  Carriers are
demanding scalable solutions that reduce the number of devices and complexity of
operating large capacity networks.

     Increased Service Velocity. Networks and network demands are changing
rapidly, and carriers want a cost-effective means of increasing capacity on a
continual basis. As a key building block of the public network, routers must

                                      -4-
<PAGE>

therefore have the ability to expand capacity without the costly delays of
forklift upgrades, complex network reconfigurations, or other significant
disruptions of the network.

     Quality of Service Functionality that Enables New Revenue-Generating
Services. As carriers consolidate existing services on the IP backbone, as well
as offer new services, they must deliver quality of service, or the ability to
assign different priorities to different traffic types. Quality of service is
crucial to the delivery of time-sensitive data streams, such as voice and video.
Routers must provide quality of service functionality over IP without adversely
affecting performance. In addition to prioritizing packets, routers must be able
to manage and control network congestion to enable carriers to deliver service
level guarantees to their customers.

     Carrier-Class Reliability. The equipment that carriers deploy within their
networks must offer the highest level of up-time and redundancy. To meet this
requirement, known as carrier-class reliability, router designs must minimize
any single points of failure and provide automatic recovery from network
failures and device errors.

     High Performance. In order to capitalize on the increasing capacity offered
by optical technologies, carriers demand high levels of performance and
flexibility. Although there are different measures for determining performance
of routers, we believe the most critical measure is the ability to process and
forward packets at transmission rates matching the line rates available over the
fiber optic core.

     Interoperability. Due to economic constraints associated with upgrading an
entire network to accommodate new technologies, it is critical that new network
equipment support the protocols and devices already deployed in carrier
networks.

     Instead of trying to adapt older technologies or interim solutions that
provide only incremental increases in capacity, carriers are now seeking
solutions that will enable them to cost-effectively build next-generation
optical networks designed to capitalize on the opportunities created by the
growth of the Internet and the proliferation of data traffic.

THE AVICI SOLUTION

  Our high-performance TSR is engineered to provide a long-term solution for the
next-generation carrier networks by providing a platform for growth and control
of increasing volumes of data traffic. Our solution is designed to provide the
following key benefits:

     Cost-Effective Network Expansion and Operation. By providing a system that
scales from small configurations to the industry's largest capacity router,
Avici enables customers to design router-based networks that can grow as the
demand for capacity grows without the need for constant re-engineering of the
network. The TSR's scalable architecture reduces the number of interface cards
needed when compared with solutions using small, fixed configuration devices.
By minimizing the need for inefficient clustering, continuous network upgrades
and layers of legacy equipment, the TSR reduces the overall cost of expanding
and operating the network.

     Rapid Response to Network Demands. The scalability of the TSR enables
carriers to incrementally add capacity in a cost-effective, non-disruptive
manner. This capability for dynamic, non-disruptive bandwidth provisioning
enables carriers to service existing customers while rapidly adapting to changes
in bandwidth demand, new service offerings and increased usage.

     Ability to Offer New Revenue-Generating Services. Our TSR provides an
effective foundation for the delivery of next-generation data communication
services. The TSR enables carriers to add capacity for new services and
customers without network disruption and to prioritize IP data traffic to
effectively provide quality of service guarantees. As a result, carriers are
able to offer and charge for new and enhanced services, such as voice-over-IP
and video streaming, and can also dynamically modify their service pricing
structures.

     Long-term Carrier Solution.  Our TSR has been designed to meet the current
and evolving performance and bandwidth requirements at the core of carriers'
optical networks. The Avici TSR enables in-service scalability as demands on the
optical layer increase, thereby eliminating expensive clustering designs and
forklift upgrades. We believe that this scalability and flexibility positions
the Avici TSR as a long-term solution for carriers.

                                      -5-
<PAGE>

     Carrier-Class Reliability. The Avici TSR has been designed and manufactured
to provide carrier-class reliability. We believe the TSR's technologically-
advanced features, such as our distributed architecture, Velociti switch fabric
and Composite Links, will enhance the reliability and performance of carrier
networks. The TSR's proprietary ASIC-based design and redundancy features
provide high levels of system reliability.

     Ability to Manage High Volumes of Network Traffic at High Speeds. Our TSR,
through our Composite Link technology, is capable of processing data packets at
virtual line rates exceeding 10 gigabits per second, thereby achieving virtual
performance beyond OC-192.  In addition, the TSR provides the ability to
prioritize IP traffic through its quality of service features without any loss
of transmission speeds.

STRATEGY

  Our goal is to design, develop and provide the next generation of reliable
high-speed data networking equipment that will power the core of carriers'
optical networks and establish new standards for performance. The key elements
of our strategy are to:

  Extend Technological Capabilities.  We have developed a product architecture
closely connected to the optical transport layer and designed to be a long-term
solution within the core of carriers' optical networks. We plan to continue to
invest heavily in research and development, particularly in developing
proprietary ASICs and software, to satisfy the requirements of next-generation
carrier networks. We plan to enhance the features of the TSR and bring to market
new, complementary products. For example, during the second half of 2000 we
delivered for customer trials MultiProtocol Label Switching, or MPLS, traffic
engineering capability and 2-port OC-48c line card modules; and in the first
quarter of 2001, we delivered line card modules for OC-192c and have delivered
for customer trials line card modules for Gigabit Ethernet.  We take a leading
role in industry standard-setting forums and promote the interoperability of our
products with those of key optical switch and router vendors.

  Continue Penetration of Key Carrier Accounts.  We strive to capture the market
opportunity presented by carriers demanding additional capacity as well as
carriers seeking the means to deliver additional services. We have initially
focused on a select group of leading carriers, and we are currently
participating in a number of customer trials. We intend to broaden our target
market focus to include all carriers with fiber optic backbones. We are
expanding our direct sales force, have established our customer service
organization, and will continue to pursue partnerships with international
distributors, third-party service and support organizations and complementary
product companies to expand our market presence.

  Provide Technology to Enable New Carrier Service Offerings.  We work closely
with our customers and prospective customers to understand their network
requirements and service opportunities. We use this knowledge to develop new
features and functionality to enable carriers to deliver new revenue-generating
services. Our MPLS enables carriers to control traffic flow and to offer
services such as virtual private networks.  We will seek opportunities to
enhance our product features and promote the TSR as an effective means for
carriers to capitalize on new service opportunities.

  Expand into New Geographic Markets.  We intend to sell our products globally.
We have established relationships with leading distributors and vendors of
telecommunications equipment in Asia, and we intend to further develop our
direct Asian salesforce to support our indirect sales channels. In addition, we
have established a direct European sales presence as well as relationships with
a key systems integrator in that market, and intend to continue to expand our
presence in Europe. We have deployed the TSR with France Telecom R&D, our first
European customer, and are in trials with a number of European and Asian
carriers.

  Rely on Strategic Outsourcing.  Our outsourcing strategy enables us to focus
our resources on our core competencies of product design and development, sales
and marketing. Although we design and develop our ASICs and other proprietary
technologies, we select and work closely with ASIC fabrication and electronics
manufacturing services providers to promote the cost-effective, timely and
reliable manufacture and testing of our products. To complement our internal
customer service organization, we have entered into global service and support
arrangements for our products with third parties, including Dimension Data
Holdings, plc and IBM.

                                      -6-
<PAGE>

PRODUCTS AND TECHNOLOGY

  PRODUCT ARCHITECTURE

  Our TSR has been designed to provide critical functions for carriers seeking
to build reliable IP-based networks that can capitalize on the raw capacity
provided by DWDM and other optical technologies. We utilize a parallel and
distributed design to address the large volume of packet forwarding and
increasing traffic volume requirements of the Internet. By using a distributed
architecture that incorporates processing and packet routing functionality in
our line card ASICs, our TSR is designed to provide carriers with a smooth
upgrade path from OC-48c to speeds of OC-192c and higher by changing or bundling
line card modules as they become available rather than upgrading the entire
chassis. Accordingly, this architecture provides in-service scalability and
preserves the initial investment in our TSR.

  PRODUCT PORTFOLIO

  The TSR is a 40-slot chassis which can be configured with the following
current and planned line card modules:

<TABLE>
<CAPTION>
LINK TYPE                                           LINK SPEED     STATUS
<S>                                               <C>              <C>
  Packet over SONET                               OC-3c            Commercially available
  Packet over SONET                               OC-12c           Commercially available
  Packet over SONET                               OC-48c           Commercially available
  Packet over SONET                               OC-192c          Commercially available
  Gigabit Ethernet                                1 Gigabit        In trial
  Asynchronous Transfer Mode                      OC-12c           In development
</TABLE>

  IPRIORI CARRIER SYSTEM CONTROL SOFTWARE

  IPriori is an advanced software system that has been developed to optimize and
control switching and routing in the TSR. IPriori is built on a distributed
model, which uses multiple processor units to provide increased levels of
reliability and scalability, and is specifically designed to address the system
requirements arising from a large number of ports. Through our extensive field
testing and network deployments, we have successfully demonstrated our
interoperable implementations of standard protocols such as BGP, OSPF and IS-IS.

  COMPOSITE LINKS

  The Avici TSR connects to the optical transport layer through many physical
connections. Physical connections between two TSRs can be combined into a single
virtual network interface to provide a carrier with a high-capacity connection.
This single network connection is called a Composite Link. Composite Link
technology enables carriers to add additional lines or increase or decrease
transmission speeds on a particular Composite Link without disrupting the
network. This enables carriers to meet increases in bandwidth demand and to
offer new services to their customers more quickly. Each Composite Link can be
configured with up to 16 network interfaces and enables carriers to achieve
effective line speeds of 160 gigabits per second. With this feature, the TSR is
able to recognize heavy or light traffic demand in the network and dynamically
add and remove physical connections from the composite group. When traffic
increases and physical links are needed or when traffic decreases and links can
be removed from a composite group, the TSR communicates this information to
optical equipment to change network connections appropriately. This maintains
optimum traffic routing. Because our Composite Links operate with no network
disruption, they enable the rapid provisioning of additional bandwidth while
maintaining a stable and reliable environment for IP services.

  We have complemented our Composite Links with MPLS functionality to provide
traffic engineering capabilities and enable carriers to control and efficiently
balance data traffic across their networks. We believe MPLS is a key component
of differentiated IP-based services and, when combined with other quality of
service mechanisms, will enable carriers to deliver enhanced network services.

  VELOCITI SWITCH FABRIC

  Our Velociti switch fabric is the mechanism that transfers data from an input
line card to specific output cards in the TSR. This direct communication
provides high speed data transfer and, as additional capacity is needed, enables
cost-effective addition of line cards. Because all data handling, switching and
packet processing has been incorporated into the line cards, carriers are able
to support higher speed line cards without forklift upgrades. The Velociti
switch

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fabric also gives the TSR a high level of reliability by creating multiple
connections between pairs of input and output line cards. In the event one path
fails, one of the backup paths is selected to continue data transmission,
thereby substantially reducing the risk of disruption to the network.

  ASIC-BASED PACKET ROUTING TECHNOLOGY

  We have consolidated all data-flow and control processes, including packet
input and output framing, forwarding, scheduling, and switching into our
application specific integrated circuits, or ASICs. All of our ASICs reside on
each line card module. Accordingly, the overall capacity of the TSR increases
with the addition of each line card. These ASICs provide high levels of
performance by enabling line rate packet forwarding performance regardless of
packet address and route table size.

  Our ASICs are designed to provide the following functions and benefits:

<TABLE>
<CAPTION>
        ASIC                              FUNCTION                                    CUSTOMER BENEFITS
<S>                    <C>                                              <C>

Input Framer           Analyzes and identifies incoming IP packets      Enhances ability to manage network traffic
                       and marks them for prioritization                to enforce quality of service
Forwarding             Determines packet destination and forwards the   Maintains network performance as bandwidth
                       packet at line rates                             demand increases
Packet Scheduling      Manages intelligent prioritization and           Ensures optimal system performance across
                       efficient use of the TSR's switching capacity    high volumes of traffic flows.
Fabric Switching and   Provides Velociti switch fabric that is          Creates high performance and economical
 Packet Memory         responsible for communication among line card    scalability
                       modules
Quality of Service     Prioritizes packets for transmission             Enables the creation and delivery of
                                                                        differentiated IP-based services
Output Framer          Controls outbound traffic to ensure              Provides additional control of packet flows
                       conformance to quality of service requirements   to ensure network stability
</TABLE>

SALES AND MARKETING

  We sell and market our products primarily through our direct sales force,
systems integrators and distributors. Our sales cycle to carriers typically is a
lengthy and deliberate process. After preliminary discussions with our sales
organization, prospective customers may receive evaluation equipment to
encourage formal testing. The sales cycle normally includes laboratory testing
in which the TSR is evaluated against competing products for performance,
scalability, reliability, interoperability and other measures. Upon completion
of the laboratory tests, one product is typically selected for field trials in
which the product is deployed in a carrier's network in a limited and controlled
fashion. Only after successful completion of field trials will carriers place
orders for commercial deployment across their networks over time.

  Our direct sales efforts are focused on the largest carriers. As of December
31, 2000, our sales and marketing organization consisted of 50 employees, of
which 22 were located in our headquarters in North Billerica, Massachusetts, 17
were located in a total of 4 sales and support offices around the United States
and 11 were located in sales and support offices in Europe and Asia.

  Our marketing objectives include building market awareness and acceptance of
Avici and the Avici TSR as well as generating qualified customer leads. In
addition to traditional marketing activities, we are working closely with
standards bodies such as the Optical Internetworking Forum and IETF to promote
the interoperation of our routers with optical equipment from other vendors.

  Our international sales are conducted through a direct sales force, systems
integrators, distributors and a sales representative. We have regional partners
in Japan,  Korea, China and Southeast Asia. In addition, in order to further our
international sales objectives, we will continue identifying and establishing
relationships with additional country-specific distributors.

                                      -8-
<PAGE>

CUSTOMERS

     AT&T has deployed the TSR in its North American IP backbone network. The
TSR has also been deployed by France Telecom R & D in the VTHD research network,
by several agencies of the United States government and by the DARPA-funded
National Transparent Optical Network. In addition, Enron Broadband Services,
Qwest Communications and Williams Communications have agreed to future minimum
purchases of the TSR. Deployment of the TSR is dependent upon the successful
completion of field trials with these customers. The TSR is currently in trials
and tests with additional prospective customers. During 2000, shipments to AT&T,
Enron Broadband Services and Qwest Communications each accounted for greater
than 10% of our net revenue and in the aggregate represented 71% of our net
revenue in 2000.

CUSTOMER SERVICE AND SUPPORT

  We believe that a broad range of support services is critical to the
successful installation and ongoing support of the TSR, the development of long-
term relationships with customers and the generation of additional sales of the
TSR to our customers. We are committed to providing our customers with the
highest levels of service and support. As of December 31, 2000, we employed 32
people in our customer service and support organization. To complement our
internal customer service organization, we have entered into global service and
support arrangements for our products with third parties, including Dimension
Data Holdings, plc and IBM.

RESEARCH AND DEVELOPMENT

  We have assembled a team of skilled engineers with significant experience in
optics, hardware and software, and with particular strengths in the areas of
high speed interconnect, scalable connection fabrics, ASIC development and
Internet routing protocols. As of December 31 , 2000, we had 220 employees
responsible for product design and development, quality assurance and
documentation. We believe that strong product development capabilities are
essential to our strategy of enhancing our core technology and developing
additional applications in an effort to maintain the competitiveness of our
product offerings. We have made, and will continue to make, a substantial
investment in research and development. Research and development expenses were
$54.1 million for the year ended December 31, 2000, $36.8 million for the year
ended December 31, 1999 and $27.4 million for the year ended December 31, 1998.

COMPETITION

  The market for intelligent data networking equipment is intensely competitive,
subject to rapid technological change and significantly affected by new product
introductions and other market activities of industry participants. This market
historically has been dominated by Cisco Systems, which as a result of its early
leadership position in the market has been able to develop and promote a broad
product line of routers. We also compete with other established companies such
as Juniper Networks. We may experience a reluctance by our prospective customers
to replace or expand their current infrastructure solutions, which may be
supplied by these competitors, with our products. In addition, these competitors
have significantly broader product lines than we do and may bundle their
products with other networking products in a manner that may discourage
prospective customers from purchasing our TSR. In order to compete effectively,
we must deliver a product that is superior in meeting the needs of carriers and:

  . scales easily and efficiently with minimum disruption to the network;

  . interoperates with existing network designs and equipment vendors;

  . provides extremely high network reliability;

  . provides high speed interfaces and high performance packet processing
    capabilities;

  . reduces complexity by decreasing the need for overlapping equipment;

  . provides effective network management; and

  . provides a cost-effective solution for our target customers.

                                      -9-
<PAGE>

  Many of our current and potential competitors have greater selling and
marketing, technical, manufacturing, financial and other resources, more
customers, greater market recognition and more established relationships and
alliances in the industry. As a result, these competitors may be able to
develop, enhance and expand their product offerings more quickly, adapt more
swiftly to new or emerging technologies and changes in customer demands, devote
greater resources to the marketing and sale of their offerings, pursue
acquisitions and other opportunities more readily and adopt more aggressive
pricing policies.

INTELLECTUAL PROPERTY

  Our success and ability to compete are dependent on our ability to develop and
maintain the proprietary aspects of our technology and operate without
infringing on the proprietary rights of others. We rely on a combination of
patent protection, copyrights, trademarks, trade secret laws, and contractual
restrictions on disclosure and other methods to protect the proprietary aspects
of our technology. These legal protections afford only limited protection for
our technology. We presently have 15 patent applications pending in the United
States and related foreign patent applications pending and we cannot be certain
that patents will be granted based on these or any other applications, or that,
even if issued, the patents will adequately protect our technology. We seek to
protect our source code for our software, documentation and other written
materials under trade secret and copyright laws, and we seek to limit disclosure
of our intellectual property by requiring employees, consultants and any third-
party with access to our proprietary information to execute confidentiality
agreements with us.

  While we rely on patent, copyright, trade secret and trademark law to protect
our technology, we also believe that factors such as the technological and
creative skills of our personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position. There can be no assurance that
others will not develop technologies that are similar or superior to our
technology.

  Our success will depend upon our ability to obtain necessary intellectual
property rights and protect our intellectual property rights. We cannot be
certain that we will be able to obtain the necessary intellectual property
rights or that other parties will not contest our intellectual property rights.

MANUFACTURING

  We outsource the manufacture and assembly of our products to contract
manufacturers. We primarily use Celestica, Inc. and Sanmina Corporation, both of
which provide comprehensive manufacturing services, including assembly, test and
control and procurement of material, on our behalf. We design product tests that
are conducted using our test equipment by the contract manufacturer. We believe
that the outsourcing of our manufacturing will enable us to conserve the working
capital that would be required to purchase capital equipment, will allow us to
adjust manufacturing volumes to meet changes in demand and will enable us to
more quickly deliver products.

EMPLOYEES

  As of December 31, 2000, we had a total of 365 employees, of which 220 were in
research and development, 50 were in sales and marketing, 31 were in
administration and finance, 32 were in manufacturing and operations and 32 were
in customer service and support.

  Our future success will depend in part on our ability to attract, retain and
motivate highly qualified technical, sales and management personnel, for whom
competition is intense. Our employees are not represented by any labor union. We
believe our relations with our employees are good.

ITEM 2.   PROPERTIES

  Our headquarters are currently located in three leased facilities situated in
the same office complex in North Billerica, Massachusetts, consisting of
approximately 81,000, 51,000 and 18,000 square feet under leases that expire in
October 2007, July 2004 and June 2005, respectively. We also lease sales office
space in several locations in the United States and in Europe.

  The commercial real estate market in the Boston area is unpredictable in terms
of available space, rental and occupancy rates and preferred locations. Although
we expect our current space is adequate to support our targeted

                                      -10-
<PAGE>

growth for the next twelve to eighteen months, we cannot be certain that
additional space will be available when we require it, that it will be
affordable or that it will be in a preferred location.

ITEM 3.  LEGAL PROCEEDINGS

  We are not currently a party to any material litigation. In the ordinary
course of business, we may from time to time become involved in various lawsuits
and claims.

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

     No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.

                                    PART II

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

PRICE RANGE OF COMMON STOCK

     Our common stock has been traded on the Nasdaq National Market under the
symbol "AVCI" since July 28, 2000. Prior to that time, there was no public
market for our stock. The following table sets forth, for the periods indicated,
the high and low closing sale prices as reported on the Nasdaq National Market.

<TABLE>
<CAPTION>
                                                                                              HIGH          LOW
                                                                                              ----          ---
<S>                                                                                      <C>           <C>
Third Quarter (since July 28, 2000)....................................................       $174.50        $86.72
Fourth Quarter.........................................................................       $ 95.95        $16.25
</TABLE>

     As of March 7, 2001, there were approximately 907 stockholders of record.

DIVIDEND POLICY

   We have never paid or declared any cash dividends on our common stock or
other securities and do not anticipate paying cash dividends in the foreseeable
future. Any future determination to pay cash dividends will be at the discretion
of the board of directors and will be dependent upon our financial condition,
results of operations, capital requirements, general business condition and such
other factors as the board of directors may deem relevant.

ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

     The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and notes thereto and
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and other financial data included elsewhere in this report.  The
statement of operations data for the years ended December 31, 2000, 1999 and
1998 and the balance sheet data as of December 31, 2000 and 1999 are derived
from our audited consolidated financial statements which are included elsewhere
in this report. The statement of operations data for the year ended December 31,
1997 and the period from inception (November 12, 1996) through December 31, 1996
and the consolidated balance sheet data as of December 31, 1998, 1997 and 1996
are derived from our audited consolidated financial statements which are not
included in this report. The historical results are not necessarily indicative
of results to be expected for any future period.

                                      -11-
<PAGE>

<TABLE>
<CAPTION>




                                                  PERIOD FROM
                                                   INCEPTION
                                              (NOVEMBER 12, 1996)                 YEAR ENDED DECEMBER 31,
                                                    THROUGH          --------------------------------------------------
                                               DECEMBER 31, 1996        1997       1998         1999          2000
                                               -----------------      --------   ----------   ----------   -----------
                                                           (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<S>                                             <C>                  <C>         <C>          <C>          <C>
Statement of Operations Data:
Gross revenue.................................  $               --   $           $            $            $    15,887
Common stock warrant discount.................                  --          --           --           --           817
                                                ------------------    --------   ----------   ----------   -----------
  Net revenue.................................                  --          --           --           --        15,070
Cost of revenue...............................                  --          --           --           --        11,157
                                                ------------------    --------   ----------   ----------   -----------
  Gross margin................................                  --          --           --           --         3,913
OPERATING EXPENSES:
  Research and development....................                  --       4,168       27,357       36,821        54,056
  Sales and marketing.........................                  --          --        1,630        5,601        12,717
  General and administrative..................                 123         858        2,010        3,041         4,770
  Stock-based compensation....................                  --         325           60        3,171        18,659
  Common stock warrant expense................                  --          --           --           --         2,400
  Purchased in-process research and
    development...............................                  --          --           --           --         4,000
                                                ------------------    --------   ----------   ----------   -----------
   Total operating expenses...................                 123       5,351       31,057       48,634        96,602
                                                ------------------    --------   ----------   ----------   -----------
Loss from operations..........................                (123)     (5,351)     (31,057)     (48,634)      (92,689)
Interest income...............................                  --         272        1,301        1,533         8,735
Interest expense..............................                  --     (    85)   (     362)        (689)         (733)
                                                ------------------    --------   ----------   ----------   -----------
Net loss  ....................................               $(123)   $ (5,164)  $  (30,118)  $  (47,790)  $   (84,687)
                                                ==================    ========   ==========   ==========   ===========
Basic and diluted net loss per share..........  $               --    $( 34.71)    $( 19.05)    $( 13.99)     $(  3.69)
                                                ==================    ========   ==========   ==========   ===========
Weighted average common basic and diluted
shares........................................                 --      148,785    1,581,038    3,416,534    22,938,383
                                                ==================    ========   ==========   ==========   ===========
Pro forma basic and diluted net loss per
 share (unaudited)............................                                                              $(    2.03)
                                                                                                           ===========

Pro forma weighted average common basic and
 diluted shares (unaudited)...................                                                              41,763,735
                                                                                                           ===========

</TABLE>

Prior to the Company's initial public offering, weighted average common shares
used in computing basic and diluted net loss per share exclude unvested shares
of common stock subject to repurchase rights, as well as shares issuable upon
conversion of redeemable convertible preferred stock.  Weighted average common
shares used in computing pro forma basic and diluted net loss per share includes
the weighted average effect of the foregoing unvested restricted shares of
common stock as well as shares issuable upon conversion of redeemable
convertible preferred stock from the respective dates of issuance.  Basic and
diluted net loss per share are the same because all outstanding common stock
options have been excluded, as they are considered antidilutive.

<TABLE>
<CAPTION>
                                                               AS OF DECEMBER 31,
                                                -------------------------------------------------
                                                1996     1997       1998       1999        2000
                                                -----   -------   --------   --------    --------
                                                                ( IN THOUSANDS )
<S>                                             <C>     <C>       <C>        <C>        <C>
BALANCE SHEET DATA:
Cash, cash equivalents and investments........  $ 436   $ 6,870   $ 23,192   $ 47,917    $254,931
Working capital...............................    435     5,825     17,822     40,863     225,340
Total assets..................................    451     8,903     31,359     61,839     302,088
Long-term obligations, less current portion...     --     1,471      5,521      6,390       3,072
Redeemable convertible preferred stock........    500    11,017     55,098    123,441          --
Total stockholders' equity (deficit)..........    (65)   (4,917)   (35,080)   (79,746)    267,878
</TABLE>

                                      -12-
<PAGE>

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

     The following discussion and analysis should be read in conjunction with
"Selected Consolidated Financial Data" and our consolidated financial statements
and the related notes thereto included elsewhere herein. This discussion
contains forward-looking statements that involve risks and uncertainties. Our
actual results could differ materially from those anticipated in the forward-
looking statements as a result of certain factors including those discussed in
"Factors That May Affect Future Results" included elsewhere herein.

OVERVIEW

     Avici Systems provides high-speed data networking equipment that enables
telecommunications companies and Internet service providers to transmit high
volumes of information across their fiber optic networks.

     Since our inception, we have incurred significant losses. As of December
31, 2000, we had an accumulated deficit of $168.3 million. Our operating
activities from inception through 1999 were primarily devoted to research and
development, including the design and development of our proprietary application
specific integrated circuits, or ASICs, and software, and system testing the
Avici Terabit Switch Router product, or TSR. Revenue was first recognized during
the first quarter of 2000. We have also built our administrative, marketing,
sales, customer support and manufacturing organizations and developed strategic
relationships with systems integrators, distributors, customers and
complementary vendors. We have not achieved profitability on a quarterly or an
annual basis and anticipate that we will continue to incur significant operating
losses in the foreseeable future. We have a lengthy sales cycle for our products
and, accordingly, we expect to incur significant selling and other expenses
before we realize the related revenue. We expect to incur significant sales and
marketing, research and development and general and administrative expenses as
we expand our business and, as a result, we will need to generate significant
revenues to achieve and maintain profitability.

     The TSR became commercially available in the fourth quarter of 1999. We
currently market the TSR to major carriers in North America through a direct
sales force.  We also market our products internationally through a direct sales
force, systems integrators, distributors and a sales representative in Asia and
a direct sales force in Europe.  We currently provide product installation and
customer field support through our internal customer service organization and
third-party support organizations.

     We currently generate revenue from sales of our TSR, which is our only
product.  We recognize revenue from product sales upon shipment, provided that a
purchase order has been received or a contract has been executed, there are no
uncertainties regarding customer acceptance, the sales price is fixed or
determinable and collectibility is deemed probable. If uncertainties regarding
customer acceptance exist, revenue is recognized when these uncertainties are
resolved.  Amounts collected or billed prior to satisfying revenue recognition
criteria are recorded as deferred revenue.  We also generate revenue from
support and maintenance as well as installation and service.  We defer revenue
from support and maintenance contracts and recognize it ratably over the period
of the related agreements.  We expect to recognize revenue from installation and
other services as the work is performed. We record an estimate of warranty
liability for parts and labor on our products at the time we recognize revenue.

     We expect that in the foreseeable future, substantially all of our revenues
will continue to depend on sales of our TSR to current customers and a limited
number of potential new customers.  Generally, these customers are not
contractually committed to purchase any minimum quantities of products from us.
Enron Broadband Services and Williams Communications have agreed to future
minimum purchases of the TSR and follow-on features totaling $45.0 million
through the end of the second quarter 2002.  Deployment of the TSR is dependent
upon successful completion of field trials with these customers.  Additionally,
Qwest Communications has agreed to an undisclosed minimum purchase and is
currently conducting a field trial.  We recently entered into a three year
procurement agreement with AT&T, which defines the terms and conditions under
which AT&T may purchase equipment.  The agreement contains no minimum purchase
commitments.  Although the TSR was deployed in AT&T's North American IP backbone
network, there can be no assurance that deployment in AT&T's network will result
in future orders.  The TSR has also been deployed by France Telecom R&D in the
VTHD research network, our first European customer, by several agencies of the
United States government and by the DARPA-funded National Transparent Optical
Network. The TSR is currently in trials and tests with additional prospective
customers.

                                      -13-
<PAGE>

  We outsource our manufacturing operations to contract manufacturers that
assemble and test our products in accordance with our specifications.
Accordingly, a significant portion of our cost of revenue involves payment to
these entities.  Our cost of revenue also includes payments to LSI Logic, which
develops several of our proprietary ASICs.  These proprietary ASICs are very
complex and LSI Logic is currently our sole source supplier for them.  Our cost
of revenue also includes overhead costs associated with our manufacturing,
mainly material procurement.  Warranty costs and inventory provisions will be
expensed as cost of revenue.

  Research and development expenses consist primarily of salaries and related
employee costs, prototype, equipment and materials costs and third-party costs
and fees related to the development and prototyping of our proprietary
technology, including our ASICs.  We expense research and development costs as
incurred.  We expect our research and development expenses to increase in
absolute dollars as we continue to invest in next generation products and
features in response to customer demand.

  Sales and marketing expenses consist primarily of salaries and related
employee costs, sales commissions, travel, public relations and other costs
associated with marketing material and tradeshows.  We expect that sales and
marketing expenses will increase in absolute dollars in the future as we hire
additional sales and marketing personnel, establish sales offices in new
locations domestically and internationally and initiate additional marketing
programs.

  General and administrative expenses consist primarily of salaries and related
costs for executive, finance, legal, facilities, human resources and information
technology personnel and professional fees.  We expect that general and
administrative expenses will increase in absolute dollars as we add personnel
and incur additional costs related to the growth of our business and operation
as a public company.

     In December 2000, in connection with the execution of a nonexclusive
systems and services agreement, the Company issued a warrant to AT&T to purchase
850,000 shares of the Company's common stock at a per-share exercise price of
$27.73.  The agreement between the Company and AT&T provides AT&T with the
ability, but not the obligation, to purchase equipment and services from the
Company.  The warrant is nonforfeitable, becomes fully exercisable in one year
and has a term of five years.  The fair value of the warrant was calculated
using the Black-Scholes valuation model to be $9.8 million.  The fair value of
the warrant has been deferred as a reduction to equity and is currently being
amortized as an offset to gross revenue on a straight-line basis over the three-
year term of the agreement.  As of December 31, 2000, $816,666 has been
amortized.

     During the years ended December 31, 1999 and 2000, the Company recorded
non-cash deferred compensation charges of approximately $10,406,000 and
$34,665,000, respectively.  These amounts represent the aggregate difference
between the deemed fair value of the Company's common stock and the exercise
price of stock options and restricted stock granted and the selling price of
stock sold.  All stock options granted and stock sold prior to 1999 were at fair
market value, as determined by the Board of Directors, and, therefore, did not
result in deferred compensation.  The deferred compensation will be recognized
as an expense over the vesting period of the stock and stock options.  During
the years ended December 31, 1999 and 2000, the Company recorded approximately
$2,977,000 and $17,381,000, respectively, of compensation expense.  The Company
expects to recognize compensation expense of approximately $13,502,000,
$7,121,000, $3,261,000 and $830,000 during the years ended December 31, 2001,
2002, 2003 and 2004, respectively, based on stock and stock options issued prior
to December 31, 2000.

RESULTS OF OPERATIONS

     FISCAL YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998

     Net Revenue.  Net revenue was $15.1 million for the year ended December 31,
2000. Revenue is recorded net of common stock warrant discount which totaled
$816,666.  The Company had no revenue in 1999 or 1998. During 2000, shipments to
AT&T, Enron Broadband Services and Qwest Communications each accounted for
greater than 10% of our net revenue and in the aggregate represented 71% of our
net revenue in 2000.

     Cost of Revenue.  Cost of revenue was $11.2 million for the year ended
December 31, 2000. Cost of revenue includes the cost of manufacturing overhead.
Cost of revenue as a percentage of net revenue was approximately 74% for the
year ended December 31, 2000 reflecting the high cost of starting up production
along with the lower margin mix between bays and modules. We anticipate cost of
revenue as a percentage of net revenue to decrease as the future mix of product
configurations change.

                                      -14-
<PAGE>

     Research and Development.  Research and development expenses increased from
$27.4 million in 1998 to $36.8 million in 1999 to $54.1 million in 2000. These
increases were due mainly to increased salary and salary-related expenses of
$2.1 million in 1999 and $11.1 million in 2000, increased material contract
development costs associated with the development of the TSR of $5.1 million in
1999 and $1.3 million in 2000 and an increase in facilities and other related
costs of $1.2 million in 1999 and $4.6 million in 2000.

     Sales and Marketing.  Sales and marketing expenses increased from $1.6
million in 1998 to $5.6 million in 1999 to $12.7 million in 2000, due mainly to
increased salary and salary-related expenses of $1.6 million in 1999 and $5.2
million in 2000, increased facilities and other related costs of $1.2 million in
1999 and $871,000 in 2000, increased marketing promotional costs of $392,000 in
1999, as well as an increase of $742,000 in travel-related expenses in 2000.

     General and Administrative.  General and administrative expenses increased
from $2.0 million in 1998 to $3.0 million in 1999 to $4.8 million in 2000 due
mainly to increased salary and salary-related expenses of $382,000 in 1999 and
$692,000 in 2000 and increased facilities, information systems and other
expenses necessary to support our growing scale of operations of $648,000 in
1999 and $1.1 million in 2000.

     Stock-Based Compensation.  Stock-based compensation expense increased from
$60,000 in 1998 to $3.2 million in 1999 to $18.7 million in 2000 in connection
with restricted stock and stock options granted during those periods at prices
subsequently deemed to be below fair market value on the date of grant.

     Common Stock Warrant Expense.  Common stock warrant expense represents the
Black-Scholes value of a warrant issued to a potential customer. Common stock
warrant expense was $2.4 million for the year ended December 31, 2000. The
Company had no common stock warrant expense for the comparable periods of 1999
and 1998.

     Purchased In-Process Research and Development. The Company's in-process
research and development ("IPR&D") is comprised of a single research and
development project which is focused on certain aspects of optical switching
technology. At the date of purchase, the project was estimated to be 13%
complete and continuing research and development commitments to complete the
project were expected to approximate $1.5 million. As of December 31, 2000, the
project was estimated to be 19% complete and remaining research and development
commitments were estimated to approximate $1.4 million.

     The $4.0 million value assigned to the purchased IPR&D was determined by
estimating the costs to develop the purchased technology into a commercially
viable optical application, estimating the resulting cash flows from the
application and discounting the net cash flows to their present value. At the
date of acquisition, this project had not yet reached technological feasibility
and the IPR&D had no alternative future uses. Revenue projections used to value
the IPR&D project are based on estimates of relevant market size and growth
factors, expected trends in technology and the nature and expected timing of new
product introductions by the Company and its competitors.

     The rate used to discount the net cash flows to their present value was 35%
based on cost of capital considerations adjusted for certain risks associated
with the in-process technology.

  Interest Income.  Interest income increased from $1.3 million in 1998 to $1.5
million in 1999 to $8.7 million in 2000.  These increases were due to increases
in cash balances available for investment.

  Interest Expense.  Interest expense increased from $361,000 in 1998 to
$689,000 in 1999 to $733,000 in 2000. These increases were due to increases in
equipment financed through capital leases.

NET OPERATING LOSS AND TAX CREDIT CARRYFORWARDS

  We have not recorded a provision for income taxes because we have experienced
net losses from our inception. As of December 31, 2000, we had net operating
loss and tax credit carryforwards of approximately $159,292,000 and $6,278,000,
respectively. Approximately $3,679,000 of the Company's net operating loss
carryforwards relate to deductions associated with the Company's stock option
plans, which will be benefited through stockholder's equity if realized.  These
carryforwards will expire at various dates through 2020, if not utilized.
Utilization of the net operating losses and tax credits may be subject to a
substantial annual limitation due to the ownership change limitations contained
in the Internal Revenue Code and similar state provisions. The annual limitation
may result in the expiration of the net

                                      -15-
<PAGE>

operating loss and credits before utilization. Due to the uncertainty that
exists regarding the recoverability of the associated deferred tax assets, a
full valuation allowance has been recorded against these assets.

Liquidity and Capital Resources

     Since our inception, we have financed our operations through an initial
public offering, private sales of equity securities, and, to a lesser extent,
equipment lease financing. From inception through December 31, 2000, we raised
approximately $410.3 million from these equity offerings. During the year ended
December 31, 2000, we used $57.6 million in cash for operating activities,
compared to $41.0 million used in the year ended December 31, 1999. The increase
in cash usage resulted principally from the ongoing research and development
costs of the TSR, including increased personnel and material costs. We expect to
continue to invest heavily in research and development as we enhance the
functionality of our TSR and develop new complementary products. We also will
continue to increase our investment in capital assets as we expand our
operations.

     At December 31, 2000, our primary sources of liquidity were $126.5 million
in cash and cash equivalents and $128.5 million in investments. On July 27,
2000, the Company's amended registration statement for the initial public
offering of 8,050,000 shares of its common stock, including the underwriters'
overallotment option for 1,050,000 shares, became effective. The initial public
offering price to the public of the common stock was $31.00 per share. The
offering closed on August 2, 2000 and resulted in net proceeds to the Company of
approximately $232.1 million, after deducting underwriting discounts and
commissions and before deducting expenses payable by the Company. Additionally,
on August 2, 2000 the Company completed a private placement for the issuance of
322,582 shares of its common stock concurrently with the close of its initial
public offering at the initial public offering price of $31.00 per share, which
resulted in proceeds to the Company of approximately $10.0 million. In April and
May, 2000, the Company generated $44.5 million in a preferred stock financing.

     Purchases of property and equipment were $20.1 million for the year ended
December 31, 2000 and $4.6 million for the year ended December 31, 1999, and
consisted primarily of purchases of application software, test equipment and
computer equipment, including workstations and servers to support our increased
research and development activities. We financed $1.7 million during the year
ended December 31, 2000 and $4.4 million for the year ended December 31, 1999
through capital lease arrangements. As of December 31, 2000, our future minimum
lease payment obligations were $7.4 million under capital leases which require
annual payments of $4.1 million in 2001, $2.5 million in 2002, $738,000 in 2003
and $46,000 in 2004.  We expect capital expenditures to increase as we further
expand our operations, enhance our information systems and as our employee base
continues to grow. The timing and amount of future capital expenditures will
depend primarily on our future growth.  The Company expects that its capital
expenditures will be approximately $35.0 million in 2001. In addition, our
future minimum lease payment obligations under operating leases is $7,796,000
which require payments of $1,479,000 in 2001, $1,156,000 in 2002, 2003 and 2004,
$1,065,000 in 2005, $973,000 in 2006 and $811,000 in 2007.

     At December 31, 2000, we have a master lease agreement with a leasing
company that is also a stockholder. The agreement expires in May 2001. The
equipment leased under this agreement remains the property of the lender at the
end of the term. However, due to the length of the contract terms, the leases
are recorded as capital lease obligations. Leases under the agreement have
various terms ranging from 36 to 48 months and accrue interest at various annual
rates. As of December 31, 2000 $5.8 million was still available under this
master lease agreement.

     We also borrowed $1.3 million during 1998 under a term-loan agreement with
the same lender for software purchases. We are required to repay this loan in 30
monthly installments of approximately $49,000, including principal and interest.
Repayment began in July 1999, with a final payment in the amount of $187,500 due
at the end of the term. The effective annual interest rate of this loan is 17%.

     We expect that working capital and capital expenditure requirements will
increase significantly as product sales increase, creating larger customer
receivable balances, the need to build inventory in advance of shipment and the
need for increased levels of test and management information systems equipment.
We believe that our existing cash, cash equivalents and investments and
available capital lease financing will be sufficient to meet our operating and
capital requirements for at least the next 12 months. However, we could be
required, or could elect, to raise additional funds during that period and we
may need to raise additional capital in the future. We may not be able to obtain
additional capital on terms favorable to us or at all. The issuance of
additional equity or equity-related securities will be dilutive to our
stockholders. If we cannot raise funds on acceptable terms, or at all, we may
not be able to develop or enhance our

                                      -16-
<PAGE>

products or respond appropriately to competitive pressures, which would
seriously limit our ability to increase our revenue and grow our business.

Recent Accounting Pronouncements

  In March 2000, the Financial Accounting Standards Board (FASB) issued
interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an Interpretation of APB Opinion No. 25." The interpretation
clarifies the application of APB Opinion No. 25 in specified events, as defined.
The interpretation is effective July 1, 2000. The adoption of this
interpretation did not have any effect on the accompanying consolidated
financial statements.

  In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 101, "Revenue Recognition." This bulletin
summarizes certain views of the SEC on applying generally accepted accounting
principles to revenue recognition in financial statements. We believe that our
current revenue recognition policy complies with the guidelines in the bulletin.
The adoption of SAB No. 101 did not have any effect on the accompanying
consolidated financial statements.

  During 1998, 1999 and 2000, the FASB issued SFAS Nos. 133, 137 and 138,
respectively, relating to the accounting for derivative instruments and hedging
activities.  The Company will adopt the provisions of these standards in 2001.
The adoption of these standards is not expected to have a material effect on the
Company's consolidated financial condition or results of operations.

FACTORS THAT MAY AFFECT FUTURE RESULTS

  We expect that substantially all of our revenues will be generated from a
limited number of customers. Our revenues will not grow if our products are not
selected for or do not successfully pass field trial tests.

     We currently have a limited number of customers. We expect that in the
foreseeable future substantially all of our revenues will continue to depend on
sales of our TSR to these customers and a limited number of potential new
customers. Our sales cycle typically involves a lengthy sales consultation
process followed by laboratory testing in which our product is evaluated against
competing products. If our product is selected for field trials after laboratory
testing, our product is then tested in an operational environment. Generally,
our customers do not contractually commit to purchase any minimum quantities of
products from us until we have successfully demonstrated specific performance
criteria in these field trials. We cannot predict whether the TSR will
successfully complete laboratory tests or field trials with particular customers
or whether these customers will order and commercially deploy the TSR in
meaningful volumes. The failure of current or prospective customers to purchase
our product for any reason, including the failure to pass field trials, any
determination not to install our product in their networks or any downturn in
their business, would seriously harm our ability to build a successful business.
Even if we are successful in promoting the adoption of our product, customers
usually test, purchase and deploy competitive products for various segments of
their networks. Accordingly, we will likely face additional competitive
challenges in further penetrating customer accounts.

  THE TSR IS CURRENTLY OUR ONLY PRODUCT AND OUR FUTURE REVENUES DEPEND ON
ENHANCEMENTS TO THE TSR AND THE COMMERCIAL SUCCESS OF THE TSR.

  Our future growth and our future revenue depend on the commercial success of
our TSR, which is the only product that we currently offer.  We have  shipped
our product to a limited number of current and prospective customers. These
entities are currently using our product in their internal networks only except
for AT&T, which has deployed our TSR in its North American IP backbone network.
Our other customers have not yet fully deployed our product in large network
environments and may not choose to do so. Even if these customers do fully
deploy our product, it may not operate as expected. The failure of the product
to operate as expected could delay or prevent its adoption. We must also
continue to enhance the features and functionality of the TSR to meet customer
requirements. In addition, the failure of these planned product enhancements to
operate as expected could delay or prevent future sales of our TSR. If our
target customers do not adopt, purchase and successfully deploy our TSR and our
planned product enhancements, our revenues will not increase significantly.

  OUR FAILURE TO INCREASE OUR REVENUES WOULD PREVENT US FROM ACHIEVING AND
MAINTAINING PROFITABILITY.

  We have incurred significant losses in each quarterly and annual period since
inception and expect to continue to incur significant losses in the future. As
of December 31, 2000, we had an accumulated deficit of $168.3 million. We

                                      -17-
<PAGE>

began recognizing revenues during the year ended December 31, 2000. We cannot be
certain that our revenues will increase or that we will generate sufficient
revenues to achieve profitability. We plan to continue product development and
to increase the number of our engineering, sales, marketing and administrative
employees. These efforts will require significant expenditures, a substantial
portion of which we will make long before any significant revenue related to
these expenditures may be realized. In addition, our operating expenses are
based largely on anticipated revenue trends and a significant portion of our
expenses, such as personnel and real estate facilities costs, is fixed. As a
result, we will need to generate significant revenues to achieve and maintain
profitability. If we fail to achieve significant increases in our revenues, the
size of our operating losses may be larger than expected. We may never achieve
profitability or generate positive cash flows from operations. If we do achieve
profitability or positive cash flows from operations in any period, we may not
be able to sustain or increase profitability or positive cash flows on a
quarterly or annual basis.

  WE RELY ON SINGLE OR LIMITED SOURCE SUPPLIERS FOR SEVERAL KEY COMPONENTS. IF
WE ARE UNABLE TO PURCHASE THESE COMPONENTS ON A TIMELY BASIS, WE WILL NOT BE
ABLE TO DELIVER OUR TSR TO OUR CUSTOMERS WITHIN THE TIMEFRAMES REQUIRED AND WE
MAY EXPERIENCE ORDER CANCELLATIONS.

  We currently specify and purchase through our contract manufacturers several
key components from single or limited sources. We have worked with LSI Logic for
over three years to develop several of our key proprietary application specific
integrated circuits, or ASICs, which are custom designed integrated circuits
built to perform a specific function more rapidly than a general purpose
microprocessor. These proprietary ASICs are very complex and LSI Logic is
currently our sole source supplier for them. We do not have a long-term, fixed-
price or minimum volume of supply agreement with LSI Logic. Our ASICs generally
require a lead-time of 20 weeks. If required, we would likely be unable to
develop an alternate source to LSI Logic in a timely manner, which could hurt
our ability to deliver our TSR to our customers. We also purchase other critical
components, including optical components, field programmable gate arrays and
other ASICs, from sole or limited sources, and at times some of these components
are subject to allocation. Although we believe that there are alternative
sources for many of these components, in the event of a disruption in supply, we
may not be able to develop an alternate source in a timely manner or at
favorable prices.

  We typically specify and purchase through our contract manufacturers all of
our components, including our ASICs, under purchase orders placed from time to
time. We do not carry significant inventories of components and have no
guaranteed supply arrangements with our vendors. If we are unable to purchase
our critical components, or to provide for the production of our ASICs, at times
and in volumes as our business requirements necessitate, we will not be able to
manufacture and deliver our TSR to our customers in accordance with their volume
and schedule requirements. If we are not able to satisfy the delivery
requirements of our customers, they may reduce any future orders or eliminate
our status as a vendor. Our reputation also would likely be harmed and, given
the limited number of customers in our target market, we may not be able to
replace any lost business with new customers. In addition, even if we are able
to obtain these critical components in sufficient volume and on schedules that
permit us to satisfy our delivery requirements, we have little control over
their cost. Accordingly, the lack of alternative sources for these components
may force us to pay higher prices. If we are unable to obtain these components
from our current suppliers or others at economical prices, our margins would be
adversely impacted unless we could raise the prices of our products in a
commensurate manner. The existing competitive conditions may not permit us to do
so, in which case we may suffer increasing losses or reduced profits.

 WE HAVE BEEN IN BUSINESS FOR A SHORT PERIOD OF TIME AND YOUR BASIS FOR
EVALUATING US IS LIMITED.

  We were founded in November 1996 and our TSR became commercially available
during the fourth quarter of 1999. Accordingly, we have limited meaningful
historical financial data upon which to base projected revenues and planned
operating expenses and upon which investors may evaluate us and our prospects.
In addition, our limited operating history means that we have less insight into
how technological and market trends may affect our business. The revenue and
income potential of our business, and in particular the TSR, is unproven and the
market that we are addressing is rapidly evolving. Our ability to sell our TSR
depends on, among other things, the level of demand for intelligent high-speed
routers. You should consider our business and prospects in light of the risks
and difficulties frequently encountered by companies like ours in the early
stages of development.

  THE LONG AND VARIABLE SALES CYCLE FOR OUR TSR MAY CAUSE REVENUES AND OPERATING
RESULTS TO VARY UNEXPECTEDLY FROM QUARTER TO QUARTER, WHICH COULD AFFECT THE
MARKET PRICE OF OUR COMMON STOCK.

  A customer's decision to purchase our TSR involves a significant commitment of
its resources and a lengthy evaluation, testing and product qualification
process. As a result, our sales cycle is likely to be lengthy. Throughout the

                                      -18-
<PAGE>

sales cycle, we spend considerable time and expense educating and providing
information to prospective customers about the use and features of our TSR. Even
after our customers make a decision to purchase, we believe that our customers
will deploy our TSR slowly and deliberately. The timing of deployment can vary
widely and depends on the skills of the customer, the size of the network
deployment, the complexity of the customer's network environment and the degree
of hardware and software configuration necessary. Customers with significant or
complex networks usually expand their networks in large increments on a periodic
basis. Accordingly, we expect to receive purchase orders for significant dollar
amounts on an irregular and unpredictable basis. Because of our limited
operating history and the nature of our business, we cannot predict these sales
and deployment cycles. These long sales cycles, as well as our expectation that
customers will tend to sporadically place large orders with short lead times,
may cause our revenues and results of operations to vary significantly and
unexpectedly from quarter to quarter.

  OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS OR MAY NOT INTEROPERATE WITHIN
THE NETWORKS OF OUR CUSTOMERS, WHICH COULD RESULT IN REDUCED DEMAND FOR OUR
PRODUCTS OR COSTLY LITIGATION AGAINST US.

  Our TSR is complex and is designed to be deployed in large and complex
networks with large volumes of traffic. Accordingly, our TSR can only be fully
tested when completely deployed in these types of networks. To date, AT&T has
deployed our product in its North American IP backbone network and other
customers are using our product solely in test networks. Despite this deployment
and internal testing, our customers may discover errors or defects in the
hardware or the software, or the product may not operate as expected even after
it has been fully deployed. In addition, many of our customers will require that
our products be designed to interface with their existing networks, each of
which may have different specifications and utilize multiple protocol standards.
Our customers' networks contain multiple generations of products that have been
added over time as these networks have grown and evolved. Our products must
interoperate with many of the products within these networks as well as future
products in order to meet the requirements of our customers. Because our
products are critical to the networks of our customers, any significant
interruption in their service as a result of defects in our product or the
failure of our product to interoperate within our customers' networks could
result in lost profits or damage to these customers. These problems could cause
us to incur significant service and warranty costs, divert engineering personnel
from product development efforts and significantly impair our ability to
maintain existing customer relations and attract new customers. Although our
contracts with our customers generally contain provisions designed to limit our
exposure to potential product liability claims, such as disclaimers of
warranties and limitations on liability for special, consequential and
incidental damages, a court might not enforce a limitation on our liability,
which could expose us to financial loss. In addition, a product liability claim,
whether successful or not, would likely be time consuming and expensive to
resolve and would divert management time and attention. Further, if we are
unable to fix the errors or other problems that may be identified in full
deployment, we would likely experience loss of or delay in revenues and loss of
market share and our business and prospects would suffer.

  OUR FAILURE TO COMPETE EFFECTIVELY, PARTICULARLY AGAINST CISCO SYSTEMS,
JUNIPER NETWORKS, AND OTHER ESTABLISHED PARTICIPANTS WITH GREATER FINANCIAL AND
OTHER RESOURCES THAN OURS, COULD LIMIT OUR ABILITY TO INCREASE OUR MARKET SHARE.

  The competition in the network infrastructure equipment market is intense.
This market historically has been dominated by Cisco Systems, although we also
compete with other companies such as Juniper Networks. Our prospective customers
may be reluctant to replace or expand their current infrastructure solutions,
which may be supplied by one or more of these more established competitors, with
our products. Further, many of our competitors have greater selling and
marketing, technical, manufacturing, financial and other resources, more
customers, greater market recognition and more established relationships and
alliances in the industry. As a result, these competitors may be able to
develop, enhance and expand their product offerings more quickly, adapt more
swiftly to new or emerging technologies and changes in customer demands, devote
greater resources to the marketing and sale of their offerings, pursue
acquisitions and other opportunities more readily and adopt more aggressive
pricing policies. In addition, established or emerging network equipment vendors
may also focus on our target market, thereby further intensifying competition.
In order to compete effectively with these competitors, we must demonstrate that
our products are superior in meeting the needs of carriers and provide high
levels of reliability, scalability and interoperability in a cost-effective
manner.

  In addition, we believe that understanding the infrastructure requirements of
telecommunications carriers and other service providers, experience in working
with these providers to develop new services for their customers and an ability
to provide vendor-sponsored financing are important competitive factors in our
market. We have limited experience in working with telecommunications carriers
and other service providers. In addition, we do not currently have the ability
to provide vendor-sponsored financing and this may influence the purchasing
decision of prospective customers, which may decide to purchase products from
one of our competitors that offers such financing.

                                      -19-
<PAGE>

  If we are unable to compete successfully against our current and future
competitors, we could experience order cancellations and price reductions. If
this occurs, our revenues may not grow, our gross margins could decrease and we
could experience additional losses.

  WE ARE LIKELY TO FACE DIFFICULTIES IN OBTAINING AND RETAINING CUSTOMERS IF WE
DO NOT EXPAND OUR SALES ORGANIZATION AND OUR CUSTOMER SERVICE AND SUPPORT
OPERATIONS.

  Our TSR requires a sophisticated sales effort targeted at a limited number of
key individuals within our target customers' organizations. This effort requires
specialized sales personnel and systems engineers. We continue to staff our
direct sales force and plan to hire additional qualified sales personnel and
systems engineers. The competition for these individuals is intense, and we
might not be able to hire the type and number of sales personnel and systems
engineers that we need to be successful. In addition, we believe that our future
success, particularly in international markets, is dependent upon our ability to
establish successful relationships with a variety of systems integrators and
distribution partners. We have entered into agreements with only a small number
of systems integrators and distribution partners. These systems integrators and
distribution partners are not prohibited from selling products that compete with
our TSR. We cannot be certain that we will be able to reach agreement with
additional systems integrators and distribution partners on a timely basis or at
all, or that our systems integrators and distribution partners will devote
adequate resources to selling our product. If we are unable to expand our direct
and indirect sales operations, we may not be able to increase market awareness
or sales of our product, which may prevent us from achieving and maintaining
profitability.

  The complexity of our products and the difficulty of installing them also
require highly trained customer service and support personnel. We will need to
increase our customer service and support organization to support a broader base
of customers. Hiring customer service and support personnel is very competitive
in our industry because there are a limited number of people available with the
necessary technical skills and understanding of our market. In addition, once we
hire these personnel, they may require extensive training in our product. If we
are unable to expand our customer service and support organization and train
them rapidly, or engage, manage and retrain third-party service and support
organizations, we may not be able to increase sales of our product.

  WE DEPEND UPON CONTRACT MANUFACTURERS AND ANY DISRUPTION IN THESE
RELATIONSHIPS MAY CAUSE US TO FAIL TO MEET THE DEMANDS OF OUR CUSTOMERS AND
DAMAGE OUR CUSTOMER RELATIONSHIPS.

  We do not have internal manufacturing capabilities. We rely on a small number
of contract manufacturers to manufacture our products in accordance with our
specifications and to fill orders on a timely basis. These contract
manufacturers procure material on our behalf and provide comprehensive
manufacturing services, including assembly, test and control. We have
historically been dependent on two contract manufacturers, Sanmina Corporation
and Celestica, Inc. We may not be able to effectively manage our relationships
with these contract manufacturers and they may not meet our future requirements
for timely delivery and quality. If, as we expect, we experience increased
demand for our TSR, the challenges we face in managing our relationships with
these manufacturers will be increased. Each of our contract manufacturers also
builds products for other companies, and we cannot be certain that they will
always have sufficient quantities of inventory available to fill orders placed
by our customers, or that they will allocate their internal resources to fill
these orders on a timely basis. Qualifying a new contract manufacturer and
commencing volume production is expensive and time consuming and could result in
a significant interruption in the supply of our product. If we are required or
choose to change one or both of our contract manufacturers, we may lose revenue
and damage our customer relationships.

  IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD
INCUR ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS.

  Our contract manufacturers are not obligated to supply products to us for any
specific period, in any specific quantity or at any certain price, except as may
be provided in a particular purchase order. We generally provide forecasts of
our demand to these manufacturers up to 12 months prior to scheduled delivery of
product to our customers. If we overestimate our requirements, our manufacturers
may have excess inventory, which would increase our costs. If we underestimate
our requirements, our manufacturers may have an inadequate inventory, which
could result in delays in delivery to our customers and recognition of revenue.
In addition, the lead times for materials and components we order vary
significantly and depend on factors such as the specific supplier, contract
terms and demand for each component at

                                      -20-
<PAGE>

a given time. For example, our ASICs have a lead time of up to 20 weeks. We also
may experience shortages of other components from time to time, which also could
delay the manufacturing of our products.

  THE UNPREDICTABILITY OF OUR QUARTERLY RESULTS OF OPERATIONS MAY ADVERSELY
AFFECT THE TRADING PRICE OF OUR COMMON STOCK.

  Our quarterly operating results are likely to vary significantly in the future
based on a number of factors related to our industry, the markets for our
products and how we manage our business. We have little or no control over many
of these factors and any of these factors could cause the price of our common
stock to fluctuate significantly. In addition to the risks discussed elsewhere
in this section, the following may also adversely affect the trading price of
our common stock:

 . fluctuations in the demand for high-speed routers, including our TSR;

 . the timing and size of customer orders for our products or cancellations of
   orders;

 . the timing of product acceptance by customers;

 . the timing and level of research and development and prototype expenses;

 . the distribution channels through which we sell our products; and

 . general economic conditions, as well as conditions specific to the
   telecommunications industry.

  We plan to significantly increase our operating expenses to fund greater
levels of research and development, expand our sales and marketing operations,
broaden our customer support capabilities and develop new distribution channels.
We also plan to expand our general and administrative functions to address the
increasing size and scope of our business. Our operating expenses are largely
based on anticipated organizational growth and revenue trends and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, if revenue for a particular quarter is below our expectations
for any of the reasons set forth above, or for any other reason, we could not
proportionately reduce operating expenses for that quarter. Accordingly, this
revenue shortfall would have a disproportionate effect on our expected operating
results for that quarter, which could result in significant variations in our
operating results from quarter to quarter.

  Due to the foregoing factors, we believe that quarter-to-quarter comparisons
of our operating results are not a good indication of our future performance.
You should not rely on our results or growth for any single quarter as an
indication of our future performance. It is likely that in some future quarters,
our operating results may be below the expectations of public market analysts
and investors. In this event, the price of our common stock may fall.

  IF WE DO NOT RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO RAPID TECHNOLOGICAL
CHANGES, OUR PRODUCTS COULD BECOME OBSOLETE AND WE WOULD PROBABLY BE UNABLE TO
ATTRACT NEW CUSTOMERS.

  The market for high-speed router products is likely to be characterized by
rapid technological change, evolving industry standards and frequent new product
introductions. The introduction of new products by competitors, market
acceptance of products based on new or alternative technologies or the emergence
of new industry standards could render our existing or future products obsolete.
Accordingly, we may be required to make significant and ongoing investments in
future periods in order to remain competitive. The development of new products
or technologies is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may be unable to respond
quickly or cost-effectively to these developments, and we may not be able to
obtain the necessary funds to develop or acquire new technologies or products
needed to compete. We also cannot assure you that any products we do develop
will gain market acceptance.

  In addition, in order to introduce products incorporating new technologies and
new industry standards, we must be able to gain access to the latest
technologies used by our customers, our suppliers and other network vendors. Any
failure to gain access to the latest technologies could impair our ability to
develop competitive products.

                                      -21-
<PAGE>

  CISCO'S LEADERSHIP POSITION IN OUR MARKET COULD CREATE TECHNICAL CHALLENGES TO
OUR ABILITY TO SELL OUR PRODUCTS.

  In developing our products, we have made, and will continue to make,
assumptions about the standards that may be adopted by our customers and
competitors. If the standards adopted are different from those that we have
chosen to support, market acceptance of our products would likely be
significantly reduced and our business will be seriously harmed. Because Cisco
maintains a leadership position in selling products that currently comprise the
infrastructure of the Internet, Cisco may have the ability to establish de facto
standards within the industry. Any actions by Cisco that diminish compliance by
our products with industry or de facto standards or the ability of our products
to interoperate with other Internet-related products would be damaging to our
reputation and our ability to generate revenue.

  CUSTOMER REQUIREMENTS ARE LIKELY TO EVOLVE, AND WE WILL NOT RETAIN CUSTOMERS
OR ATTRACT NEW CUSTOMERS IF WE DO NOT ANTICIPATE AND MEET SPECIFIC CUSTOMER
REQUIREMENTS.

  Our future success will also depend upon our ability to develop and manage key
customer relationships in order to introduce a variety of new products and
product enhancements that address the increasingly sophisticated needs of our
customers. Our current and prospective customers may require product features
and capabilities that our TSR does not have. We must effectively anticipate and
adapt to customer requirements and offer products that meet those demands in a
timely manner. Our failure to develop products that satisfy customer
requirements would seriously harm our ability to achieve market acceptance for
our products. In addition, we may experience design, manufacturing, marketing
and other difficulties that could delay or prevent our development, introduction
or marketing of new products and enhancements. Material delays in introducing
new products may cause customers to forego purchases of our products and
purchase those of our competitors, which could seriously harm our business. The
introduction of new or enhanced products also requires that we manage the
transition from older products in order to minimize disruption in customer
ordering patterns and ensure that adequate supplies of new products can be
delivered to meet anticipated customer demand. Our inability to effectively
manage this transition would cause us to lose current and prospective customers.

  IF WE ARE UNABLE TO MANAGE OUR PLANNED EXPANSION EFFECTIVELY, WE MAY INCUR
INCREASED COSTS AND PLACE TOO MANY DEMANDS UPON OUR MANAGEMENT TEAM.

  We have expanded our operations rapidly since our inception and we expect to
continue to increase the size and scope of our operations, both domestically and
internationally.  Our growth has significantly increased our operating
complexity and has required, and will continue to require, significant time
commitments from our management team, thereby severely restricting their ability
to manage our business. Our ability to successfully offer our products and
implement our business plan in a rapidly evolving market requires an effective
planning and management process. We expect that we will need to continue to
improve our financial, managerial and manufacturing controls and information
systems, and to continue to expand, train and manage our work force. We may not
be able to implement adequate control and reporting systems in an efficient and
timely manner. We also expect that we will be required to manage multiple
relationships with various customers and third parties. Further, the management
of our operations in diverse locations may also complicate the task of managing
our growth. Our failure to manage our expansion effectively could increase our
costs, adversely affect our relations with customers and suppliers and adversely
affect our revenues and operating margins.

  OUR ABILITY TO DEVELOP, MARKET AND SUPPORT PRODUCTS DEPENDS ON RETAINING OUR
MANAGEMENT TEAM AND ATTRACTING AND RETAINING HIGHLY QUALIFIED INDIVIDUALS IN OUR
INDUSTRY.

  Our future success depends on the continued services of our management team,
which has significant experience with the data communications,
telecommunications and Internet infrastructure markets, as well as relationships
with many of the communications service providers and business partners that we
currently or may in the future rely on in implementing our business plan. The
loss of the services of our management team or any key executive could have a
significant detrimental effect on our ability to execute our business strategy.

  Our future success also depends on our continuing ability to identify, hire,
train, assimilate and retain large numbers of highly qualified engineering,
sales, marketing, managerial and support personnel. The demand for qualified
personnel is high and competition for their services is intense. The competition
for qualified employees in our industry is particularly intense in the Boston,
Massachusetts area where our principal operations are located. We have from time
to time experienced, and we expect to continue to experience in the future,
difficulty in hiring and retaining highly skilled employees with appropriate
qualifications. In particular, we have experienced difficulty in hiring
qualified ASIC, software, systems and test and customer support engineers. The
loss of the services of any of our key employees, the

                                      -22-
<PAGE>

inability to attract or retain qualified personnel in the future or delays in
hiring required personnel, particularly engineers and sales personnel, could
delay the development and introduction of and negatively impact our ability to
sell our products.

  WE FACE RISKS ASSOCIATED WITH OUR INTERNATIONAL EXPANSION THAT COULD IMPAIR
OUR ABILITY TO GROW OUR REVENUES ABROAD.

  We intend to further expand our presence in international markets. We
currently have eleven sales representatives and sales engineers in  Europe and
one in Asia. Our international sales are conducted through a direct sales force,
systems integrators, distributors and a sales representative. We have regional
partners in Japan, Korea, China and Southeast Asia. In addition to our direct
sales force in Europe, we have established a partnership with Dimension Data, a
leading systems integrator of carrier equipment, to provide support services. In
order to further our international sales objectives, we intend to continue to
identify and establish relationships with additional country-specific
distributors.  We will require significant management attention and financial
resources to successfully develop our direct and indirect international sales
and support channels.

  We have limited experience in marketing and distributing our TSR
internationally and we expect that we will need to develop versions of our
product that comply with local standards. We may not be able to develop
international market demand for our TSR. In addition, our international
operations will expose us to a number of risks that we do not have to address in
our domestic operations, including:

 . greater difficulty in collecting accounts receivable and longer collection
   periods;

 . greater difficulty in enforcing agreements;

 . differences in technology standards;

 . difficulties and costs of staffing and managing foreign operations;

 . the impact of recessions in economies outside the United States;

 . unexpected changes in regulatory requirements;

 . certification requirements;

 . foreign currency exchange rate fluctuations;

 . reduced protection for intellectual property rights in some countries;

 . potentially adverse tax consequences; and

 . political and economic instability.

  We expect that our international sales will be generally denominated in United
States dollars. As a result, increases in the value of the United States dollar
relative to foreign currencies would cause our products to become less
competitive in international markets and could result in limited, if any, sales
and profitability. To the extent that we denominate sales in foreign currencies
or incur significant operating expenses denominated in local currencies, we will
be exposed to increased risks of currency fluctuations.

  WE MAY EXPERIENCE DIFFICULTY IN IDENTIFYING, ACQUIRING AND INTEGRATING
ACQUISITION CANDIDATES.

  We expect to supplement our internal growth by acquiring complementary
businesses, technologies or product lines. We may not be able to identify and
acquire suitable candidates on reasonable terms. We compete for acquisition
candidates with other companies that have substantially greater financial,
management and other resources than we do. If we do complete an acquisition,
integrating newly acquired organizations and products and services is likely to
be expensive, time consuming and a strain on our managerial resources.
Acquisitions, in particular, multiple acquisitions over a short period of time,
involve a number of risks that may result in our failure to achieve the desired
benefits of the transaction.

                                      -23-
<PAGE>

  We may finance acquisitions by issuing shares of our common stock, which could
dilute our existing stockholders. We may also use cash or incur additional debt
to pay for these acquisitions. In addition, we may be required to expend
substantial funds to develop acquired technologies. We may also be required to
amortize significant amounts of goodwill and other intangible assets in
connection with future acquisitions, which could adversely affect our operating
results.

  OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS THAT COULD
SUBJECT US TO SIGNIFICANT LIABILITY AND DIVERT THE TIME AND ATTENTION OF OUR
MANAGEMENT.

  We regard our products and technology as proprietary. We attempt to protect
them through a combination of patent protection, copyrights, trademarks, trade
secret laws, contractual restrictions on disclosure and other methods. These
methods may not be sufficient to protect our proprietary rights. We presently
have 15 patent applications pending in the United States and related foreign
patent applications pending and we cannot be certain that patents will be
granted based on these or any other applications, or that, even if issued, the
patents will adequately protect our technology. We also generally enter into
confidentiality agreements with our employees, consultants and customers, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise misappropriate and use our products or
technology without authorization, particularly in foreign countries where the
laws may not protect our proprietary rights to the same extent as do the laws of
the United States, or to develop similar technology independently. We may need
to resort to litigation in the future to enforce our intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others. This litigation could result in substantial
costs and diversion of resources and could harm our business.

  We also license technologies from third parties, some of which we license
without indemnification from the licensor for infringement of third party
intellectual property rights. We are continuing to develop and acquire
additional intellectual property. Although we have not been involved in any
litigation relating to our intellectual property, including intellectual
property that we license from third parties, we expect that participants in our
markets will be increasingly subject to infringement claims. Third parties may
try to claim our products infringe their intellectual property. Any claim,
whether meritorious or not, could be time consuming, result in costly litigation
and/or require us to enter into royalty or licensing agreements. Although we
carry general liability insurance, our insurance may not cover potential claims
of this type or may not be adequate to indemnify us for all liability that may
be imposed. In addition, any royalty or licensing agreements might not be
available on terms acceptable to us or at all, in which case we would have to
cease selling, incorporating or using the products that incorporate the
challenged intellectual property and expend substantial amounts of resources to
redesign our products. If we are forced to enter into unacceptable royalty or
licensing agreements or to redesign our products, our business and prospects
would suffer.

 WE ARE UNCERTAIN OF OUR ABILITY TO OBTAIN ADDITIONAL FINANCING FOR OUR FUTURE
CAPITAL NEEDS.

  We expect our current cash, cash equivalents and investments will meet our
working capital and capital expenditure needs for at least the next twelve
months. We may need to raise additional funding at that time or earlier if we
decide to undertake more rapid expansion, including acquisitions of
complementary products or technologies, or if we increase our marketing and/or
research and development efforts in order to respond to competitive pressures.
We cannot be certain that we will be able to obtain additional financing on
favorable terms, if at all. We may obtain additional financing by issuing shares
of our common stock, which could dilute our existing stockholders. If we cannot
raise needed funds on acceptable terms, or at all, we may not be able to develop
or enhance our products or respond appropriately to competitive pressures, which
would seriously harm our business.

  THE MARKET PRICE OF OUR COMMON STOCK MAY BE MATERIALLY ADVERSELY AFFECTED BY
MARKET VOLATILITY.

  The price at which our common stock trades is highly volatile and fluctuates
substantially. Given the limited amount of our product sales and our limited
number of customers, the announcement of any significant customer developments,
awards or losses or of any significant partnerships or acquisitions by us or our
competitors could have a material adverse effect on our stock price. In
addition, the stock market in general has, and technology companies in
particular have, from time to time experienced extreme price and volume
fluctuations that have often been unrelated or disproportionate to the operating
performance or prospects of such companies.

                                      -24-
<PAGE>

  In the past, securities class action litigation has often been brought against
companies following periods of volatility in the market price of their
securities. Those companies, like us, that are involved in rapidly changing
technology markets are particularly subject to this risk. We may be the target
of litigation of this kind in the future. This securities litigation, if any,
could result in substantial costs and divert management's attention and
resources, which could cause serious harm to our business. We could also incur
significant damages as a result of such litigation.

 THE MARKET PRICE OF OUR COMMON STOCK MIGHT DECLINE DUE TO FUTURE NON-CASH
CHARGES TO EARNINGS.

  We have recorded and begun to amortize non-cash charges to earnings as a
result of options and restricted stock granted prior to the closing of our
initial public offering to employees and consultants at prices deemed to be
below fair market value on the dates of grant. Our future operating results will
reflect the continued amortization of those charges over the vesting period of
the options and restricted stock. These charges will negatively impact future
operating results. It is not possible to calculate the future impact with
respect to consultant grants as the amount of these charges to earnings
fluctuates with the price of our common stock and other factors. It is possible
that some investors might consider this impact on operating results to be
material, which could result in a decline in the price of our common stock. In
addition, in 2000 we incurred non-cash charges relating to the issuance of
common stock warrants to a customer. Approximately $9.0 million of the value of
these warrants will be amortized against revenue over the next 11 quarters.

  OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD INHIBIT A TAKEOVER THAT
STOCKHOLDERS MAY CONSIDER FAVORABLE.

  There are provisions of Delaware law and our charter and by-laws that could
make it more difficult for a third party to acquire us, even if doing so would
be beneficial to our stockholders. If a change of control or change in
management is delayed or prevented, the market price of our common stock could
suffer.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The following discussion about our market risk involves forward-looking
statements. Actual results could differ materially from those projected in the
forward-looking statements. We are exposed to market risk related to changes in
interest rates and foreign currency exchange rates. We do not use derivative
financial instruments for speculative or trading purposes.

INTEREST RATE SENSITIVITY

     We maintain an investment portfolio consisting mainly of investment grade
money market funds, corporate obligations, federal agency obligations, state and
municipal bonds with a weighted-average maturity of less than one year. These
held-to-maturity securities are subject to interest rate risk and will fall in
value if market interest rates increase. If market interest rates were to
increase immediately and uniformly by 10% from levels at December 31, 2000, the
fair market value of these investments would decline by an immaterial amount. We
have the ability to hold our fixed income investments until maturity. Therefore,
we would not expect our operating results or cash flows to be affected to any
significant degree by a sudden change in market interest rates on our securities
portfolio. The following table provides information about our investment
portfolio. For investment securities, the table presents principal cash flows
and related weighted average interest rates by expected maturity dates.

<TABLE>
<CAPTION>
                                          CARRYING
                                   VALUE AT DECEMBER 31,
                                            2000
                                   ----------------------
                                                       MATURING IN
                                    ----------------------------------------------
                                                  2001                2002                GRAND TOTAL
                                    -------------------------    ----------------       --------------
<S>                               <C>                           <C>                 <C>
Cash and Cash Equivalents                 $126,455,226                $         -          $126,455,226
Weighted Average Interest Rate                    6.69%                         -                  6.69%
Investments                               $106,937,148                $21,538,936          $128,476,084
Weighted Average Interest Rate                    6.38%                      6.56%                 6.41%
  Total Portfolio                         $233,392,374                $21,538,936          $254,931,310
Weighted Average Interest Rate                    6.55%                      6.56%                 6.55%
</TABLE>

                                      -25-
<PAGE>

Exchange Rate Sensitivity

     We operate primarily in the United States, and all sales to date have been
made in U.S. dollars. Accordingly, there has not been any material exposure to
foreign currency rate fluctuations.

                                      -26-
<PAGE>

ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>

                                                                                                        Page
                                                                                                        ----
<S>                                                                                                     <C>
Report of Independent Public Accountants..............................................................    28
Consolidated Balance Sheets...........................................................................    29
Consolidated Statements of Operations.................................................................    30
Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders' (Deficit) Equity..    31
Consolidated Statements of Cash Flows.................................................................    32
Notes to Consolidated Financial Statements............................................................    33
</TABLE>

                                      -27-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Stockholders of
Avici Systems Inc.:

We have audited the accompanying consolidated balance sheets of Avici Systems
Inc. (a Delaware corporation) and subsidiaries as of December 31, 1999 and 2000,
and the related consolidated statements of operations, redeemable convertible
preferred stock and stockholders' (deficit) equity and cash flows for each of
the three years in the period ended December 31, 2000.  These financial
statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States.  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 financial position of Avici Systems Inc. and
subsidiaries as of December 31, 1999 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2000, in conformity with accounting principles generally accepted
in the United States.


                                                            Arthur Andersen LLP
Boston, Massachusetts
January 17, 2001

                                      -28-
<PAGE>

<TABLE>
<CAPTION>
                                                                                          DECEMBER 31,
                                                                                  -----------------------------
ASSETS                                                                                    1999            2000
                                                                                  ------------   -------------
<S>                                                                               <C>            <C>
Current Assets:
 Cash and cash equivalents                                                        $ 34,242,471   $ 126,455,226
 Investments                                                                        13,674,979     106,937,148
 Inventories                                                                         3,632,518      14,978,760
 Trade accounts receivable                                                             598,800       6,340,587
 Prepaid expenses and other current assets                                             269,751       1,766,234
                                                                                  ------------   -------------

     Total current assets                                                           52,418,519     256,477,955
                                                                                  ------------   -------------

Property and Equipment, at cost:
 Equipment under capital lease                                                      10,774,032      14,121,692
 Computer equipment                                                                  2,236,936      10,113,729
 Test equipment                                                                              -       6,809,354
 Leasehold improvements                                                                732,180       2,153,819
 Furniture and fixtures                                                                 68,138         578,779
                                                                                  ------------   -------------

                                                                                    13,811,286      33,777,373

 Less--Accumulated depreciation and amortization                                     4,726,776       9,997,066
                                                                                  ------------   -------------

                                                                                     9,084,510      23,780,307
                                                                                  ------------   -------------

Other Assets:
 Investments                                                                                 -      21,538,936
 Restricted cash                                                                       188,000         290,875
 Other asset                                                                           100,000               -
 Deferred financing costs                                                               48,000               -
                                                                                  ------------   -------------

     Total other assets                                                                336,000      21,829,811
                                                                                  ------------   -------------

                                                                                  $ 61,839,029   $ 302,088,073
                                                                                  ============   =============

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS' (DEFICIT) EQUITY

Current Liabilities:
 Current maturities of long-term obligations                                      $  2,968,490   $   4,259,308
 Accounts payable                                                                    5,833,367      13,708,404
 Accrued expenses                                                                    1,000,017       7,140,248
 Deferred revenue                                                                    1,753,400       6,030,460
                                                                                  ------------   -------------

     Total current liabilities                                                      11,555,274      31,138,420
                                                                                  ------------   -------------

Long-Term Obligations, less current maturities                                       6,390,264       3,071,556
                                                                                  ------------   -------------

Commitments (Note 5)

Redeemable Convertible Preferred Stock, $0.01 par value:
 Authorized--30,156,127 shares at December 31, 1999
 and no shares at December 31, 2000
 Issued and outstanding--29,881,127 shares at December 31, 1999
 and no shares at December 31, 2000                                               123,441,055               -
                                                                                  ------------   -------------

Warrants to Purchase Series B Redeemable Convertible Preferred Stock                   198,000               -
                                                                                  ------------   -------------

Stockholders' (Deficit) Equity:
 Preferred stock, $0.01 par value-
  Authorized--no shares at December 31, 1999 and
  5,000,000 shares at December 31, 2000
  Issued and outstanding--none                                                               -               -
 Common stock, $0.0001 par value-
  Authorized--50,000,000 shares at December 31, 1999 and
  250,000,000 shares at December 31, 2000
  Issued and outstanding--6,053,698 shares at December 31, 1999 and
  48,287,714 shares at December 31, 2000                                                   606           4,829
 Additional paid-in capital                                                         11,475,243     459,986,783
 Common stock warrants                                                                       -      12,398,000
 Subscriptions receivable                                                             (215,000)     (2,500,000)
 Deferred compensation and other consideration                                      (7,428,874)    (33,696,576)
 Accumulated deficit                                                               (83,577,539)   (168,314,939)
                                                                                  ------------   -------------

     Total stockholders' (deficit) equity                                          (79,745,564)    267,878,097
                                                                                  ------------   -------------

                                                                                  $ 61,839,029   $ 302,088,073
                                                                                  ============   =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.

                                      -29-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                     Consolidated Statements of Operations
<TABLE>
<CAPTION>
                                                                                        YEARS ENDED DECEMBER 31,
                                                                             ----------------------------------------------
                                                                                      1998            1999            2000
                                                                              ------------    ------------    ------------
<S>                                                                          <C>             <C>             <C>
Gross revenue                                                                $  -            $  -             $ 15,886,597

Common stock warrant discount                                                            -               -         816,666
                                                                              ------------    ------------    ------------

     Net revenue                                                                         -               -      15,069,931

Cost of Revenue                                                                          -               -      11,157,347
                                                                              ------------    ------------    ------------

     Gross margin                                                                        -               -       3,912,584
                                                                              ------------    ------------    ------------

Operating Expenses:
 Research and development(1)                                                    27,357,222      36,821,219      54,055,443
 Sales and marketing(1)                                                          1,630,133       5,601,384      12,717,199
 General and administrative(1)                                                   2,010,043       3,040,732       4,770,449
 Stock-based compensation                                                           60,062       3,170,549      18,659,175
 Common stock warrant expense                                                            -               -       2,400,000
 Purchased in-process research and development                                           -               -       4,000,000
                                                                              ------------    ------------    ------------

     Total operating expenses                                                   31,057,460      48,633,884      96,602,266
                                                                              ------------    ------------    ------------

     Loss from operations                                                      (31,057,460)    (48,633,884)    (92,689,682)

Interest Income                                                                  1,300,728       1,532,751       8,735,216

Interest Expense                                                                  (360,840)       (688,795)       (732,934)
                                                                              ------------    ------------    ------------

     Net loss                                                                 $(30,117,572)   $(47,789,928)   $(84,687,400)
                                                                              ============    ============    ============

Net Loss per Share:
 Basic and diluted                                                                 $(19.05)        $(13.99)         $(3.69)
                                                                              ============    ============    ============
 Pro forma basic and diluted (unaudited)                                                                            $(2.03)
                                                                                                              ============

Shares Used in Computing Net Loss per Share:
 Basic and diluted                                                               1,581,038       3,416,534      22,938,383
                                                                              ============    ============    ============
 Pro forma basic and diluted (unaudited)                                                                        41,763,735
                                                                                                              ============

(1)Excludes noncash, stock-based compensation, as follows:
  Research and development                                                    $     60,062    $  2,373,939    $ 12,372,846
  Sales and marketing                                                                    -         636,028       3,712,785
  General and administrative                                                             -         160,582       2,573,544
                                                                              ------------    ------------    ------------
                                                                              $     60,062    $  3,170,549    $ 18,659,175
                                                                              ============    ============    ============
</TABLE>

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

                                      -30-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

     Consolidated Statements of Redeemable Convertible Preferred Stock and
                         Stockholders' (Deficit) Equity

<TABLE>
<CAPTION>
                                          REDEEMABLE CONVERTIBLE
                                            PREFERRED STOCK                            COMMON STOCK
                                         ------------------------                   ----------------------     ADDITIONAL
                                          NUMBER OF    REDEMPTION      WARRANTS     NUMBER OF   $0.0001 PAR      PAID-IN
                                            SHARES       VALUE       OUTSTANDING     SHARES        VALUE         CAPITAL
                                          ----------   -----------   ------------    ---------   -----------    ---------

<S>                                      <C>         <C>             <C>           <C>          <C>           <C>
Balance, December 31, 1997                12,267,000 $  11,017,000     $ 198,000    5,668,750        $  567    $    423,396
 Sale of Series C Redeemable
 Convertible
  Preferred Stock, net of
  issuance costs of $57,671                4,500,000    21,135,000             -            -             -               -
 Sale of Series D Redeemable
  Convertible                              4,885,650    22,946,270             -            -             -               -
  Preferred Stock, net of
  issuance costs of $65,033
 Exercise of common stock options                  -             -             -        9,500             1             882
 Issuance of common stock options
  to a consultant                                  -             -             -            -             -          60,062
 Issuance of common stock
  to a consultant                                  -             -             -       26,000             3           7,997
 Issuance of restricted
  stock and related
  compensation expense                             -             -             -      334,800            33         186,768
 Repurchase of restricted stock                    -             -             -     (135,938)          (14)         (3,595)
 Net loss                                          -             -             -            -             -               -
                                         ----------- -------------   -----------   ----------        ------    ------------
Balance, December 31, 1998                21,652,650    55,098,270       198,000    5,903,112           590         675,510
 Sale of Series C Redeemable
  Convertible Preferred Stock,
  net of issuance costs of $17,855           500,000     4,000,000             -            -             -               -
 Sale of Series D Redeemable
  Convertible
  Preferred Stock,
  net of issuance costs of $19,344           542,850     4,342,800             -            -             -               -
 Sale of Series E Redeemable
  Convertible
  Preferred Stock, net of
  issuance costs of $169,528               7,185,627    59,999,985             -            -             -               -
 Deferred compensation related
  to stock options and stock grants                -             -             -            -             -      10,405,923
 Amortization of deferred compensation             -             -             -            -             -               -
 Exercise of common stock options                  -             -             -      158,739            16         111,017
 Issuance of common stock                          -             -             -       56,500             6         122,994
 Issuance of restricted stock                      -             -             -       10,000             1          39,999
 Repurchase of restricted stock                    -             -             -      (74,653)           (7)           (700)
 Expense related to grant of
  stock options to nonemployees                    -             -             -            -             -         120,500
 Net loss                                          -             -             -            -             -               -
                                         ----------- -------------   -----------   ----------        ------    ------------
Balance, December 31, 1999                29,881,127   123,441,055       198,000    6,053,698           606      11,475,243
 Sale of Series F Redeemable
  Convertible Preferred Stock,
  net of issuance costs of $50,000         2,969,769    44,546,535             -            -             -               -
 Deferred compensation related to
  stock options and stock grants                   -             -             -            -             -      34,665,160
 Amortization of deferred compensation             -             -             -            -             -               -
 Stock purchased by an officer                     -             -             -      100,000            10       2,499,990
 Issuance of common stock
  related to concurrent
  private placements                               -             -             -      322,582            32       9,999,989
 Issuance of common
  stock at initial public
  offering, net of issuance
  costs of $1,907,221                              -             -             -    8,050,000           805     230,173,474
 Exercise of common stock options                  -             -             -    1,085,904           109       2,012,689
 Payment of subscription receivable                -             -             -            -             -               -
 Issuance of common stock warrants                 -             -             -            -             -               -
 Amortization related to warrants                  -             -             -            -             -               -
 Issuance of restricted common stock               -             -             -        3,000             -          12,000
 Repurchase of restricted stock                    -             -             -     (178,366)          (18)       (114,450)
 Conversion of convertible preferred
  stock into common stock                (32,850,896) (167,987,590)            -   32,850,896         3,285     167,984,305
 Conversion of preferred stock
  warrants into common stock warrants              -             -      (198,000)           -             -               -
 Expense related to grant of stock
  options to nonemployees                          -             -             -            -             -       1,278,383
 Net loss                                          -             -             -            -             -               -
                                         ----------- -------------   -----------   ----------        ------    ------------
Balance, December 31, 2000                         - $  -            $  -          48,287,714        $4,829    $459,986,783
                                         =========== =============   ===========   ==========        ======    ============

</TABLE>


<TABLE>
<CAPTION>

                                                                                 DEFERRED                             TOTAL
                                               COMMON                          COMPENSATION                        STOCKHOLDERS'
                                                STOCK      SUBSCRIPTIONS         AND OTHER          ACCUMULATED      (DEFICIT)
                                               WARRANTS      RECEIVABLE        CONSIDERATION          DEFICIT          EQUITY
                                            -------------  ----------------  ------------------   ----------------   ---------

<S>                                      <C>              <C>                <C>                <C>              <C>
Balance, December 31, 1997                 $          -    $           -                   -      $  (5,340,608)   $ (4,916,645)
 Sale of Series C Redeemable
  Convertible Preferred Stock,
  net of issuance costs of $57,671                    -                -                   -            (57,671)        (57,671)
 Sale of Series D Redeemable
  Convertible Preferred Stock, net of
  issuance costs of $65,033                           -                -                   -            (65,033)        (65,033)
 Exercise of common stock options                     -                -                   -                  -             883
 Issuance of common stock options to a
  consultant                                          -                -                   -                  -          60,062
 Issuance of common stock to a
 consultant                                           -                -                   -                  -           8,000
 Issuance of restricted
  stock and related compensation
  expense                                             -         (175,000)                  -                  -          11,801
 Repurchase of restricted stock                       -                -                   -                  -          (3,609)
 Net loss                                             -                -                   -        (30,117,572)    (30,117,572)
                                           ------------      -----------        ------------      -------------    ------------
Balance, December 31, 1998                            -         (175,000)                  -        (35,580,884)    (35,079,784)
 Sale of Series C
  Redeemable Convertible Preferred
  Stock, net of issuance costs of
  $17,855                                             -                -                   -            (17,855)        (17,855)
 Sale of Series D Redeemable
  Convertible Preferred Stock,
  net of issuance costs of $19,344                    -                -                   -            (19,344)        (19,344)
 Sale of Series E Redeemable Convertible
  Preferred Stock, net of
  issuance costs of $169,528                          -                -                   -           (169,528)       (169,528)
 Deferred compensation related
  to stock options and stock grants                   -                -         (10,405,923)                 -               -
 Amortization of deferred compensation                -                -           2,977,049                  -       2,977,049
 Exercise of common stock options                     -                -                   -                  -         111,033
 Issuance of common stock                             -                -                   -                  -         123,000
 Issuance of restricted stock                         -          (40,000)                  -                  -               -
 Repurchase of restricted stock                       -                -                   -                  -            (707)
 Expense related to grant of
  stock options to nonemployees                       -                -                   -                  -         120,500
 Net loss                                             -                -                   -        (47,789,928)    (47,789,928)
                                           ------------      -----------        ------------      -------------    ------------
Balance, December 31, 1999                            -         (215,000)         (7,428,874)       (83,577,539)    (79,745,564)
 Sale of Series F Redeemable
  Convertible Preferred Stock,
  net of issuance costs of $50,000                    -                -                   -            (50,000)        (50,000)
 Deferred compensation related to
  stock options and stock grants                      -                -         (34,665,160)                 -               -
 Amortization of deferred compensation                -                -          17,380,792                  -      17,380,792
 Stock purchased by an officer                        -       (2,500,000)                  -                  -               -
 Issuance of common stock related
  to concurrent private placements                    -                -                   -                  -      10,000,021
 Issuance of common stock at
  initial public offering, net
  of issuance costs of $1,907,221                     -                -                   -                  -     230,174,279
 Exercise of common stock options                     -         (180,722)                  -                  -       1,832,076
 Payment of subscription receivable                   -          286,031                   -                  -         286,031
 Issuance of common stock warrants           12,200,000                -          (9,800,000)                 -       2,400,000
 Amortization related to warrants                     -                -             816,666                  -         816,666
 Issuance of restricted common stock                  -                -                   -                  -          12,000
 Repurchase of restricted stock                       -          109,691                   -                  -          (4,777)
 Conversion of convertible preferred
  stock into common stock                             -                -                   -                  -     167,987,590
 Conversion of preferred
  stock warrants into common
  stock warrants                                198,000                -                   -                  -         198,000
 Expense related to grant of
  stock options to
  nonemployees                                        -                -                   -                  -       1,278,383
 Net loss                                             -                -                   -        (84,687,400)    (84,687,400)
                                           ------------      -----------        ------------      -------------    ------------
Balance, December 31, 2000                  $12,398,000      $(2,500,000)       $(33,696,576)     $(168,314,939)   $267,878,097
                                           ============      ===========        ============      =============    ============
</TABLE>

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

                                      -31-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES

                     Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                          FOR THE YEARS ENDED DECEMBER 31,
                                                                                   ----------------------------------------------
                                                                                        1998            1999            2000
                                                                                    ------------    ------------   -------------

<S>                                                                                <C>             <C>             <C>
Cash Flows from Operating Activities:
 Net loss                                                                           $(30,117,572)   $(47,789,928)  $ (84,687,400)
 Adjustments to reconcile net loss to net cash used in operating activities-
  Depreciation and amortization                                                        1,654,023       3,147,557       5,273,678
  Amortization of deferred financing costs                                                50,000          50,000          48,000
  Loss on disposal of property and equipment                                                   -               -         145,570
  Compensation expense associated with issuance of stock options to nonemployees          60,062         193,500       1,278,383
  Compensation expense associated with issuance of common stock warrants                       -               -       3,216,666
  Stock-based compensation                                                                     -       2,977,049      17,380,792
  Changes in current assets and liabilities-
   Inventories                                                                                 -      (3,632,518)    (11,346,242)
   Trade accounts receivable                                                                   -        (598,800)     (5,741,787)
   Prepaid expenses and other current assets and other assets                           (163,095)       (118,469)     (1,396,483)
   Restricted cash                                                                      (188,000)         40,000        (102,875)
   Accounts payable                                                                    2,813,495       2,613,688       7,875,037
   Accrued expenses                                                                      144,198         395,191       6,140,231
   Deferred revenue                                                                            -       1,753,400       4,277,060
                                                                                    ------------    ------------   -------------

     Net cash used in operating activities                                           (25,746,889)    (40,969,330)    (57,639,370)
                                                                                    ------------    ------------   -------------

Cash Flows from Investing Activities:
 Purchases of property and equipment                                                  (2,678,835)       (242,156)    (18,378,770)
 Proceeds from sale of equipment                                                          13,245               -               -
 Purchases of investments                                                                      -     (13,674,979)   (131,986,179)
 Sales of investments                                                                          -               -      17,185,074
                                                                                    ------------    ------------   -------------

     Net cash used in investing activities                                            (2,665,590)    (13,917,135)   (133,179,875)
                                                                                    ------------    ------------   -------------

Cash Flows from Financing Activities:
 Proceeds from sale of redeemable convertible preferred stock, net of issuance        43,958,566      68,136,058      44,496,535
  costs
 Proceeds from sales of common stock, net of issuance costs                                    -               -     240,174,300
 Proceeds from long-term obligations                                                   1,250,000               -               -
 Payments on long-term obligations                                                      (490,972)     (2,359,392)     (3,752,165)
 Payments on subscriptions receivable                                                          -               -         286,031
 Repurchase of restricted stock                                                           (3,609)           (707)         (4,777)
 Proceeds from exercise of stock options                                                  20,684         161,034       1,832,076
                                                                                    ------------    ------------   -------------

     Net cash provided by financing activities                                        44,734,669      65,936,993     283,032,000
                                                                                    ------------    ------------   -------------

Net Increase in Cash and Cash Equivalents                                             16,322,190      11,050,528      92,212,755

Cash and Cash Equivalents, beginning of year                                           6,869,753      23,191,943      34,242,471
                                                                                    ------------    ------------   -------------

Cash and Cash Equivalents, end of year                                              $ 23,191,943    $ 34,242,471   $ 126,455,226
                                                                                    ============    ============   =============

Supplemental Disclosure of Cash Flow Information:
 Cash paid during the year for-
  Interest                                                                          $    310,840    $    638,795   $     692,590
                                                                                    ============    ============   =============

Supplemental Disclosure of Noncash Investing and Financing Activities (Notes
 4(c) and 4(g)):
 Equipment acquired under capital lease obligations                                 $  4,820,232    $  4,400,454   $   1,736,276
                                                                                    ============    ============   =============
</TABLE>


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

                                      -32-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(1)  OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

Avici Systems Inc. and subsidiaries (the Company) was incorporated in the State
of Delaware on November 12, 1996 and was organized to design and develop high-
speed data networking equipment for the carrier market.  The Company's Terabit
Switch Router product (TSR) is designed to cost-effectively provide high-
speed/high-volume capacity, carrier-class reliability and in-service
scalability, or the ability to incrementally add capacity to the network without
disrupting network performance.

The Company is devoting significant efforts toward product research and
development.  As such, it is subject to a number of risks and challenges similar
to other companies in a similar stage of development.  These risks include, but
are not limited to, dependence on few customers, dependence on key individuals,
dependence on contract manufacturers and key suppliers of integral components,
the need to develop and market commercially usable products, the ability to
obtain adequate financing to support growth and product development and
competition from substitute products and larger companies with greater
financial, technical, management and marketing resources.

The Company incurred net losses of approximately $30,100,000, $47,800,000 and
$84,700,000 for the years ended December 31, 1998, 1999 and 2000, respectively.
At December 31, 2000, the Company had an accumulated deficit of approximately
$168,300,000 and has funded those losses through the sale of redeemable
convertible preferred stock, the proceeds from the sale of its common stock and
the issuance of certain long-term obligations.  The Company is dependent on the
proceeds of these financings to meet its future working capital and research and
development needs.

The accompanying consolidated financial statements reflect the application of
certain significant accounting policies as described in this note and elsewhere
in these notes to consolidated financial statements.

(A)  REVENUE RECOGNITION

   The Company recognizes revenue from product sales upon shipment, provided
   that a purchase order has been received or a contract has been executed,
   there are no uncertainties regarding customer acceptance, the sales price is
   fixed or determinable and collectibility is deemed probable.  If
   uncertainties regarding customer acceptance exist, the Company recognizes
   revenue when those uncertainties are resolved.  For arrangements that include
   the delivery of multiple elements, revenue is allocated to the various
   elements based on vendor-specific objective evidence of fair value (VSOE).
   The Company uses the residual method when VSOE does not exist for one of the
   delivered elements in an arrangement.  Revenue from support and maintenance
   contracts is recognized ratably over the period of the related agreements.
   Revenue from installation and other services is recognized as the work is
   performed.  Amounts collected or billed prior to satisfying the above revenue
   recognition criteria are recorded as deferred revenue.

   In December 1999, the Securities and Exchange Commission (SEC) issued Staff
   Accounting Bulletin (SAB) No. 101, Revenue Recognition.  This bulletin
   summarizes certain views of the SEC on applying generally accepted accounting
   principles to revenue recognition in financial statements.  The Company
   believes that its current revenue recognition policy complies with the
   guidelines in the bulletin. The adoption of SAB No. 101 did not have any
   effect on the accompanying consolidated financial statements.

   Warranty costs are estimated and recorded by the Company at the time of
   product revenue recognition.

(B) CASH AND CASH EQUIVALENTS AND INVESTMENTS

   The Company follows the provisions of Statement of Financial Accounting
   Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and
   Equity Securities.  The Company has classified its cash equivalents and
   investments as held-to-maturity and recorded them at amortized cost, which
   approximates market value.  The Company considers all highly liquid
   investments with original maturities of three months or less at the date of
   acquisition to be cash equivalents.  Cash and cash equivalents include money
   markets, certificates of deposit and commercial paper.  As of December 31,
   2000, investments consisted of the following:

                                      -33-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



<TABLE>
<CAPTION>

                                                     AVERAGE
                                                    REMAINING
            HELD TO MATURITY                        MATURITIES
              SECURITIES                              (DAYS)                         AMORTIZED COST
              ----------                              ------                         ---------------

<S>                                                  <C>                  <C>
         Commercial Paper                                  153                           $ 80,523,846
         U.S. Government Obligations                       303                             14,362,940
         Corporate Bonds                                   425                             33,589,298
                                                                                     ----------------
          Total:                                                                         $128,476,084
                                                                                     ================
</TABLE>

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

  (D)  INVENTORIES

   Inventories are stated at the lower of cost (first-in, first-out) or market
   and consist of the following:

<TABLE>
<CAPTION>
                                                  December 31,
                                            ---------------------------
                                                 1999            2000
                                             ----------     -----------
<S>                                      <C>             <C>

      Finished goods and work in             $1,922,876     $ 2,850,844
      process
      Raw materials                           1,709,642      12,127,916
                                             ----------     -----------

                                             $3,632,518     $14,978,760
                                             ==========     ===========
</TABLE>
(e)  Depreciation and Amortization

   Property and equipment are stated at cost, net of accumulated depreciation
   and amortization.  Expenditures for maintenance and repairs are charged to
   expense as incurred, whereas major betterments are capitalized as additions
   to property and equipment.  The Company provides for depreciation and
   amortization on the straight-line basis and charges to operations amounts
   that allocate the cost of the assets over their estimated useful lives as
   follows:

<TABLE>
<CAPTION>
            ASSET CLASSIFICATION           ESTIMATED
                                          USEFUL LIFE
<S>                                     <C>

      Equipment under capital lease      Life of lease
      Computer equipment                    3 years
      Test equipment                        3 years
      Leasehold improvements                3 years
      Furniture and fixtures                5 years
</TABLE>

                                      -34-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



(F) CONCENTRATIONS OF CREDIT AND OTHER RISKS

   SFAS No. 105, Disclosure of Information about Financial Instruments with Off-
   Balance Sheet Risk and Financial Instruments with Concentrations of Credit
   Risk, requires disclosure of any significant off-balance sheet and credit
   risk concentrations.  The Company's principal credit risk relates to its
   cash, cash equivalents, investments and accounts receivable.  The Company
   invests its excess cash, cash equivalents and investments primarily in
   deposits with commercial banks and high-quality corporate securities. Three
   customers represented 71% of net revenue for the year ending December 31,
   2000.  As of December 31, 1999 and 2000, two and three customers,
   respectively, accounted for 100% and 90%, respectively, of trade accounts
   receivable. The Company generally does not require collateral for sales to
   customers. The Company has no off-balance sheet concentrations such as
   foreign exchange contracts, option contracts, or other foreign hedging
   arrangements.

   Certain key components used in the Company's products are procured from
   single or limited source suppliers, and the Company relies on single or
   limited contract manufacturers for the assembly of its products.  The failure
   of a supplier, including a contract manufacturer, to deliver on schedule
   could delay or interrupt the Company's delivery of products and thereby
   adversely affect the Company's revenues and operating results.

(G) FAIR VALUE OF FINANCIAL INSTRUMENTS

   The Company's financial instruments mainly consist of cash and cash
   equivalents, investments, trade accounts receivable, subscriptions
   receivable, accounts payable and a term loan.  The carrying amounts of these
   instruments approximate their fair value.

(H) RESEARCH AND DEVELOPMENT AND SOFTWARE-DEVELOPMENT COSTS

   The costs of the development of hardware products and enhancements to
   existing hardware products are expensed as incurred.  The Company accounts
   for its software development costs in accordance with SFAS No. 86, Accounting
   for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed.
   Accordingly, the costs for the development of new software that are included
   in the hardware products and substantial enhancements to such existing
   software are expensed as incurred until technological feasibility has been
   established, at which time any additional costs would be capitalized.  The
   Company determines technological feasibility has been established at the time
   at which a working model of the software has been completed.  Because the
   Company believes its current process for developing software is essentially
   completed concurrently with the establishment of technological feasibility,
   no costs have been capitalized to date.

(I) NET LOSS PER SHARE AND PRO FORMA NET LOSS PER SHARE

   Basic and diluted net loss per share are presented in conformity with SFAS
   No. 128, Earnings per Share, for all periods presented.  In accordance with
   SFAS No. 128, basic and diluted net loss per common share was determined by
   dividing net loss available for common stockholders by the weighted average
   common shares outstanding during the period, less shares subject to
   repurchase.  Basic and diluted net loss per share are the same because all
   outstanding common stock options have been excluded, as they are considered
   antidilutive.  Options to purchase a total of 1,682,850, 3,969,935 and
   10,724,510 common shares have been excluded from the computations of diluted
   weighted average shares outstanding for the years ended December 31, 1998,
   1999 and 2000, respectively.  Shares of common stock issuable upon the
   conversion of outstanding shares of redeemable convertible preferred stock
   have also been excluded for all periods presented until such shares converted
   to common stock upon completion of the Company's initial public offering (see
   Note 4(b)).

   In accordance with the SEC SAB No. 98, Earnings per Share in an Initial
   Public Offering, the Company has determined that there were no nominal
   issuances of the Company's common stock prior to the Company's initial public
   offering.

                                      -35-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



   The Company's historical capital structure is not indicative of its capital
   structure after its initial public offering due to the automatic conversion
   of all shares of redeemable convertible preferred stock into common stock
   concurrent with the closing of the Company's initial public offering and the
   elimination of the Company's repurchase right related to restricted stock
   (see Note 4(g)).  Accordingly, unaudited pro forma net loss per share data
   has been presented for the year ended December 31, 2000 assuming the
   conversion of all outstanding shares of redeemable convertible preferred
   stock into common stock and the elimination of the Company's repurchase right
   related to its restricted stock outstanding upon the closing of the Company's
   initial public offering using the if-converted method from the latter of
   January 1, 2000 or the respective date of issuance.

   The following table reconciles the weighted average common shares outstanding
   to the shares used in the computation of unaudited pro forma basic and
   diluted net loss per share:

<TABLE>
<CAPTION>
                                                    YEAR ENDED
                                                    DECEMBER 31,
                                                      2000
                                                    ----------
<S>                                            <C>

      Weighted average common shares
      outstanding                                   22,938,383
        Add--Weighted average common shares
        issued upon the conversion of
        redeemable convertible preferred stock      17,699,247
        Add--Acceleration of vesting of
         restricted stock                            1,126,105
                                                    ----------
      Pro forma basic and diluted weighted
      average common shares outstanding             41,763,735
                                                    ==========


</TABLE>

(j)  Comprehensive Income (Loss)

   SFAS No. 130, Reporting Comprehensive Income, requires disclosure of all
   components of comprehensive income on an annual and interim basis.
   Comprehensive income is defined as the change in equity of a business
   enterprise during a period from transactions and other events and
   circumstances involving nonowner sources.  The Company does not have any
   items of comprehensive income (loss) other than its reported net loss.

(K)  STOCK-BASED COMPENSATION

   The Company uses the intrinsic value-based method of Accounting Principles
   Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, to
   account for all of its employee stock-based compensation plans and uses the
   fair value method of SFAS No. 123, Accounting for Stock-Based Compensation to
   account for all nonemployee stock-based compensation.

   In March 2000, the Financial Accounting Standards Board (FASB) issued
   interpretation No. 44, Accounting for Certain Transactions Involving Stock
   Compensation--An Interpretation of APB Opinion No. 25.  The interpretation
   clarifies the application of APB Opinion No. 25 in specified events, as
   defined.  The interpretation is effective July 1, 2000.  The adoption of this
   interpretation did not have any effect on the accompanying consolidated
   financial statements.

(L) DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE

   SFAS No. 131, Disclosures about Segments of an Enterprise and Related
   Information, establishes standards for reporting information regarding
   operating segments and establishes standards for related disclosures about
   products and services and geographic areas.  Operating segments are
   identified as components of an enterprise about which separate discrete
   financial information is available for evaluation by the chief operating
   decision maker, or decision making group, in making decisions regarding
   resource allocation and assessing performance.

                                      -36-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   To date, the Company has viewed its operations and manages its business as
   principally one operating segment, the telecommunications equipment industry.

(M)  DERIVATIVE INSTRUMENTS

   During 1998, 1999 and 2000, the FASB issued SFAS Nos. 133, 137 and 138,
   respectively, relating to the accounting for derivative instruments and
   hedging activities.  The Company will adopt the provisions of these standards
   in 2001.  The adoption of these standards is not expected to have a material
   effect on the Company's consolidated financial condition or results of
   operations.

(2)  LONG-TERM OBLIGATIONS

Long-term obligations consist of the following:

<TABLE>
<CAPTION>
                                                 December 31,
                                           --------------------------------
                                              1999                 2000
                                            ----------           ----------

<S>                                <C>                  <C>
Capital leases                              $8,292,120           $6,773,653
Term loan                                    1,066,634              557,211
                                            ----------           ----------

                                             9,358,754            7,330,864

Less--Current amount                         2,968,490            4,259,308
                                            ----------           ----------

                                            $6,390,264           $3,071,556
                                            ==========           ==========
</TABLE>

The Company has a master lease agreement with a lender who is also a preferred
stockholder.  This agreement provides for up to $12,000,000 of lease financing
on certain types of equipment, as defined.  On May 8, 2000, the Company amended
its master lease agreement.  The amendment provides for an increase in the lease
financing available under the master lease agreement by $6,000,000.  Leases
under the agreement have various terms ranging from 36 to 48 months and accrue
interest at annual effective rates between 8.03% and 9.23%.  Equipment leased
under this agreement remains the property of the lender at the end of the term;
however, due to the length of the term, the leases are recorded as capital lease
obligations.  As of December 31, 2000, approximately $5,763,000 was still
available under this master lease agreement.

The Company also has a term loan agreement with this lender, which provides for
maximum borrowings of $1,250,000.  The loan line was fully utilized to purchase
software.  Repayment of advances are due in 30 monthly installments of principal
plus interest of approximately $49,000 per month beginning in July 1999, with a
final payment of principal and interest in the amount of $187,500 at the end of
the term.  The effective annual interest rate under the term loan is 17%.

                                      -37-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



Future minimum payments due under these agreements at December 31, 2000 are as
follows:

<TABLE>
<CAPTION>
                                                  TERM LOAN         CAPITAL LEASES

For the years ending,
<S>                                          <C>                  <C>
 2001                                                   $557,211           $4,138,386
 2002                                                          -            2,475,840
 2003                                                          -              737,513
 2004                                                          -               46,380
                                             -------------------           ----------

    Total payments                                      $557,211            7,398,119
                                             ===================

Less--Amounts representing interest                                           624,466
                                                                           ----------

     Present value of future minimum lease                                 $6,773,653
      payments                                                             ==========
</TABLE>
(3)  Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes.  Under SFAS No. 109, deferred tax assets or
liabilities are computed based on the difference between the financial statement
and income tax bases of assets and liabilities using currently enacted tax
rates.  Deferred income tax expense or credits are based on changes in the asset
or liability from period to period.

No provision for federal or state income taxes has been recorded, as the Company
has incurred net operating losses since inception.  As of December 31, 2000, the
Company had net operating loss carryforwards for federal and state income tax
purposes and tax credit carryforwards of approximately $159,292,000 and
$6,278,000, respectively.  Approximately $3,679,000 of the Company's net
operating loss carryforwards relate to deductions associated with the Company's
stock option plans, which will be benefited through stockholders' equity if
realized.  The net operating loss carryforwards expire through 2020, and are
subject to review and possible adjustment by the Internal Revenue Service (IRS).
The Tax Reform Act of 1986 contains provisions that may limit the net operating
loss carryforwards available to be used in any given year in the event of
significant changes in ownership interest, as defined.

The approximate income tax effects of each type of temporary differences and
carryforwards are as follows:

<TABLE>
<CAPTION>
                                                         December 31,
                                                -----------------------------------
                                                     1999                  2000
                                                 ------------          ------------

<S>                                       <C>                   <C>
Net operating loss carryforwards                 $ 24,314,000          $ 64,196,000
Research credit carryforwards                       4,230,000             6,278,000
Other                                               3,095,000             3,946,000
                                                 ------------          ------------

     Gross deferred tax assets                     31,639,000            74,420,000

Valuation allowance                               (31,639,000)          (74,420,000)
                                                 ------------          ------------

                                                 $  -                  $  -
                                                 ============          ============
</TABLE>

Due to the uncertainty surrounding the realization of the deferred tax assets,
the Company has provided a full valuation allowance against these amounts at
December 31, 1999 and 2000.

                                      -38-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)




(4)  STOCKHOLDERS' (DEFICIT) EQUITY

(A)  CAPITALIZATION

   As of December 31, 2000, the Company has authorized capital stock, which
   consists of 250,000,000 shares of common stock, $0.0001 par value per share
   and 5,000,000 shares of preferred stock, $0.01 par value per share that may
   be issued by the Board of Directors from time to time in one or more series
   without stockholder approval.  As of December 31, 2000, the Company has
   48,287,714 shares of common stock outstanding and no shares of preferred
   stock outstanding.

(B) INITIAL PUBLIC OFFERING AND CONCURRENT PRIVATE PLACEMENT

   On July 27, 2000, the Company's amended registration statement for the
   initial public offering of 8,050,000 shares of its common stock, including
   the underwriters' over-allotment option for 1,050,000 shares became
   effective.  The initial public offering price to the public was $31.00 per
   share.  The offering closed on August 2, 2000, and resulted in net proceeds
   to the Company of approximately $232.1 million after deducting underwriting
   discounts and commissions and before deducting expenses payable by the
   Company.  As a result of the initial public offering, 32,850,896 shares of
   common stock were issued upon the conversion of all of the Company's
   redeemable convertible preferred stock.  Additionally, on August 2, 2000, the
   Company completed a private placement for the issuance of 322,582 shares of
   its common stock concurrently with the close of its initial public offering
   at the initial public offering price of $31.00 per share, which resulted in
   proceeds to the Company of approximately $10.0 million.

(C) REDEEMABLE CONVERTIBLE PREFERRED STOCK

   In April 2000, the Company amended its certificate of incorporation to
   authorize 3,333,333 shares of Series F redeemable convertible preferred
   stock.  Also, in April and May 2000, the Company sold 2,969,769 shares of
   Series F redeemable convertible preferred stock for which it received gross
   proceeds of approximately $44.5 million.

   The Company had a total of 32,850,896 shares of redeemable convertible
   preferred stock outstanding, comprised of Series A, Series B, Series C-1,
   Series C-2, Series C-3, Series D-1, Series D-2, Series D-3, Series E and
   Series F, upon the closing of the Company's initial public offering.  All
   outstanding redeemable convertible preferred stock was automatically
   converted into 32,850,896 shares of common stock upon the closing of the
   initial public offering of the Company's common stock on August 2, 2000.

(D)  COMMON STOCK WARRANTS

   In connection with the term loan and master lease agreement discussed in Note
   2, the Company issued two warrants to purchase an aggregate of 275,000 shares
   of Series B to the lender.  The warrants, all of which are exercisable as of
   December 31, 2000, have an exercise price of $1.00 per share and expire
   August 2, 2003.  The deemed fair market value of these warrants using the
   Black-Scholes option pricing model prescribed by SFAS No. 123 was recorded as
   deferred financing costs and is being amortized over the life of the loans as
   interest expense.

   In connection with the initial public offering, the warrants to purchase
   275,000 shares of Series B redeemable convertible preferred stock
   automatically converted into warrants to purchase 275,000 shares of the
   Company's common stock.  As of December 31, 2000, none of the warrants have
   been exercised.

   On August 2, 2000, the Company issued a warrant to a potential customer to
   purchase 100,000 shares of the Company's common stock at $31.00 per share.
   The warrant is nonforfeitable, becomes fully exercisable in one

                                      -39-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



   year and has a term of five years. The potential customer had not purchased
   any product from the Company nor was it obligated to purchase any product or
   service from the Company as a condition to granting of the warrant.
   Accordingly, the fair value of the warrant, which was calculated using the
   Black-Scholes valuation model to be $2.4 million, has been expensed in the
   accompanying consolidated statement of operations for the year ending
   December 31, 2000.

   In December 2000, in connection with the execution of a nonexclusive systems
   and services agreement (the Agreement), the Company issued a warrant to a
   customer to purchase 850,000 shares of the Company's common stock at a per-
   share exercise price of $27.73.  The Agreement between the Company and the
   customer provides the customer with the ability, but not the obligation, to
   purchase equipment and services from the Company.  The warrant is
   nonforfeitable, becomes fully exercisable in one year and has a term of five
   years.  The fair value of the warrant was calculated using the Black-Scholes
   valuation model to be $9.8 million.  The fair value of the warrant has been
   deferred as a reduction to equity and is currently being amortized as an
   offset to gross revenue on a straight-line basis over the three-year term of
   the Agreement.  As of December 31, 2000, $816,666 has been amortized.

(E) EQUITY-BASED COMPENSATION PLANS

   In June 1997, the Company adopted the 1997 Stock Incentive Plan, which
   provides for the issuance of up to 10,776,250 shares of common stock
   incentives. In April and May 2000, an additional 5,000,000 shares were
   authorized under the Plan by the Board of Directors, increasing the total
   authorized shares under the Plan to 15,776,250.

   In May 2000, the Board of Directors approved, subject to stockholder
   approval, the 2000 Stock Option and Incentive Plan (collectively, the 1997
   Stock Incentive Plan and the 2000 Stock Option and Incentive Plan, the
   Plans).  Stockholder approval was granted on June 28, 2000.  The maximum
   number of shares with respect to which awards may be granted to any employee
   under the 2000 Stock Option and Incentive Plan shall not exceed 500,000
   shares of common stock during any calendar year.  In addition, any shares not
   yet issued under the 1997 Stock Incentive Plan on or before the date of the
   Company's initial public offering or shares subject to options outstanding on
   the date of the Company's initial public offering which have been forfeited
   or terminated will be available for issuance under the 2000 Stock Option and
   Incentive Plan.

   The Plans provide for the grant of stock-based awards to the Company's
   employees, officers, directors, consultants and advisors.  Under the Plans,
   the Company may grant options that are intended to qualify as incentive stock
   options within the meaning of Section 422 of the Internal Revenue Code,
   options not intended to qualify as incentive stock options, restricted stock
   and other stock-based awards. Incentive stock options may be granted only to
   employees of the Company.

   As of December 31, 2000, 1,255,520 shares were available for future grant.

                                      -40-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



(F) OPTION GRANTS

    Option activity under the Plans is as follows:

<TABLE>
<CAPTION>
                                                                                WEIGHTED
                                                                  RANGE OF       AVERAGE
                                                  NUMBER OF       EXERCISE      EXERCISE
                                                    SHARES         PRICES         PRICE
                                                 ------------  --------------  -----------

<S>                                              <C>           <C>             <C>
      Outstanding, December 31, 1998               1,682,850     $  0.01-2.00       $ 0.69
      Granted                                      2,572,850        2.00-4.00         3.15
      Exercised                                     (158,739)       0.10-3.00         0.70
      Forfeited                                     (127,026)       0.10-4.00         0.91
                                                  ----------     ------------       ------

      Outstanding, December 31, 1999               3,969,935        0.01-4.00         2.28
                 Granted                           8,020,150      4.00-133.00        20.61
                Exercised                         (1,085,904)      0.10-12.00         1.94
                Forfeited                           (379,671)     0.10-133.00        11.02
                                                  ----------     ------------       ------

      Outstanding, December 31, 2000              10,524,510     $0.10-133.00       $15.79
                                                  ==========     ============       ======

        Exercisable, December 31, 2000               951,984                        $ 6.94
                                                  ==========                        ======
</TABLE>
   The following table summarizes information relating to currently outstanding
   and exercisable stock options as of December 31, 2000:

<TABLE>
<CAPTION>
                                     OPTIONS OUTSTANDING
                                          WEIGHTED                               EXERCISABLE
                         --------------------------------------------   ----------------------------
                         NUMBER OF
                          SHARES
                        OUTSTANDING         AVERAGE            WEIGHTED                       WEIGHTED
                        AT DECEMBER         REMAINING          AVERAGE                        AVERAGE
          EXERCISE          31,            CONTRACTUAL         EXERCISE     NUMBER OF         EXERCISE
           PRICE           2000            LIFE (IN YEARS)      PRICE        SHARES           PRICE
           -----         -------          -----------------   --------       -------         ----------
<S>                     <C>             <C>              <C>             <C>             <C>
        $   0.01-1.00         828,219            7.18           $ 0.64         350,163          $ 0.45
            2.00-3.00         699,366            8.14             2.31         110,357            2.03
           4.00-12.00       4,215,475            8.90             5.60         378,226            4.59
          15.00-19.81       3,316,750            9.79            18.08           9,070           15.00
          25.00-40.00         895,000            9.50            28.56          83,335           28.00
         88.38-133.00         569,700            9.67            96.31          20,833           96.75
                           ----------                           ------         -------          ------

                           10,524,510                           $15.79         951,984          $ 6.94
                           ==========                           ======         =======          ======
</TABLE>
(g)  Restricted Stock Grants

   Prior to the closing of the Company's initial public offering, restricted
   stock grants were made to employees and entitled the participants to acquire
   shares of common stock subject to repurchase by the Company and/or certain
   other investors.  Shares vested over a 48-month period.  The Company was able
   to repurchase unvested shares at their original issuance cost.  Vested shares
   were subject to the right of first refusal by the Company and certain other
   investors.  Upon closing of the Company's initial public offering on August
   2, 2000, the Company's rights under restricted stock grants terminated and
   employees became 100% vested.

   During 2000 the Company provided loans to a former officer and a former
   employee in the amount of $286,031, bearing interest at 6% and 6.5%,
   respectively, to fund their purchase of an aggregate of 164,865 shares of
   restricted stock and the exercise of stock options.  The vesting of certain
   of these stock grants and options were accelerated in connection with the
   individuals' termination of employment.  Payment of the loans

                                      -41-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   was unconditional and the loans were partially secured by the personal assets
   of the individuals. As of December 31, 2000, all of the loan amounts and
   interest has been repaid. In connection with these transactions, compensation
   expense of $665,000 was recorded in the accompanying consolidated statement
   of operations for the year ending December 31, 2000.

   In fiscal 2000, the Company granted an officer the right to purchase 100,000
   shares of restricted stock and, in connection with the purchase, loaned the
   individual $2,500,000.  These shares vest over 12 months at a rate of 8.334%
   per month. The loan is non-interest-bearing with limited recourse to the
   individual and is secured by the restricted securities. The loan has a
   maturity of 10 years and is to be repaid from the proceeds of the sale of the
   related restricted securities, if such sale precedes the maturity date.  The
   full amount of the loan is outstanding at December 31, 2000 and has been
   recorded as a subscription receivable within stockholders' equity in the
   accompanying consolidated balance sheet. As a result of the limited recourse
   on this note, the Company is treating this issuance similar to a stock
   option.

(h) 2000 Employee Stock Purchase Plan

   In May 2000, the Board of Directors approved, subject to stockholder
   approval, the 2000 Employee Stock Purchase Plan.  Stockholder approval was
   granted on June 28, 2000.  A total of 750,000 shares of common stock have
   been reserved for issuance under this plan.  The 2000 Employee Stock Purchase
   Plan contains consecutive, overlapping, 24-month offering periods.  Each
   offering period includes four consecutive six-month purchase periods.
   Eligible employees may purchase common stock at a price equal to 85% of the
   lower of the fair market value of the common stock (i) at the beginning of
   the offering period or (ii) at the end of the purchase period, whichever is
   lower, with the option price at the beginning of the first offering period
   equal to 85% of the initial public offering price.  Participation is limited
   to 10% of the employees eligible compensation, not to exceed $25,000 per
   calendar year or amounts allowed by the Internal Revenue Code.  On January 1
   of each year, commencing with January 1, 2001, the aggregate number of shares
   of common stock available for purchase under the 2000 Employee Stock Purchase
   Plan will automatically increase by the number of shares necessary to cause
   the total number of shares then available for purchase to be 750,000 shares.

(I) 2000 NONEMPLOYEE DIRECTOR STOCK OPTION PLAN

   In May 2000, the Board of Directors approved, subject to stockholder
   approval, the 2000 Nonemployee Director Stock Option Plan, or Director Plan.
   Stockholder approval was granted on June 28, 2000.  A total of 400,000 shares
   of common stock have been authorized for issuance under the Director Plan.
   On January 1 of each year, commencing with January 1, 2001, the aggregate
   number of shares available for grant under the plan will automatically
   increase by the number of shares necessary to cause the total number of
   shares then available for grant to be 400,000 shares.

   The Director Plan is administered by the compensation committee.  Under the
   Director Plan, each nonemployee director who becomes a member of the Board of
   Directors after the date of the initial public offering will be automatically
   granted on the date first elected to the Board of Directors an option to
   purchase 35,000 shares of common stock, which will vest in four equal
   installments over four years.  In addition, provided that the director
   continues to serve as a member of the Board of Directors, each nonemployee
   director will be automatically granted on the date of each annual meeting of
   stockholders following his or her initial option grant date an option to
   purchase 15,000 shares of common stock, 5,000 shares of which will vest
   immediately and 10,000 shares of which will vest in four equal installments
   over four years.  The Company granted a total of 200,000 options to its
   nonemployee directors at the time of the Company's initial public offering.
   Such options vest in four equal installments over four years.

                                      -42-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)



(J) ACCOUNTING FOR STOCK-BASED COMPENSATION

   During the years ended December 31, 1999 and 2000, the Company recorded non-
   cash deferred compensation charges of approximately $10,406,000 and
   $34,665,000, respectively.  These amounts represent the aggregate difference
   between the deemed fair value of the Company's common stock and the exercise
   price of stock options and restricted stock granted and the selling price of
   stock sold.  All stock options granted and stock sold prior to 1999 were at
   fair market value, as determined by the Board of Directors, and, therefore,
   did not result in deferred compensation.  The deferred compensation will be
   recognized as an expense over the vesting period of the stock and stock
   options.  During the years ended December 31, 1999 and 2000, the Company
   recorded approximately $2,977,000 and $17,381,000, respectively, of
   compensation expense.  The Company expects to recognize compensation expense
   of approximately $13,502,000, $7,121,000, $3,261,000 and $830,000 during the
   years ended December 31, 2001, 2002, 2003 and 2004, respectively, based on
   stock and stock options issued prior to December 31, 2000.

   During 1998, 1999 and 2000, the Company issued options to consultants
   totaling 75,000, 60,000 and 14,000, respectively.  Such options generally
   vest either immediately or over three years.  The Company values these
   options using the Black-Scholes option pricing model.  The Company recorded
   stock-based compensation expense of approximately $60,000, $194,000 and
   $1,278,000 for the years ended December 31, 1998, 1999 and 2000,
   respectively, related to these options.  In accordance with Emerging Issues
   Task Force 96-18, Accounting for Equity Instruments That Are Issued to Other
   Than Nonemployees For Acquiring, or in Conjunction with Selling, Goods or
   Services, the Company will record the fair value of these options as stock-
   based compensation expense over the period the services are provided.  As of
   December 31, 2000, all of these options were 100% vested.

   SFAS No. 123 requires the measurement of the fair value of stock options or
   warrants to be included in the consolidated statement of operations or
   disclosed in the notes to the consolidated financial statements.  The Company
   has determined that it will continue to account for stock-based compensation
   for employees under APB Opinion No. 25 and will elect the disclosure-only
   alternative under SFAS No. 123, which requires disclosure of the pro forma
   effects on earnings as if the fair-value-based method of accounting under
   SFAS No. 123 had been adopted, as well as certain other information.

   The Company has computed the pro forma disclosures required under SFAS No.
   123 for stock and option grants during 1998, 1999 and 2000, using the Black-
   Scholes option pricing model prescribed by SFAS No. 123, using the following
   assumptions:

<TABLE>
<CAPTION>
                                          1998             1999             2000
                                    ----------       ----------       ----------
<S>                             <C>              <C>              <C>

      Risk-free interest rate        4.18-5.63%       4.91-6.19%       5.03-6.51%
      Expected dividend yield                -                -                -
           Expected lives            4.5 years        4.5 years        4.5 years
        Expected volatility                 80%              80%              80%
       Weighted average fair        $     0.18       $     2.08       $    13.34
      value of options granted
</TABLE>

                                      -43-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


   If compensation cost had been determined for stock and option grants to
   employees based on the provisions of SFAS No. 123, the Company's net loss and
   net loss per share for the years ended December 31, 1998, 1999 and 2000 would
   have increased to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                     1998             1999              2000
                             ------------     ------------      ------------
<S>                        <C>              <C>              <C>

      Net loss-
          As reported        $(30,117,572)    $(47,789,928)     $(84,687,400)
           Pro forma          (30,192,119)     (48,455,849)      (96,058,270)

      Basic and diluted
      net loss per share-
          As reported        $     (19.05)    $     (13.99)     $      (3.69)
           Pro forma               (19.10)          (14.18)            (4.19)
</TABLE>

   The Black-Scholes option pricing model was developed for use in estimating
   the fair value of traded options that have no vesting restrictions and are
   fully transferable.  In addition, option pricing models require the input of
   highly subjective assumptions, including expected stock price volatility.
   Because the Company's employee stock and option grants have characteristics
   significantly different from those of traded options, and because changes in
   the subjective input assumptions can materially affect the fair value
   estimate, in management's opinion, the existing models do not necessarily
   provide a reliable single measure of the fair value of its employee stock and
   option grants.

(K)  INVESTOR RIGHTS AGREEMENT

   The holders of redeemable convertible preferred stock and certain common
   stockholders have entered into an agreement to provide for certain
   arrangements with respect to the registration of their shares.  The agreement
   provides that 180 days after the Company's initial public offering, certain
   investors may require the Company to register certain shares.

(5)  COMMITMENTS

The Company has operating lease commitments for its facilities that expire in
2007.  The approximate minimum future rent payments under these leases as of
December 31, 2000, are as follows:

<TABLE>
<S>                                                    <C>
Years ending December 31,
 2001                                                           $1,479,000
 2002                                                            1,156,000
 2003                                                            1,156,000
 2004                                                            1,156,000
 2005                                                            1,065,000
 Thereafter                                                      1,784,000
                                                                ----------
     Total future minimum lease payments                        $7,796,000
                                                                ==========
</TABLE>

Rent expense included in the accompanying consolidated statements of operations
was approximately $337,000, $470,000 and $901,000 for the years ended December
31, 1998, 1999 and 2000, respectively.  In connection with its leases, the
Company had to provide letters of credit equal to approximately $291,000.  The
letters of credit are collateralized by cash of $291,000 and such amount of cash
is recorded as restricted in the accompanying consolidated balance sheet as of
December 31, 2000.

                                      -44-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(6)  PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

The Company entered into a perpetual nonexclusive license agreement with an
investor for the use of certain ideas, concepts and other intellectual property.
As consideration for the license, the Company paid the strategic investor $4.0
million.  The Company obtained an independent appraisal of this intellectual
property to assist in the allocation of the $4.0 million license payment.  Based
on this appraisal, the Company expensed the license payment as the purchase of
in-process research and development (IPR&D) in the accompanying consolidated
statement of operations for the year ending December 31, 2000.

The IPR&D is comprised of a single research and development project focusing on
certain effects of optical switching technology.  At the date of purchase, the
project was estimated to be 13% complete and continuing research and development
commitments to complete the project were expected to approximate $1.5 million.
As of December 31, 2000, the project was estimated to be 19% complete and
remaining research and development commitments were estimated to approximate
$1.4 million.

The $4.0 million value assigned to the purchased IPR&D was determined by
estimating the costs to develop the purchased technology into a commercially
viable optical application, estimating the resulting cash flows from the
application and discounting the net cash flows to their present value.  At the
date of acquisition, this project had not yet reached technological feasibility
and the IPR&D had no alternative future uses.  Revenue projections used to value
the IPR&D project are based on estimates of relevant market size and growth
factors, expected trends in technology and the nature and expected timing of new
product introductions by the Company and its competitors.

The rate used to discount the net cash flows to their present value was 35%
based on cost of capital considerations adjusted for certain risks associated
with the in-process technology.

(7)  EMPLOYEE BENEFIT PLAN

The Company has a 401(k) Plan that provides for eligible employees to make
contributions on a tax-deferred basis.  All employees on the first day of the
month following their date of employment are eligible to participate in the
401(k) Plan.  Contributions are limited to 15% of their annual compensation, as
defined, subject to certain IRS limitations.  The Company may contribute to the
Plan at its discretion.  No employer contributions were made for all periods
presented.

(8)  TECHNOLOGY ASSISTANCE AND DISTRIBUTION AGREEMENTS

The Company entered into a technology assistance agreement with a holder of
redeemable convertible preferred stock for assistance with its product-
development program.  The Company initially agreed to pay the stockholder a
total of $5,150,000 for the assistance.  During 1998, the Company expanded the
scope of the technology assistance agreement.  Through 1999, the Company
expensed as research and development approximately $9,902,000, all of which had
been paid.

The Company also had a distribution agreement with this stockholder.  The
distribution agreement established guidelines as to how both companies will work
together once the Company's product is commercialized.

In August 1999, the Company and this stockholder entered into a termination
agreement.  This agreement provides for the termination of the technology
assistance agreement, the distribution agreement and a technology license
agreement.

                                      -45-
<PAGE>

                      AVICI SYSTEMS INC. AND SUBSIDIARIES
                               DECEMBER 31, 2000
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(9)  ACCRUED EXPENSES

Accrued expenses at December 31, 1999 and 2000 consists of the following:

<TABLE>
<CAPTION>
                                                  December 31,
                                          --------------------------------
                                                1999                 2000
                                          ----------           ----------
<S>                              <C>                  <C>

Payroll and payroll-related               $  815,719           $3,338,423
Other                                        184,298            3,801,825
                                          ----------           ----------

                                          $1,000,017           $7,140,248
                                          ==========           ==========
</TABLE>
(10) Selected Quarterly Financial Data (Unaudited)

CONSOLIDATED STATEMENT OF OPERATIONS DATA (IN THOUSANDS)

<TABLE>
<CAPTION>
                                            MARCH 31,                JUNE 30,         SEPTEMBER 30,       DECEMBER 31, 2000
                                              2000                    2000              2000                   2000
                                              ----                    ----              -----                  ----
<S>                                  <C>                 <C>                 <C>                     <C>

Net revenue                                   $    504            $  2,217                $  4,356              $  7,993
                                              ========            ========                ========              ========

Gross profit                                  $     75            $    418                $  1,219              $  2,201
                                              ========            ========                ========              ========

Net loss                                      $(16,680)           $(25,958)               $(23,644)             $(18,405)
                                              ========            ========                ========              ========

Basic and diluted net loss per                $  (3.68)           $  (5.11)               $  (0.70)             $  (0.38)
 share                                        ========            ========                ========              ========

<CAPTION>

                                            MARCH 31,                JUNE 30,         SEPTEMBER 30,       DECEMBER 31, 2000
                                              2000                    2000              2000                   2000
                                              ----                    ----              -----                  ----
<S>                                  <C>                 <C>                 <C>                     <C>


Net revenue                                   $  -                $  -                  $  -                   $  -
                                              ========            ========                ========              ========

Gross profit                                  $  -                $  -                  $  -                   $  -
                                              ========            ========                ========              ========

Net loss                                      $(10,035)           $(10,420)               $(10,192)             $(17,143)
                                              ========            ========                ========              ========

Basic and diluted net loss per
 share                                        $  (3.61)           $  (3.24)               $  (2.80)             $  (4.25)
                                              ========            ========                ========              ========
</TABLE>

                                      -46-
<PAGE>

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

      None.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      The information required by this Item 10 is incorporated herein by
reference to our Definitive Proxy Statement with respect to our 2001 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
not later than 120 days after the end of the fiscal year.

ITEM 11.  EXECUTIVE COMPENSATION

      The information required by this Item 11 is incorporated herein by
reference to our Definitive Proxy Statement with respect to our 2001 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
not later than 120 days after the end of the fiscal year.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      The information required by this Item 12 is incorporated herein by
reference to our Definitive Proxy Statement with respect to our 2001 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
not later than 120 days after the end of the fiscal year.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      The information required by this Item 13 is incorporated herein by
reference to our Definitive Proxy Statement with respect to our 2001 Annual
Meeting of Stockholders to be filed with the Securities and Exchange Commission
not later than 120 days after the end of the fiscal year.

                                      -47-
<PAGE>

                                    PART IV

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

(a)       The following documents are filed as a part of this Form 10-K:

     1.   All Financial Statements. (see "Consolidated Financial Statements and
Supplementary Data" at Item 8 and incorporated herein by reference).

  2.  Financial Statement Schedules.  (Schedules to the Financial Statements
have been omitted because the information required to be set forth therein is
not applicable or is shown in the accompanying Consolidated Financial Statements
or notes thereto).

  3.    Exhibits
        --------

  The following exhibits are filed as part of and incorporated by reference into
this Form 10-K:

<TABLE>
<CAPTION>

EXHIBIT NUMBER                                 DESCRIPTION OF DOCUMENT
---------------                                ------------------------


<C>              <S>
            3.1  Fourth Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.2
                 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
                 herein by reference)
            3.2  Amended and Restated By-Laws of the Registrant (previously filed as Exhibit 3.4 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
            4.1  Specimen certificate representing the Registrant's Common Stock (previously filed as
                 Exhibit 4.1 to our Registration Statement on Form S-1 (File No. 333-37316), which is
                 incorporated herein by reference)
          10.1*  1997 Stock Incentive Plan (previously filed as Exhibit 10.1 to our Registration Statement
                 on Form S-1 (File No. 333-37316), which is incorporated herein by reference)
          10.2*  2000 Stock Option and Incentive Plan (previously filed as Exhibit 10.2 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
          10.3*  2000 Employee Stock Purchase Plan, as amended on December 20, 2000
          10.4*  2000 Non-Employee Director Stock Option Plan (previously filed as Exhibit 10.4 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
           10.5  Fifth Amended and Restated Investor Rights Agreement, by and among the registrant and the
                 Investors and Founders listed therein, dated as of April 24, 2000, as amended (previously
                 filed as Exhibit 10.5 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
           10.6  Omnibus Agreement, dated August 26, 1999, between the Registrant and Nortel Networks Inc.
                 (previously filed as Exhibit 10.6 to our Registration Statement on Form S-1 (File No.
                 333-37316), which is incorporated herein by reference)
           10.7  Lease, dated June 2, 1998, between the Registrant and Y-CEE Investment Trust, as amended
                 (previously filed as Exhibit 10.7 to our Registration Statement on Form S-1 (File No.
                 333-37316), which is incorporated herein by reference)
           10.8  EMC Module Supply Agreement, dated May 1999, between the Registrant and Nortel Networks
                 Inc. (previously filed as Exhibit 10.8 to our Registration Statement on Form S-1 (File
                 No. 333-37316), which is incorporated herein by reference)
          10.9+  Procurement Agreement, dated May 17, 2000, between the Registrant and Williams
                 Communications, Inc. (previously filed as Exhibit 10.9 to our Registration Statement on
                 Form S-1 (File No. 333-37316), which is incorporated herein by reference),
         10.10*  Offer letter, dated December 1, 1998, from the registrant to Brian McCormack (previously

</TABLE>

                                      -48-
<PAGE>

<TABLE>
<C>            <S>
                 filed as Exhibit 10.10 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
         10.11*  Offer letter, dated January 13, 2000, from the Registrant to Paul F. Brauneis (previously
                 filed as Exhibit 10.11 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
          10.12  Lease, dated June 8, 2000, between the Registrant and Yvon Cormier, Trustee of Y-C
                 Investment Trust V (previously filed as Exhibit 10.12 to our Registration Statement on
                 Form S-1 (File No. 333-37316), which is incorporated herein by reference)
         10.13*  Offer letter, dated July 27, 2000 between the Registrant and Steven B. Kaufman
                 (previously filed as Exhibit 10.1 to our Form 10-Q for the quarterly period ended
                 September 30, 2000 filed with the Commission on November 13, 2000, which is incorporated
                 herein by reference)
          10.14  Lease, dated August 2, 2000, between the Registrant and Y-CEE Investment Trust
                 (previously filed as Exhibit 10.2 to our Form 10-Q for the quarterly period ended
                 September 30, 2000 filed with the Commission on November 13, 2000, which is incorporated
                 herein by reference)
           21.1  Subsidiaries of the Company
           23.1  Consent of Arthur Andersen LLP
           24.1  Power of Attorney (included as part of the signature page of this Report)
</TABLE>

* Indicates a management contract or any compensatory plan, contract or
arrangement

+ Confidential treatment granted for certain portions of this Exhibit pursuant
to Rule 406 promulgated under the Securities Act, which portions are omitted and
filed separately with the Securities and Exchange Commission

(b)  Reports on Form 8-K

We filed a current report on Form 8-K dated December 21, 2000 to report under
Item 5 the announcement of the execution of the procurement agreement with AT&T
Corporation ("AT&T") and the issuance of a warrant to AT&T to purchase 850,000
shares of the Company's common stock.

                                      -49-
<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.


                              AVICI SYSTEMS INC.
Date: March 29, 2001

                              By:  /s/ Paul F. Brauneis
                                   --------------------
                                 Paul F. Brauneis
                                 Chief Financial Officer and Treasurer


                        POWER OF ATTORNEY AND SIGNATURES

     We, the undersigned officers and directors of Avici Systems Inc., hereby
severally constitute and appoint Paul F. Brauneis, our true and lawful attorney,
with full power to him, to sign for us in our names in the capacities indicated
below, any amendments to this Annual Report on Form 10-K (including post-
effective amendments), and to file the same, with all exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
and generally to do all things in our names and on our behalf in our capacities
as officers and directors to enable Avici Systems Inc., to comply with the
provisions of the Securities Act of 1933, as amended, hereby ratifying and
confirming our signatures as they may be signed by our said attorneys, or any of
them, to said Annual Report and all amendments thereto.

     Pursuant to the requirements of the Securities Act of 1933, this Annual
Report on Form 10-K has been signed by the following persons in the capacities
and on the date indicated.

<TABLE>
<CAPTION>
            SIGNATURE                                     TITLE
<S>                                <C>                                                  <C>

/s/ Surya R. Panditi               Chief Executive Officer, Co-Chairman and Director      Date: March 29, 2001
---------------------------------  (principal executive officer)
Surya R. Panditi

/s/ Steven B. Kaufman              President, Chief Operating Officer and Director        Date: March 29, 2001
---------------------------------
Steven B. Kaufman

/s/ Paul F. Brauneis               Chief Financial Officer, Treasurer and Secretary       Date: March 29, 2001
---------------------------------  (principal financial officer and principal
Paul F. Brauneis                   accounting officer)


/s/ James R. Swartz                Co-Chairman and Director                               Date: March 29, 2001
---------------------------------
James R. Swartz

/s/ Stephen M. Diamond             Director                                               Date: March 29, 2001
---------------------------------
Stephen M. Diamond

/s/ Catherine M. Hapka             Director                                               Date: March 29, 2001
---------------------------------
Catherine M. Hapka

/s/ Richard T. Liebhaber           Director                                               Date: March 29, 2001
---------------------------------
Richard T. Liebhaber

/s/ James Mongiello                Director                                               Date: March 29, 2001
---------------------------------
James Mongiello

/s/ Henry Zannini                  Director                                               Date: March 29, 2001
---------------------------------
Henry Zannini
</TABLE>

                                      -50-
<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT NUMBER                                   DESCRIPTION OF DOCUMENT
---------------                                  -----------------------


<C>              <S>
            3.1  Fourth Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.2
                 to our Registration Statement on Form S-1 (File No. 333-37316), which is incorporated
                 herein by reference)
            3.2  Amended and Restated By-Laws of the Registrant (previously filed as Exhibit 3.4 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
            4.1  Specimen certificate representing the Registrant's Common Stock (previously filed as
                 Exhibit 4.1 to our Registration Statement on Form S-1 (File No. 333-37316), which is
                 incorporated herein by reference)
          10.1*  1997 Stock Incentive Plan (previously filed as Exhibit 10.1 to our Registration Statement
                 on Form S-1 (File No. 333-37316), which is incorporated herein by reference)
          10.2*  2000 Stock Option and Incentive Plan (previously filed as Exhibit 10.2 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
          10.3*  2000 Employee Stock Purchase Plan, as amended on December 20, 2000
          10.4*  2000 Non-Employee Director Stock Option Plan (previously filed as Exhibit 10.4 to our
                 Registration Statement on Form S-1 (File No. 333-37316), which is incorporated herein by
                 reference)
           10.5  Fifth Amended and Restated Investor Rights Agreement, by and among the registrant and the
                 Investors and Founders listed therein, dated as of April 24, 2000, as amended (previously
                 filed as Exhibit 10.5 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
           10.6  Omnibus Agreement, dated August 26, 1999, between the Registrant and Nortel Networks Inc.
                 (previously filed as Exhibit 10.6 to our Registration Statement on Form S-1 (File No.
                 333-37316), which is incorporated herein by reference)
           10.7  Lease, dated June 2, 1998, between the Registrant and Y-CEE Investment Trust, as amended
                 (previously filed as Exhibit 10.7 to our Registration Statement on Form S-1 (File No.
                 333-37316), which is incorporated herein by reference)
           10.8  EMC Module Supply Agreement, dated May 1999, between the Registrant and Nortel Networks
                 Inc. (previously filed as Exhibit 10.8 to our Registration Statement on Form S-1 (File
                 No. 333-37316), which is incorporated herein by reference)
          10.9+  Procurement Agreement, dated May 17, 2000, between the Registrant and Williams
                 Communications, Inc. (previously filed as Exhibit 10.9 to our Registration Statement on
                 Form S-1 (File No. 333-37316), which is incorporated herein by reference),
         10.10*  Offer letter, dated December 1, 1998, from the registrant to Brian McCormack (previously
                 filed as Exhibit 10.10 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
         10.11*  Offer letter, dated January 13, 2000, from the Registrant to Paul F. Brauneis (previously
                 filed as Exhibit 10.11 to our Registration Statement on Form S-1 (File No. 333-37316),
                 which is incorporated herein by reference)
          10.12  Lease, dated June 8, 2000, between the Registrant and Yvon Cormier, Trustee of Y-C
                 Investment Trust V (previously filed as Exhibit 10.12 to our Registration Statement on
                 Form S-1 (File No. 333-37316), which is incorporated herein by reference)
         10.13*  Offer letter, dated July 27, 2000 between the Registrant and Steven B. Kaufman
                 (previously filed as Exhibit 10.1 to our Form 10-Q for the quarterly period ended
                 September 30, 2000 filed with the Commission on November 13, 2000, which is incorporated
                 herein by reference)
          10.14  Lease, dated August 2, 2000, between the Registrant and Y-CEE Investment Trust
                 (previously filed as Exhibit 10.2 to our Form 10-Q for the quarterly period ended
                 September 30, 2000 filed with the Commission on November 13, 2000, which is
</TABLE>
<PAGE>

<TABLE>
<C>              <S>
                 incorporated herein by reference)
           21.1  Subsidiaries of the Company
           23.1  Consent of Arthur Andersen LLP
           24.1  Power of Attorney (included as part of the signature page of this Report)
</TABLE>

* Indicates a management contract or any compensatory plan, contract or
arrangement

+ Confidential treatment granted for certain portions of this Exhibit pursuant
to Rule 406 promulgated under the Securities Act, which portions are omitted and
filed separately with the Securities and Exchange Commission